MCDC Non-Compliance May Prove Costly

The Securities and Exchange Commission has recently completed settlements with the majority of municipal underwriters and a group of issuers under its Municipalities Continuing Disclosure Cooperation initiative, successfully encouraging issuers and underwriters to voluntarily disclose their past non-compliance and improving the future continuing disclosure of issuers. These enforcement actions and settlements show that their economic impact has so far been limited to some consulting expenses of voluntary compliance for issuers and de minimis penalties for underwriters.

However, the issuers who may not have come forward during the MCDC's self-reporting period will experience a much higher incremental cost of non-compliance than those faced by consenting issuers. Most of that cost will be in the form of additional risk premium paid on future borrowings in addition to possible civil monetary penalties by the SEC. What is worse is that the burden of the municipalities' non-compliance in their past continuing disclosure obligations will be paid for by future taxpayers.

The SEC settled with a total of 72 municipal underwriters in June 2015, September 2015 and February 2016 under the MCDC initiative with the civil penalties occasionally reaching the maximum possible penalty of $500,000. However, the first wave of settlements against 71 municipal issuers announced in August 2016 included few issuers in various public finance categories from a very broad group and do not provide extensive coverage of the vast municipal bond issuer universe, suggesting that the SEC might still be working on some self-disclosure cases which might be announced in the future.

Cost of Compliance, Rating Downgrades
Even though the SEC did not impose monetary fines in its settlements with the issuers, the direct cost of complying with the MCDC was quoted as one common apprehension among muni issuers at its outset in a recent article. The issuers' cost of continuing disclosure reviews, typically external consultants' fees, varied from $2,000 to $18,000 and is quite negligible compared to the civil penalties paid by some self-reporting underwriters or potential incremental financing costs as discussed below.

A more severe concern among the issuers was the possible adverse impact of the MCDC settlements on the credit ratings. Initially, some comforting reassurances from a Standard and Poor's (S&P) commentary indicated that MCDC settlements would not immediately lead to downgrades, which may hold true as the SEC may have already concluded that the issuers who self-reported had already improved their continuing disclosure efforts.

However, the worries still remain, since S&P effectively confined such rating inaction to issuers' preemptive efforts to address the disclosure deficiencies, while those with more serious and unaddressed violations might have elected not to self-report. The SEC is expected to undertake more comprehensive reviews of issuers and underwriters and bring enforcement actions where the issuers might have chosen not to self-report under the MCDC initiative, if it has not yet started doing so.

Rating agencies incorporate such disclosure gaps in their assessment of issuers. S&P commentary describes the credit consideration of disclosure practices around the capabilities of the management, including their plans to remediate violations and to improve disclosure. That said, S&P reveals that a more immediate rating action could be imminent if severe deficiencies are identified and the violations involve malfeasance. Equally, all applicable public finance rating methodologies from the leading rating agencies corroborate that issuers' disclosure practices constitute an important aspect of the rating agencies' consideration; carrying a 20%-to-30% weight on the rating grid or additional qualitative overlay that could instigate a rating downgrade of up to three notches – thereby increasing issuers' cost of future financings by commanding higher risk premiums.

Additional Costs of Downgrades
We recently analyzed the possible impact of a one alphanumeric notch downgrade on the rating of a high investment grade (Moody's-Aa / S&P-AA range) higher education institution also considering a plan to issue a new series of bonds at or close to par. Our regression analysis indicated a one notch downgrade would increase the coupon rate on a notional $75 million series of new bonds (similar to previously issued bond series with a staggered maturity structure and a term bond over 30-years) by 1/8 of a percentage point (0.125%). As a result, the cumulative coupon payments over the life of the new series of bonds would increase from $31.2million to $32.8million, or by more than 5%.

A similar downgrade becomes more dramatic down the rating spectrum. In another engagement, we analyzed the impact of a similar one notch downgrade on a school district (Moody's-Baa / S&P-BBB range). Our statistical analysis using information from that issuer and other similarly situated school districts indicated that such a downgrade, still within investment grade, would increase newly to be issued bonds' coupon rates by 0.30%. Accordingly, the coupon payments on a new 5-year, notional $5 million simple series of bonds would experience a cumulative increase of $45K, from $520K to $565K. In relative terms, this is close to 9% and considerable for a school district which traditionally relies on property taxes for repayment of interest and principal.

For the muni issuers who did not come forward during the MCDC's self-reporting period, the incremental cost of non-compliance with the continuing disclosure requirements will be much higher compared to what the consenting issuers faced. The cost of additional risk premium (coupon interest rates or spreads) will be incremental to any future fines that might be levied by the SEC, which will all be paid for by future taxpayers or revenue contributors.

Ozgur Kan is a Managing Director with Berkeley Research Group and leads the Credit Analytics practice. The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.