SEC Proposal on Bank Loans May Be Far Reaching

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WASHINGTON – The Securities and Exchange Commission's proposal to require issuers and borrowers to file material event notices for certain non-public financial obligations, such as bank loans and private placements, takes a broad brush approach and is potentially far-reaching.

In some cases, market participants say, the proposal may require municipal issuers to continuously monitor financial obligations for financial difficulties, such as contract failures, so they can file event notices no later than 10 days from the occurrence of the event.

Issuers also may struggle with trying to determine whether something is "material" and must therefore be disclosed in a material event notice.

The goal behind the SEC proposal filed Wednesday is simple and has been supported by most groups, as well as the Municipal Securities Rulemaking Board. Since the financial crisis, issuers and borrowers have used an increasing number of alternatives to publicly offered tax-exempt bonds that do not fall under the municipal bond disclosure regime in the SEC's Rule 15c2-12.

While municipal issuers must contractually agree to file annual financial and operating information and notices of material events in order for firms to underwrite and sell their bonds under Rule 15c2-12, there are no such disclosure requirements for bank loans, private placements or derivatives.

SEC Acting Chair Michael Piwowar said Wednesday, at the meeting where he and Commissioner Kara Stein gave the green light for the proposal to be released, that bank loans increased to $153 billion in 2015 from $67 billion in 2010.

Analysts, the credit rating agencies, MSRB, and market groups are concerned that issuers often fail to disclose that they have entered into these alternative financial obligations, let alone the terms of the obligations. These undisclosed obligations can have an impact on an issuer's indebtedness, creditworthiness and liquidity, thereby creating risks for its existing muni bondholders, they warn.

But the 112 pages of proposed rules are broadly written.

 

The Proposal

The SEC is proposing to create two new categories of material event notices that issuers and borrowers must file for financial obligations. The term financial obligation is broadly defined as "a debt obligation, lease, guarantee, derivative instrument or a monetary obligation resulting from a judicial, administrative or arbitration proceeding."

The SEC says the term "shall not include municipal securities as to which a financial official statement has been provided to the Municipal Securities Rulemaking Board consistent with this rule."

The two new categories of material events for financial obligations would be added to the 14 categories that already exist in Rule 15c2-12.

The first one, which would be a 15th material event notice category, would require an issuer or borrower to file a notice if they incur a financial obligation that is material or a financial obligation has an agreement to covenants, events of default, remedies, priority rights or similar terms "any of which affect securities holders, if material."

The second one, a 16th new material event category, would require a notice to be filed for certain actions or events related to the financial obligation that "reflect financial difficulties" such as a default, event of acceleration, termination event, or modification of terms.

Underwriters would have to reasonably determine that an issuer or borrower has agreed to provide notice of such events in its continuing disclosure agreement.

The SEC said that the need for a financial obligation to be material will "strike an appropriate balance" in the proposal. But some lawyers said that didn't work out so well under the commission's Municipalities Continuing Disclosure Cooperation initiative, under which the SEC offered underwriters and issuers lenient settlement terms for self-reporting instances over the last five years where issuers falsely stated in offering documents that they were in compliance with their continuing disclosure agreements. Issuers continually begged SEC officials for a definition of materiality.

The SEC has steadfastly refused to define materiality, though the Supreme Court ruled in TSC Industries, Inc. v. Northway, Inc., that a fact is material if there is a substantial likelihood that a reasonable investor would consider it important.

The SEC release provides examples of financial obligations that may not be material. "For example, an issuer or obligated person may incur a financial obligation for an amount that, absent other circumstances, would not raise the concerns the proposed amendments are intended to address," the SEC said in the release.

"On the other hand, if an issuer or obligated person agrees to provide a counterparty to a financial obligation with a senior position in the debt payment priority structure, and that agreement affects existing security holders, the event likely does rise to the level of importance that it should be disclosed to investors and other market participants."

The SEC notes in the release that financial obligations can have potential positive as well as negative impacts on existing security holders. It asks commenters if the proposed rule amendments should "only capture events which adversely affect security holders?"

"Positive impacts?" one muni market participant, who didn't want to be identified, asked incredulously.

 

Financial Obligations

The release contains details of what is included in the definition of a financial obligation. The term debt obligations is intended to capture short-term and long-term debt obligations of an issuer or borrower under the terms of an indenture, loan agreement or similar contract that will be repaid over time, it said.

The term lease is intended to include operating or capital leases.

"If an issuer or obligated person enters into a lease-purchase agreement to acquire an office building or an operating lease to lease an office building for a stated period of time, both would be a lease under the proposed amendments," the SEC said.

The term derivative instrument includes "any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any other similar instrument to which an issuer or obligated person is a counterparty," the SEC said. "This list is intended to be sufficiently comprehensive to cover the use of derivative instruments that may develop in the future," the commission added in a footnote.

In describing monetary obligations that fall under the definition of financial obligations, the SEC suggested they might have to be disclosed in material event notices even if they are publicized.

