In this second installment of a two-part series, David Dubrow and Kent Hiteshew propose reforms to improve disclosure standards in the municipal bond market, exploring both legislative and regulatory approaches. They outline eight key guidelines for enhancing transparency and consistency in municipal offering statements, aiming to bring these disclosures into the modern era and better protect investors.
Part one recounted the history of how the municipal bond market was exempted from regulation under the Securities Acts adopted in the 1930s and how the SEC, beginning in the 1970s, used its anti-fraud powers over broker-dealers to partially overcome the statutory exemption. Notwithstanding these efforts, municipal bond disclosure remains ungoverned by uniform disclosure standards.
As noted in Part one, the only two major municipal regulation efforts followed significant market failures: the 1975 Amendments and creation of the MSRB following New York City’s financial crisis; and, Rule 15c2-12 following the WPPSS default in the 1980s. So, it is particularly noteworthy that there has been virtually no relevant federal legislation enacted or SEC regulations issued in the wake of the far larger investor losses experienced by municipal investors after the historic Detroit and Puerto Rico bankruptcies of the last decade. In fact, with the exception of a single broker-dealer affiliate’s closed-end bond funds, there have been virtually no SEC enforcement actions brought against any of the Detroit or Puerto Rico parties. Accordingly, it may be an appropriate time to revisit the unique exemption from uniform disclosure standards of the Securities Acts that continues to plague the municipal bond market.
There are two potential approaches to making municipal offering statements subject to improved disclosure standards. If Congress were to repeal the Tower Amendment and amend the Securities Acts, the SEC and MSRB could directly regulate offering statements by setting forth specified disclosure requirements. The second approach would expand the SEC/MSRB anti-fraud regulatory authority over broker-dealers to include specified disclosure requirements within its existing Rule 15c2-12. To be clear, we are not advocating to subject municipal issuers to pre-sale registration and SEC filing. Given the number of municipal issuers and volume of issuance, this would be extremely disruptive. Furthermore, it is not clear that such pre-sale registration would represent a meaningful benefit in light of relatively low municipal default rates and existing disclosure regimes created by Rule 15c2-12.
Our preferred statutory approach would have the advantage of creating a regulatory scheme with consistent disclosure standards. Statutory authority would remove broker-dealers as the SEC/MSRB’s surrogate, providing the SEC with the authority to enforce issuer compliance with both offering statements standards and CDA reporting obligations. In addition, in setting broad disclosure standards, Congress could direct the SEC to differentiate among different classes of municipal issuers. For example, conduit borrowers should be treated more akin to the corporate-like issuers they truly represent and subjected to more rigorous standards consistent with their much higher default experience. In addition, small, infrequent governmental issuers might be afforded more abbreviated standards than larger, regular governmental issuers.
Of course, bi-partisan Congressional support for such reform will be very difficult to achieve, especially in the face of anticipated strong municipal issuer resistance. Such opposition would be unfortunate and shortsighted as uniform disclosure standards would translate to improved liquidity and secondary market pricing. This should ultimately lower borrowing costs for state and local governments.
The indirect regulatory approach is less certain. First, there is reason to believe the SEC may have exhausted the few tools that it has to protect municipal securities investors, which include: (1) sending messages to the market by enforcement actions (always a blunt instrument); (2) providing guidance through interpretive releases; and (3) imposing antifraud rules (Rule 15c2-12) on the only entities in the municipal market over which the SEC has jurisdiction, namely, municipal broker -dealers. The SEC “Staff White Paper to Congress” from 2007 noted that “…the Commission is near to the statutory limits of its present authority to address the needs of investors in municipal securities…”. Translated, the SEC staff believed that using its Rule 15c2-12 regulatory authority over municipal broker-dealers to indirectly further improve disclosure could be beyond its statutory authority. Second, issuer groups may be expected to use the Tower Amendment to legally challenge the SEC’s regulatory powers, especially in the post-Chevron judicial environment. Nevertheless, absent Congressional action, we believe the SEC should revisit expansion of Rule 15c2-12 to prescribe uniform disclosure standards for primary offerings beyond the rudimentary materiality standard.
