On March 1, 2017, the Securities and Exchange Commission (SEC) issued Release No. 34-80130 (the Release) proposing several amendments to its Rule 15c2-12 (the Rule) that would add two new events to the list of events that must be included in the continuing disclosure undertakings of municipal issuers or obligors (Borrowers) of municipal bonds. These 2 new events are:

1. The incurrence of “financial obligations, if material, or agreeing to covenants or other provisions that affect security holders, if material,” and
2. The occurrence of one or more of the following events under the terms of such a financial obligation: “default, event of acceleration, termination event, modification of terms or other similar events under the terms of a financial obligation of the obligated person,” if the event reflects financial difficulties.

The SEC has yet to respond to the comments received on the proposed changes to the Rule and has a variety of alternatives from taking no action on the rule change, implementing the rule as proposed, or adopting the rule with various modifications. Given the increasing call for greater transparency in the municipal securities industry, but without firm guidance on the “materiality question” discussed below, the best action during this waiting period is simply to prepare for change. Following are some strategies for participants in the municipal market to address the challenges posed by the proposed amendments.

A Review of the Proposed Amendments

Scope of “financial obligations” that must be disclosed. The clear focus of the Release and the proposed amendments to the Rule is provision of continuing disclosure relating to direct placements of debt obligations, but the scope of the proposed financial obligations that would have to be disclosed is significantly broader than that. The term “financial obligation” is defined in the Release to include a “(i) debt obligation, (ii) lease, (iii) guarantee, (iv) derivative instrument, or (v) monetary obligation resulting from a judicial, administrative, or arbitration proceeding.”  These terms are interpreted broadly in the Release.

For example, the Release provides that the term “lease” is intended to include an operating lease or a capital lease, while a “guarantee” is intended to capture a contingent financial obligation of the issuer or obligor to secure the obligations of a third party or of the issuer or obligor itself. Thus, an extremely wide range of obligations, if material, would need to be disclosed on the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access (EMMA) website by Borrowers if the amendments are adopted, as proposed.

Impact of “materiality” qualifier. A second area of concern is the use of materiality to qualify those events that must be disclosed. This qualification ideally would limit the amount of disclosure that must be provided only to events where there is a substantial likelihood that a reasonable investor would consider such information important in making an investment decision, based on the Basic v. Levinson standard of materiality. However, as was evidenced by the SEC’s recent Municipal Securities Disclosure Cooperation (MCDC) initiative, there is a lack of clear guidance regarding what is material to an investor in the municipal market, leading to a conservative view of materiality and what one market participant has termed “hyper disclosure.”

Determining which events are “material” to a reasonable investor could be difficult and, if the SEC does not later concur with the Borrower’s analysis, the consequences can be severe. Use of the materiality standard (without further guidance) to qualify the events that must be disclosed gives rise to the concern that Borrowers will be required to provide detailed summaries of their direct placements, leases, swaps, for example, or to post in full redacted copies of the underlying documentation, in order to comply with the amended Rule.

Preparing for Change

As described above, the amendments to the Rule as they are currently proposed could have a significant impact on the municipal market, especially upon Borrowers, but also on broker-dealers. Below are several actions that Borrowers and broker-dealers may wish to consider undertaking in response to the Release and Rule.

• Review Current Arrangements and Disclosure Policies. If the proposed amendments to the Rule are adopted, Borrowers will need to be prepared to gather and disseminate a considerably wider scope of information regarding their financial obligations than is currently the case. We recommend that Borrowers review their existing disclosure undertakings and policies and consider what modifications may be necessary to comply with the Rule as amended.
• Review Processes and Procedures for Event Notifications. Because of the potentially broad scope, the person responsible for filing event notices with EMMA will need to develop processes and procedures for becoming aware of these additional events in a timely manner, evaluating whether they are material or reflect financial difficulties, and preparing and filing the required notices, generally within 10 business days of the occurrence of the event. It seems likely that the most important and difficult element of this new, wider inquiry will be setting up processes to ensure that the designated person receives timely notice of the new events that must be disclosed.
• Revise Due Diligence Processes. Similarly, broker-dealers will need to revise their due diligence processes to devise methods of determining whether any of the new listed events have occurred and, if so, whether they were material or reflect financial difficulties and, if so, were adequately and timely reported to EMMA.
• Consider Disclosure Standards Under Federal Securities Laws and What Must Be Included in an Events Notice. Another critical element that must be borne in mind by Borrowers is that the requirements of Rule 10b-5, which requires that disclosure be accurate and complete, will apply to each of the event filings. Simply filing a notice with EMMA that a certain event has occurred may not be sufficient, even if such a notice meets the requirements of the applicable continuing disclosure undertaking. Because many of the new proposed events require a certain degree of analysis and context to determine whether they are material or reflect financial difficulties, additional disclosure necessary to provide the context of such a determination is likely to be necessary. Disclosure filed with EMMA is subject to the 10b-5 standard and therefore cannot contain any untrue statement of a material fact or omit to state any material fact necessary to make the statements therein, in light of the circumstances under which it was made, misleading.

What Resources Are Available to Learn More?

The SEC’s proposed amendments to the Rule are substantial and could have wide-ranging implications for Borrowers’ disclosure practices. We recommend that Borrowers examine their current disclosure practices and procedures to ensure that they are ready and able to comply with the Rule if and when it is amended. Additional information on the Release and the Rule, is available in the March 2017 client alert and the May 2017 webinar recording.