BACKGROUND AND PURPOSE
Municipal securities are varied and range from tax-supported bonds issued by general purpose governments to fund projects for essential services to bonds issued by industrial development authorities that loan the bond proceeds to private companies where repayment depends on the private company.
Multiple forces provide impetus for changes in the municipal sector: the momentum of Dodd-Frank legislation, the decline of bond insurance and other enhancements (which have emphasized the need to scrutinize underlying credits), and long-term structural issues that predated the financial crisis (e.g. pension and other legacy costs). Thus, certain problems were created by the financial crisis and others have been highlighted by the crisis.
In May 2010, the U.S. Securities and Exchange Commission (SEC) announced an effort to review the municipal market. Field hearings were held in 2010 and 2011. Ultimately, SEC staff will prepare a report including recommendations that may include rulemaking, changes in 'best practices,' or legislation. This article focuses on potential recommendations from such report, which as of July 6, 2012, had not been issued. One recurring strand in discussions among regulators and market professionals is that the corporate sector may provide guidance for changes in the municipal sector.
COMPARISON BETWEEN MUNICIPAL AND CORPORATE SECTORS
The general anti-fraud provisions of Rule 10b-5, which was issued pursuant to the Securities Exchange Act of 1934, as amended (the 1934 Act), also apply to the municipal sector. Municipal securities transactions rarely involve registration under the Securities Act of 1933, as amended (the 1933 Act). Municipal issuers are not subject to the periodic reporting requirements under the 1934 Act. However, issuers and certain other obligated persons are subject indirectly to certain continuing disclosure requirements under Rule 15c2-12 issued pursuant to the 1934 Act. Municipal disclosure is not subject to the technical details and specificity required in various SEC corporate filings. Specific content is shaped primarily by market expectations and Rule10b-5 anti-fraud concerns.
During the field hearings, Commissioner Walter addressed the corporate sector. She stated that the municipal securities market "lacks many of the protections customary in many other sectors of the U.S. capital markets"; referred to "the 'second class' treatment of municipal securities investors"; and stated that, "I believe that we can learn from the corporate world, but it is also essential that we recognize the differences in the municipal and corporate finance worlds and that we work together to evaluate what an appropriate framework for municipal finance disclosure should be in the future."
Five potential developments from the SEC's expected report are discussed below. These represent judgments based on issues raised in the field hearings and comments from professional trade organizations.
AGE OF FINANCIAL STATEMENTS
Market participants frequently comment on the age of financial statements. Due to timing, a number of local governmental issuers will offer bonds in official statements containing audited financial statements that are as of a date between 12-18 months prior to the date of the official statement. In these official statements, there often are no interim financial statements included. Regulatory guidance that borrows from the timeliness and age of financial statements provisions of Regulation S-X (which addresses various requirements for financial statements relevant to the 1933 and 1934 Acts and that generally require interim financial statements as of a date within 135 days of the relevant filing) might be a development.
Continuing disclosure related to municipal securities is roughly analogous to periodic reporting for public companies under the 1934 Act. Certain annual information and notices of events are required to be filed with the Municipal Securities Rulemaking Board (the MSRB). However, there is not a parallel municipal provision to quarterly
reporting pursuant to Form 10-Q. Future amendments to Rule 15c2-12 or other guidance may address quarterly or other interim disclosures in the municipal sector. In 2010, the SEC adopted amendments to Rule 15c2-12 that require that material event notices be submitted within 10 business days of occurrence of the event. In its May 2010 adopting release (Release No. 34-62184A: File No. S7-15-09), the SEC referenced the four business days requirement for Form 8-K filings for context. Form 8-K is the form utilized by publicly traded companies to disclose material events. Form 8-K may provide a reference for future changes. For example, direct bank loans have been used increasingly in lieu of public bond offerings. Concerns have been voiced about disclosing these loans which are mostly in privately placed transactions without disclosure documents. Currently, Rule 15c2-12 does not have a listed event that would pick up these transactions. However, required disclosures under Form 8-K provide an analogous event — the creation of a direct financial obligation that is material to the registrant.
"The SEC might provide a formal safe harbor for forward looking statements in the municipal securities area ... "
RISK FACTORS DISCLOSURE
"Risk Factors" disclosures are already used somewhat for certain municipal securities revenue bonds. These sections tend to be toward the middle of the offering document rather than following a summary section or the cover page/ pricing section as is the case in corporate offerings under the 1933 Act. If keeping with the general practice of not mandating specific types of disclosures, guidance in this area would likely be more principles based and less likely to give specific municipal sector risk factor examples as is done in Item 503 of Regulation S-K, which regulation governs the risk disclosure for public companies (e.g., lack of operating history, lack of profitable operations).
FORWARD LOOKING STATEMENTS
Given recent developments focusing on pension and other post-employment benefit costs and on projections and fiscal sustainability (see the Governmental Accounting Standards Board's Preliminary Views, dated November 29, 2011, on major issues related to Economic Condition Reporting: Financial Projections), the SEC might provide a formal safe harbor for forward looking statements in the municipal securities area. The statutory safe harbors for forward looking statements provided by Section 27A of the 1933 Act and Section 21E of the 1934 Act in the corporate context are not applicable in the municipal context. Related to this development, the SEC might provide guidance regarding the appropriate use of disclaimers in terms of interim and unaudited information.
Last, and least likely to emerge, would be registration similar to registration under the 1933 Act. Registration might selectively be applied to industrial development bond (IDB) financings, which are effectively corporate financings given differences in default experiences (i.e., the traditional general purpose government tax supported bonds have a historically lower default rate experience). Moreover, the interposition of a municipal issuer (which in the IDB context usually has a very limited role beyond being a conduit for tax-exemption) is not particularly relevant to whether there is adequate protection for investors. However, necessary legislative changes (i.e., changes to the Tower Amendment dating back to the 1970s) and the anticipated administrative burdens on the SEC and municipal issuers make registration less likely.
While further proposals in the municipal securities markets are anticipated on the heels of recent rulemaking and proposals, much remains to be seen. A dramatic convergence toward the corporate sector is unlikely, but the corporate sector may be a source directly or by analogy for some of these proposals. It may also provide a lens to understand municipal developments.www.cozen.com
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