Under either legal path the following guidelines should be considered:
1. All offering statements would be required to be written in plain English without extensive quoting of underlying legal documents. Offering statements are read by rating analysts, retail investors, institutional credit analysts and municipal brokers, among others. While these parties have a range of sophistication, all have a need to understand such things as the basic financial terms and security provisions of the bonds, the flow of revenue supporting the bonds, events of default and rights of bondholders under such circumstances. It is critical that these matters be disclosed in a manner that can be easily comprehended by all market participants and potential purchasers of bonds in the primary and secondary markets.
2. All offering statements would have to include executive summaries in plain English. Disclosure documents benefit greatly from clear executive summaries at the beginning of the document. These summaries provide the investor with the essentials of the bonds and serve as a preview of the more expanded disclosure in the body of the offering.
3. All offering statements would be required to include a “risks” section that summarizes all of the key credit and market risks to investors. While the inclusion of such sections has become more common in recent years, particularly in the high yield sector, many higher-grade issuers and their advisors continue to believe that the totality of their disclosure addresses investor risks without the need for a specific description of such risks. And even where such risk sections are included, they are often so over-inclusive as to render the information unhelpful to investors in evaluating the issue’s material risks.
4. Governmental issuers (as opposed to conduit borrowers) would be required to disclose:
- two years of their most recent audited financial statements;
- unaudited quarterly financials for the most recent stub period;
- a summary of material financial trends over the prior five years; and
- material factors that will likely impact future revenues and expenses.
5. All issuers would be required to report their audited annual financial results on a U.S. Generally Accepted Accounting Principles (GAAP) basis. Although modified accrual GAAP accounting is recommended by the Government Finance Officers Association (GFOA) and other municipal market practitioners, it is not the uniform industry standard, especially among smaller issuers and conduit borrowers. The use of cash accounting makes it difficult for analysts to truly measure the financial condition of issuers on a consistent and comparative basis.
6. For issuers that operate defined benefit pension plans, offering statements would have to include annual payment projections under one or more assumption scenarios. While GASB Rules 67/68 released in 2012 dramatically improved pension risk disclosure, the required net present value liability measurement does not adequately illustrate the long-term annual budget impact of such liability compared to the annual debt service of an issuer’s debt obligations. While it is true that debt service obligations are fixed compared to annual pension payments that vary based on actual future events, this does not justify abandoning any effort to provide a range of such payment scenarios so that investors can properly measure their risk of repayment relative to a major competing long-term liability. Especially in light of the favorable treatment of pension liabilities vis a vis bond obligations in recent high-profile municipal bankruptcy cases, more transparent disclosure by issuers of such liabilities is warranted. In the current market, competing pension liabilities are widely viewed as one of the greatest credit risks to municipal investors.
7. Offering statements for conduit issuances would be subject to the same substantive disclosure requirements as there would be if the underlying borrower were to issue its own securities outside of the exemptions of the municipal market. This would establish clear disclosure requirements for conduit deals and would discourage use of the municipal market to circumvent the more fulsome disclosure process otherwise imposed by the Securities Acts.
8. Appraisal and expert reports included in offering statements could not be pre-reviewed by the borrower. Too often, conduit borrowers’ pre-existing relationships with such appraisers and experts encourages them to produce a particular result and perspective in their reports. Instead, these professionals should receive information from borrowers, independently verify such information, collect their own information and write their reports independently of any borrower review or input. And if a borrower rejects using any such report in an offering statement in favor of a different expert’s report, that fact should be disclosed.
For too long, municipal securities investors have not had the benefit of a comprehensive approach to meaningful disclosure. We believe all market participants, including issuers, financial advisors, and broker-dealers should work together to bring municipal securities disclosure into the modern era by supporting requirements for uniform core elements of responsible disclosure. The specific standards to which municipal securities offering statements should be governed are certainly open to discussion and debate. But regardless of the particular details, improved municipal disclosure would benefit all market participants. Our market has become too big and important to continue to pretend the disclosure standards of more than half a century ago remain appropriate for the challenges of the 21st century. Let’s work together in our common interest.
Author disclosure: David Dubrow advises in his capacity as a partner in ArentFox Schiff on matters related to municipal bonds and tax-exempt bond financing including work on public pensions, bond workouts and municipal bankruptcy.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
