WASHINGTON - Municipal issuers need to understand the thinking inside the Securities and Exchange Commission's enforcement division, take steps to protect themselves, and consider whether fundamental changes to muni market regulation might be in their best interests, former SEC lawyer Peter Chan said in a recent interview.
Chan, the architect of the SEC's controversial Municipalities Continuing Disclosure Cooperation initiative who joined the law firm of Morgan, Lewis & Bockius earlier this month, told The Bond Buyer that issuers would be well-served if they built their disclosure policies and procedures around the idea that the SEC will continue to use the antifraud provisions in the federal securities laws to spur disclosure reforms. Chan worked at the SEC for nearly 20 years, and had been assistant regional director of the commission's Chicago office since 2010.
"The SEC division of enforcement has become the primary agent of change," Chan said, pointing out that the Tower Amendment prevents the SEC from directly regulating issuer disclosures. "The whole municipal securities market, on disclosure, is a bit of an odd duck because of the Tower Amendment. The SEC cannot dictate what needs to be disclosed, but, and this is the big 'But' that I think a lot of people have missed, the SEC can enforce the antifraud provisions of the securities law."
Municipal issuers are not exempt from those laws. Chan said the enforcement division has spent the last four years applying the antifraud rules, which prohibit making materially misleading statements or omitting material facts in connection with the purchase or sale of securities, to all potential disclosure violations. The corporate bond market is very different because the disclosure requirements are mandated and predictable, and those requirements serve as what Chan termed "guardrails" between corporate issuers and the SEC.
"When you look at the municipal securities market, because of the Tower Amendment, there are no guardrails," Chan said. "So there's either nothing or the next thing you know, you find yourself at the cliff."
The SEC needs to at least prove negligence in order to make a case against an issuer under section 17(a) of the Securities Act of 1933, he said. The guiding principal for issuers should be to have a "good faith, reasonable process" for figuring out what is material and needs to be disclosed to investors, Chan said. Materiality has been broadly defined by the Supreme Court to mean something a reasonable investor would want to know before making an investment decision.
"You don't necessarily need hundreds of thousands of dollars of costs," Chan said. "Even if you spend hundreds of thousands [of dollars] on the disclosure process, if the underlying staff handling the procedure doesn't understand this basic antifraud principal, then there's always a danger."
An intermediate approach market participants might take to help further shield themselves is to have periodic dialogues between the buy side and the sell side of the market about what institutional investors consider material, Chan suggested. In order to prove materiality in court, the SEC calls investor witnesses to testify that an untrue statement or an omission of fact misled them and would have been a factor in their investment decisions. In the SEC's June action against Harvey, Ill., for example, the SEC obtained declarations from investors explaining how knowledge of the city's prior misappropriations of bond funds would have affected their decision to buy Harvey securities.
Some securities litigation defense lawyers have suggested that the SEC would have a difficult time proving materiality in muni disclosure cases and that the SEC does not have a track record of successfully litigating those cases because municipalities generally settle them before trial. But Chan said a dialogue with major investors such as mutual funds would be a win-win by helping issuers know what to disclose to avoid SEC trouble and aiding investors in getting the disclosures they want.
"What struck me is how really commonsense this is," Chan said. "Even though you may not get into specifics, the issuer will get a pretty good sense as to what the investor community expectation is. That would include categories, such as pension liability disclosure and potentially other aspects that may not be right now obvious to the issuer."
But the biggest long-term question, Chan said, is whether issuers should want to stick with the current regulatory regime. There has generally been a sense among issuers that the Tower Amendment shields them from overbearing SEC and Municipal Securities Rulemaking Board micromanagement, but Chan said they might want to rethink that.
The Tower Amendment, which was added to the Securities Exchange Act of 1934 in the mid-1970s, prohibits the SEC and MSRB from requiring issuers to file documents with them before selling munis. "The question for all the market participants is, is this the regulatory system they really want?" Chan asked.
The enforcement division started putting more emphasis on using the antifraud provision to correct market behavior after the SEC's 2012 muni market report highlighted disclosure problems, Chan said. Market participants should assume that behavior is here to stay and not the effect of specific staff people, he added.
"Now you've got periodic enforcement actions that are actually very tough on the issuer, and on everyone," Chan said. Repealing the Tower Amendment would require an act of Congress.