"While information about a monetary obligation resulting from judicial, administrative, or arbitration proceedings may be disseminated through the media or otherwise in the issuer's or obligated person's immediate community, such information may not be circulated to investors and other market participants who reside outside of the issuer's or obligated person's locality," the SEC said.

The SEC asked commenters a number of questions, including whether the proposed definition of financial obligations should include "contracts that create future payment obligations [such as] a contract for waste disposal services."

It also asked what other financial obligations should be covered by the proposed amendments to the rule.

The SEC said that the 15th category of a material event notice filed for the issuer's or borrower's incurrence of a material financial obligation "should include a description of the material terms of the financial obligations." These may include: the date of incurrence; principal amount; maturity and amortization; interest rate, if fixed, or method of computation, if variable (and any default rates), the release said.

For the 16th category of material event notices for events reflecting financial difficulties, the SEC said a default could be a monetary default, where the issuer fails to pay principal, interest or other funds due, or a non-payment default, which there is a failure to comply with specified covenants.

The SEC went even further saying, "other similar events under the terms of a financial obligation … reflecting financial difficulties" could include such things as the failure to meet construction deadlines.

"An issuer or obligated person could fail to perform a covenant not related to payment required under a financial obligation that does not result in the occurrence of a default, but the occurrence of this other event does reflect financial difficulties of the issuer or obligated person," the SEC said in the release.

"For an example, an issuer could fail to meet a construction deadline with respect to a facility being financed by the proceeds of a financial obligation due to financial difficulties," the release said. "As a result of the failure to meet this deadline, a default does not occur, but the lender is entitled to take possession of the facility and complete construction."

"That's potentially throwing the barn door open in terms of what could be covered," said Ernie Lanza, senior counsel at Clark Hill PLC.

Jessica Giroux, general counsel and a managing director at Bond Dealers of America said that although the SEC proposal "represents a productive step by regulators to address the problem of undisclosed bank loans" the group will work with its members "to help identify potential unintended consequences."

"In addition, we want to make sure that the new event notices are narrowly tailored to pick up only those developments that are material to investors," she said.

Leslie Norwood, managing director and co-head of the municipal securities division for the Securities Industry and Financial Markets Association, said that while the SEC's proposed amendments are only about 10 lines, they are "broad ranging" based on the 112 page release explaining them.

SIFMA is pleased that the SEC has proposed to address the dearth of information that is available currently to investors regarding bank placements and other transactions, she said.

But she added that while the SEC proposal would broaden Rule 15c2-12, "We think it's an appropriate time to also talk about updating the rule and potentially eliminating provisions that are unnecessarily burdensome," such as the one requiring issuers to disclose credit rating changes. The rating agencies currently post such changes the MSRB's EMMA system, she pointed out.

SIFMA has also urged the SEC to change the rule to specify that municipal advisors have primary due diligence responsibility for offering documents in competitive transactions where they were engaged to help produce the documents, she said.

The SEC said if the proposed amendments to 15c2-12 are eventually adopted, they would apply to continuing disclosure agreements entered into in connection with primary offerings occurring on or after the compliance date. The commission said it is considering a compliance date that would be three months after final adoption to give the MSRB sufficient time to modify its EMMA system, on which material event notices are posted.

 

Burdens and Costs

For reporting and recordkeeping burdens, the SEC estimates there will be little change for the 250 dealers that underwrite offerings of muni securities. The total annual burden for all 250 dealers is currently 22,500 hours, it said. This includes 10 hours per year per dealer (2,500 total hours) to reasonably determine an issuer or borrower has contractually provided such disclosures to the MSRB and 80 hours per year per dealer (a total of 20,000 hours) to determine whether issuers and dealers have failed to comply. The SEC estimates that the proposed amendments would add 10 hours per year for dealers to determine whether issuers or borrowers have complied.

The SEC estimates that 20,000 issuers of munis with continuing disclosure agreements would prepare an additional 2,200 event notices annually under the amendments – 2,100 notices of incurrence of financial obligations and terms, if material, and 100 event notices reflecting financial difficulties.

The total burden for issuers to submit continuing disclosure documents would be 603,658 hours – 438,172 hours to submit annual filings, 151,360 hours to submit event notices submitted under the proposed rules, and 14,126 hours for issuers to submit failure to file notices.

The commission said it "does not expect dealers to incur any additional external costs associated with the proposed amendments to the rule." It estimates the burden from the proposed amendments for the MSRB would be 13,861 hours for the first year and 12,699 hours for each subsequent year. The MSRB would not have any additional external hardware and software costs other than the $10,000 it currently spends for EMMA each year, the SEC said.

The commission said it "believes that issuers generally will not incur external costs associated with the preparation of event notices filed under these proposed amendments." However they could incur some costs if they pay third parties to assist them with their disclosure abilities.

The SEC estimates that the average total annual costs currently incurred by issuers using the services of designated agents are about $9.75 million and this figure would increase by about 6% under the proposed amendments.

Each issuer would spend a one-time charge of about $100 for the revision of its template for its continuing disclosure agreement, for a total cost of $2 million for all issuers.

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