SEC's Disclosure Doctrine

CHICAGO - Municipal issuers must file material event notices when the ratings on their bonds are downgraded, even if credit rating agencies don't formally notify them that their bonds' ratings have changed, a Securities and Exchange Commission enforcement attorney said yesterday.

The issue has been a thorn in the sides of some issuer officials who feel it is unreasonable to expect state and local governments to file material event notices when the ratings on their credit-enhanced bonds are downgraded because the ratings of the insurers that backed their bonds have been lowered. While rating agencies do not contact issuers who have been affected by their downgrades directly, they do list bonds affected by their actions on their Web sites.

Members of the Government Finance Officers Association, among other market participants, have complained that the SEC's Rule 15c2-12 on disclosure places an impossible burden on issuers in such circumstances because they do not know of a single issuer that has been formally notified by either a credit rating agency or an insurer that its bonds have been downgraded in such situations.

But Mark Zehner, the SEC's Philadelphia-based regional municipal securities counsel, told bond attorneys gathered here yesterday that no issuer should allow disparities in disclosure that might enable some investors to profit from selling off their inventory of a security that they know has been downgraded while the rest of the market does not.

"It's an unusual situation. I hope it never happens, but let's face reality, that's the type of gamesmanship that happens out there," Zehner said, speaking on a "hot topics in securities law panel" at the National Association of Bond Lawyers' Bond Attorneys' Workshop here. "It all comes back to the issuer not providing timely notice to the marketplace."

Under 15c2-12, a dealer may not underwrite munis unless the issuer of the bonds has contractually agreed to disclose to nationally-recognized repositories financial and operating information at least annually, as well as the occurrence of any of 11 specified material events, such as rating changes, bond calls, and adverse tax opinions or events affecting the tax-exempt status of the bonds.

Alexandra MacLennan, a partner at Squire, Sanders & Dempsey LLP in Tampa who was also on the panel, said she didn't entirely disagree with Zehner, but noted that an issuer must first know that a material event has occurred in order to disclose it.

"If they're not aware of those rating changes, they can't be under an obligation to disclose them," she said.

Asked if he believed that the market benefited at all from the flurry of material event notices issuers have filed in the past year stemming from the downgrades to bond insurers, Zehner paused for a few seconds and said, "Yes," drawing laughs from the roughly 60 attorneys in attendance, some of whom characterized such material event notices as "gratuitous."

But Zehner stressed that "one of the things that this marketplace needs is greater transparency."

"Did 95% of [the notices] make a difference? Probably not. But did 5% make a difference? Probably," he said. "I'm making those percentages up obviously, but I do think that timely disclosure of material information with respect to securities assists the marketplace."

Zehner added that issuers that purchased credit ratings should have some ability to influence the rating agencies to disclose the changes to them. "If you're the one paying for it, then you have some control over that situation," he said.

Dean Pope, another panelist who is a partner at Hunton & Williams in Richmond, turned to Ernesto Lanza, the senior associate general counsel at the Municipal Securities Rulemaking Board who was also on the panel, and asked if the board might be able to work with the rating agencies to feed all of the rating changes through the secondary market disclosure component of the Electronic Municipal Market Access, or EMMA, system.

"It's almost a no brainer," Pope said, adding that "that direct feeds from the rating agencies to EMMA would result in a safer, simpler way of disclosing changes in bond ratings."

Lanza said that as a technical matter, "it wouldn't be a big feat" to feed ratings changes through EMMA.

"The question is putting together that type of arrangement with all of the relevant parties, which is not there now," Lanza said.

The board is currently developing a secondary market disclosure component to EMMA that will launch this winter and effectively replace the four existing national repositories, following SEC approval.

The subject of EMMA has come up repeatedly during the NABL conference, in the context of its ability to allow broker dealers and other participants to monitor issuer compliance with their continuing disclosure agreements.

Panelists have noted that the SEC's guidance on 15c2-12 says that broker-dealers are not prohibited under the rule from underwriting a municipal transaction if the issuer has failed to provide continuing disclosures tied to a previous issuance.

"However," the release says, "if a failure to comply with such previous undertakings has not been remedied as of the start of the offering, or if the party has a history of persistent and material breaches, it is doubtful whether a participating underwriter could form a reasonable basis for relying on the accuracy of the issuer's or obligated person's ongoing disclosure representations."

Zehner said yesterday that underwriters will have "play the heavy" to make sure issuers meet their continuing disclosure obligations and that they may face SEC enforcement action if they underwrite the bonds of an issuer that habitually does not meet its obligations.

At a separate panel late Wednesday Leslie Norwood, a managing director and associate general counsel at the Securities Industry and Financial Markets Association, noted that while SIFMA strongly supports EMMA, she believes it could take up to five years before users of the new system will be able to view an issuers' historic record of compliance because the database will not include any of the historical continuing disclosure documents currently housed by the four repositories.

Lanza told The Bond Buyer that the board has not looked into adding the historical continuing disclosure documents from the existing repositories, in part because converting the old files to EMMA's system would be onerous, might result in significant indexing problems and would provide only limited benefit for a relatively short period. However, he said that EMMA will allow issuers to submit older disclosures to it voluntarily.

Separately, Norwood noted at Wednesday's panel that the MSRB plans to require all document submissions to EMMA to be word-searchable PDFs until September 2009, with the exception of the documents' tables or charts.

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