Securities Law

SEC's Conduit Proposal Would Bypass Top Defaulters

WASHINGTON — The Security and Exchange Commission’s request for legislative authority to impose corporate-style registration and disclosure requirements on certain conduit borrowers may not affect the borrowers that are responsible for most defaults, according to default data and municipal market participants.

SEC Targets Conduit Bonds, Again

In its July 31 report on the municipal securities market, the SEC recommended that Congress remove exemptions in the Securities Act of 1933 that apply to corporate borrowers in muni conduit deals, reasoning that were it not for the fact that a government or governmental authority can issue tax-exempt bonds for them, they would have to finance in the corporate market and meet the registration and disclosure requirements for that market.

The SEC said its recommendation will protect investors, particularly “in light of the relatively high default rate of conduit bonds.” Conduit bonds, which generally are private-activity bonds, represent roughly 70% of municipal market defaults, the commission noted in its report.

But the SEC’s proposal would not apply to some market sectors that represent the highest percentages of defaults, according to statistics and interviews with market participants. It would not cover land-secured bonds, which are not conduit transactions, or nursing home and hospital deals, which as not-for-profit corporations would retain federal securities law exemptions from registration and corporate-style disclosure requirements.

And market participants in the housing and industrial development bond sectors said the proposed requirements, if enacted by Congress, could cause burdens for borrowers and encourage them to turn to other means of financing, such as private placements that would also retain exemptions from registration and disclosure requirements.

Land-secured bonds, also called dirt bonds, accounted for 33% of the number of defaults between 2007 and 2010, more than any other category of bonds, according to data cited in “Bloomberg Visual Guide to Municipal Bonds,” a book published this year by Robert Doty, a California-based municipal advisor and president of consulting firm AGFS.

Special-purpose governmental districts typically issue land-secured bonds to finance planned residential community infrastructure projects. The districts levy assessments on homeowners and use the money to pay debt service on the bonds. In these deals, which have been hit along with the rest of the real estate market in recent years, debt service depends on future assessments on expected homebuyers — not a steady revenue source.

Bonds for nonprofit long-term care facilities like nursing homes and hospitals accounted for 18% of the number of defaults between 2007 and 2010, according to Bloomberg data cited by Doty.

Doty said statistics show that roughly 20% of outstanding muni bond volume has been responsible for 80% of the number of defaults between 2007 and 2010.

In a report issued in March, Moody’s Investors Services found muni bonds used by hospitals and health care providers represented 32.4% of defaults between 1970 and 2011, topped only by the housing sector, which accounted for 41% of defaults. Moody’s figures were based on 71 of its rated muni issuers that defaulted over that 41-year period.

Moody’s said only five general obligation bond issuers defaulted over the period, representing 7% of defaults. But that data includes Jefferson County, Ala.’s $3.47 billion default in 2008.


“The low-hanging fruit isn’t discussed in the [SEC’s] staff report,” said one market participant who declined to be identified. There’s little indication in the report that the agency is “focusing on land-secured or long-term continuing care bonds, or other troubled parts of the market,” the source added.

SEC commissioner Elisse Walter was not available to comment.

According to bond lawyers, the SEC’s proposal would apply mostly to: small-issue industrial development bonds, or IDBs, which typically fund manufacturing plants; low- and moderate-income affordable housing bonds; redevelopment bonds for certain infrastructure projects (typically in blighted areas); and certain exempt-facility bonds used to finance airport, high-speed rail, dock, solid waste and other projects.

Conduit borrowers are already subject to antifraud laws. Under the SEC’s Rule 15c2-12 on disclosure these borrowers, or conduit issuers, must enter into agreements to provide continuing financial and other bond-related disclosures to the market. In many cases the borrowers rather than the issuers sign the agreements. However the borrowers decide how much to disclose and when to disclose it.

“Historically, conduit borrowers in many types of conduit municipal financings have provided substantially less continuing information than issuers of municipal securities involving non-conduit financings,” the SEC said in its report.

Some market participants praised the commission’s recommendations as a positive step towards increased transparency.

“Additional reporting and disclosure standards for conduit borrowers is long overdue,” said Richard Lehmann, president of Income Securities Advisors Inc. “There is a coming wave of lack of confidence in the muni market as deals default.”

Lehmann added that many conduit borrowers can access to tax-free bonds only because of the “good reputation” of municipal issuers. “Many of the conduit borrowers could not raise 10 cents on their own credit,” he said.

Lehmann said his top five categories of defaults over the past 60 months include dirt bonds issued by community development districts (357), IDBs (112), housing revenue bonds (66), university and school bonds (40), and water and sewer bonds (39). But Lehmann uses a much broader definition of payment defaults than most market participants. He includes bonds where reserves have been drawn upon to help pay debt service.

Chuck Samuels, partner at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC, is relieved that nonprofits would remain exempt. Samuels represents the National Association of Health and Higher Education Facilities Authorities, which provides financing for nonprofit healthcare and higher education facilities.


Others warn that the SEC’s proposal could have unintended consequences.

Patrick Ray, managing partner in Scottsdale, Ariz., at law firm Kutak Rock LLP, and board member of the Council of Development Finance Agencies, said 90% of bonds issued by CDFA’s members are private-activity bonds.

Any new registration and disclosure requirements for private borrowers could depress an already-struggling industry, he warned. Ray noted that “essentially” no private-activity bonds were issued in recent years in Nevada, which makes $600 million of PAB volume available annually.

“I wonder if this is a good use of [the SEC’s] resources, to go after this tiny segment of the muni market,” Ray said. “[This] may be a solution in search of a problem.”

Garth Rieman, director of housing advocacy and strategic initiatives at the National Council of State Housing Agencies, shared those concerns. Registration and disclosure burdens could dissuade private firms from acting as conduit borrowers in multifamily housing deals, he said, adding: “Registration can be time-consuming and costly, and the existing exemption is something muni issuers feel is very important.”

Stanley Keller, partner at law firm Edwards Wildman Palmer LLP, said that if the SEC obtains its proposed legislative authority private borrowers could shun conduit bonds in favor of private offerings or other financing options.

Though the SEC’s recommendation targets corporate borrowers, smaller companies can follow the commission’s easier, streamlined registration and disclosure requirements, Michael Decker, co-head of munis at the Securities Industry and Financial Markets Association, said at a recent CDFA conference.

The SEC defines “smaller reporting companies” as those that have less than $75 million worth of publicly held stock, excluding stock held by company officers and affiliates. Firms with no public stock qualify if they have annual revenue of less than $50 million.

Many large corporate borrowers, like airlines, are already subject to the SEC’s registration and disclosure requirements because they have had initial public offerings, according to Decker. While such firms would “have some additional burden associated with registration and producing a prospectus, their continuing disclosure obligations probably wouldn’t change much,” he said.

Some market participants think Congress is more likely to give the SEC authority to require corporate borrowers to meet corporate-style registration and disclosure requirements than to permit the agency to regulate the content and frequency of disclosures of all muni issuers.

But if Congress takes action, it would not likely happen until next year.

“It’s unlikely it will see congressional action in the near term,” said Decker, noting that Congress is focused on upcoming elections and fiscal issues. “We we are looking at 2013 at the earliest, if then.”



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