WASHINGTON — Municipal issuers who do not comply with their continuing disclosure agreements should be penalized, the Municipal Securities Rulemaking Board told the Securities and Exchange Commission Monday.
In an 11-page, Aug. 8 letter, addressed to SEC commissioner Elisse Walter, MSRB chair Michael Bartolotta said there “seem to be no penalties for noncompliance” and “therefore there is limited accountability” for issuers who do not comply with their continuing disclosure obligations under SEC Rule 15c2-12. The rule requires issuers to disclose annual financial and operating information as well as material and other event notices soon after such events occur.
Callers to the MSRB have “expressed frustration with the apparent unwillingness” of some issuers to provide audited financial statements within a reasonable time after their due date, he said.
“The board recommends that the commission consider issuing more interpretive guidance in this area and amending Rule 15c2-12, as necessary to impose consequences for non-compliance with continuing disclosure undertakings,” Bartolotta wrote.
Bartolotta’s remarks come as the commission is updating its 1994 interpretive release on issuers’ continuing disclosure obligations.
Walter, who presided over a municipal securities hearing in Birmingham, Ala., late last month, is also spearheading an agency-wide review of the muni market, including a staff report expected to recommend legislation, rules or rule changes, and industry best practices.
Market participants, including analysts, have complained that some issuers fail to release financial information, particularly annual financial reports, in sufficient time to be meaningful.
In a statement posted on the MSRB’s website, along with the board’s letter, MSRB executive director Lynnette Hotchkiss said the board recognizes that most issuers comply with their continuing disclosure obligations.
“However, we would like to see initiatives that help ensure investors have access to key investment-related information, perhaps including an issuer’s continuing disclosure track record,” Hotchkiss said.
In his wide-ranging letter, Bartolotta also suggested the SEC should require underwriters to contract with issuers to obtain official statements for primary offerings of variable rate-demand obligations.
The board is not aware of any justification for treating VRDOs differently from fixed-rate munis, he said.
“The amendment the MSRB supports is also necessary to level the playing field by eliminating inconsistent behavior in the market caused by injudicious reliance by some on the VRDO official statement exemption, which we believe has the potential to cause harm to those investors that purchase VRDOs without the benefit of a disclosure statement,” Bartolotta wrote. “We do not believe that the requirement to produce an official statement will disrupt the municipal marketplace since, at this point in the evolution of this product, most issuers appreciate the benefit of disclosure and prepare and distribute official statements for primary offerings of VRDOs.”
In addition, Bartolotta said the SEC should consider providing additional guidance about disclosures on underlying borrowers of credit-enhanced transactions.
In particular, he said, there are many instances in which “there is arguably inadequate disclosure” about the underlying borrower or the circumstances under which the liquidity provider or credit enhancement is not required to pay principal, interest, redemption price, or purchase price of the bonds.
“In view of the events of 2008 and the extreme financial difficulties faced by many credit enhancers, the MSRB considers such disclosure to be essential,” Bartolotta wrote. “The commission might express the view that it is a material omission to provide disclosure on the circumstances under which a credit or liquidity facility might not be available to pay debt service (including bankruptcy and other default) without providing disclosure on the financial ability of the underlying obligor to pay debt service in that event.”
For issuers who fail to comply with their continuing disclosure agreements, “there is no easy means by which to enforce compliance, short of a suit for specific performance, and there seem to be no significant regulatory repercussions for non-compliance,” Bartolotta wrote.
While some issuers may miss their self-imposed deadlines to file annual financial and operating information because of circumstances beyond their control, such as natural disasters, “in other cases, noncompliance may result from a conscious decision to suppress unfavorable financial results,” he said.
When issuers and borrowers disregard their self-imposed obligations in continuing disclosure agreements, the SEC should require “much more robust disclosures in their official statements about their previous breaches” of their agreements, Bartolotta said.
Another possibility, he said, would be requiring the agreements to include enforceable remedial steps to ensure future disclosures are made appropriately. For example, he said, the agreements could require: “the adoption of specific procedures, granting investors direct enforcement rights (for damages as well as specific performance), engagement of professionals to assist in compliance obligations, or other concrete and demonstrable actions designed to encourage compliance without initiation of a lawsuit.”
Issuers write their own continuing disclosure agreements, which typically appear in official statements, and set their own deadlines for releasing annual disclosures. These agreements are considered contracts with bondholders and only bondholders can enforce them.
In addition, Bartolotta recommended that the SEC provide guidance on disclosure of conflicts of interest, especially those stemming from contingency-fee arrangements between issuers and third parties, such as GIC brokers and swap providers.
“Shedding light on the conflicts experienced by many transaction participants, which diminish investor confidence in the municipal marketplace, will hopefully discourage transaction participants from engaging in such conflicts or persuade them to act in a manner that safeguards against the potential adverse consequences of such conflicts,” Bartolotta wrote.
Among market participants, reaction to the MSRB’s letter varied.
An independent financial advisor heralded Bartolotta’s remarks, saying they deserve careful study. "Until there is some kind of monetary penalty, universal compliance ain't going to happen," said Robert Doty, president of American Governmental Financial Services Co. in Sacramento. "There will always be slackers."
A bond attorney said the board’s letter would likely stir debate, prompting others to file contrary views.
“This is a good catalogue of hot-button topics in the municipal marketplace,” said Paul Maco, a partner at Vinson & Elkins LLP in Washington.
John McNally, a partner at Hawkins, Delafield & Wood LLP in Washington, said in an e-mail that the MSRB would “upend” the SEC’s approach by having the commission direct disclosures in official statements for variable-rate transactions.
As for continuing disclosure, he said: “I expect the SEC to reject any calls for 'consequences for non-compliance,’ in recognition that the current regulatory scheme reflects that the SEC’s jurisdiction (other than antifraud) is limited to municipal securities brokers and dealers, and reflects the limitations imposed by law, federal-state comity and the 10th Amendment,” Issuers, meanwhile, bristled at the MSRB guidance, saying the existing regime contains sufficient sanctions.
“I think it’s a major statement of policy objectives,” said Frank Hoadley, Wisconsin’s capital finance director and a member of the Government Finance Officers Association's governmental debt-management committee.
“The biggest problem I’ve got is they’re trying to push the enforcement back onto the issuers,” he added, saying he is still reviewing the board’s letter.
Another issuer said the market penalizes non-compliant issuers — investors won’t buy their bonds — and GFOA is educating members about continuing disclosure. “I think we're all in favor of voluntary compliance,” said Timothy Firestine, chief administrative officer of Montgomery County, Md.