BDA Issues Post-N.J. Disclosure Guidance for Underwriters

Underwriters who fail to revamp due diligence and disclosure practices for bond documents in negotiated transactions are vulnerable to enforcement action based on a recent pension case New Jersey settled with the Securities and Exchange Commission, a dealer group said in guidance unveiled last week.

The Bond Dealers of America’s seven-page document, entitled “Lessons Learned for Senior and Sole Managers in Negotiated Offerings Per SEC Action Against the State of New Jersey,” focuses on the responsibilities of public finance investment bankers, who generally lead an underwriter’s due-diligence efforts in negotiated offerings with state and local governments.

The guidance, prepared by Elizabeth Columbo, a partner at Nixon Peabody LLP in New York, comes a little more than a year after the SEC’s settlement of securities fraud charges with New Jersey, the first such settlement with a state.

In that settlement, the BDA said, the commission for “the first time” in the municipal securities market issued a cease-and-desist order based on negligence. In previous muni cases, the SEC based cease-and-desist orders largely on intentional or reckless disclosure deficiencies, according to the group.

“In seemingly as many ways as it can, the SEC is trying to signal to the municipal marketplace that it is concerned about the existing disclosure practices and procedures within the municipal marketplace,” the BDA said.

BDA’s guidance also warns that underwriters cannot rely on customary muni-market disclosure procedures and should evaluate their practices “with an eye toward objectively evaluating their adequacy.” Underwriters must undertake a “reasonable and professional review” of an issuer’s official statement and “reasonably conclude that the issuer prepared materially sufficient disclosure,” the group said.

In an interview, chief executive officer Michael Nicholas said the BDA received about a dozen phone calls from members after the SEC’s New Jersey case, asking generally about their responsibilities with respect to state and local issuers’ bond-related disclosure documents.

Under the Tower Amendment in the Securities Exchange Act of 1934, the Municipal Securities Rulemaking Board and the SEC cannot require issuers to file pre-sale disclosure documents. But under SEC Rule 15c2-12, dealers generally are prohibited from underwriting municipal securities unless an issuer has contractually agreed to disclose annual financial and operating information, as well as material and other event notices, with the MSRB.

“All of that gets thrust on the shoulders of a dealer to ensure the issuer is in compliance,” Nicholas said. “So that’s the real reason to put this document together.”

The BDA will prepare separate guidance for underwriters’ disclosure obligations in competitive transactions, Nicholas said.

In the New Jersey case, the SEC charged that the state misrepresented and failed to disclose to investors — who bought more than $26 billion worth of the state’s muni bonds between 2001 and 2007 — that it was underfunding its two largest defined-benefit pension plans.

New Jersey settled without admitting wrongdoing or paying a fine, but agreed to cease and desist from any future violations of the securities laws. In particular, the SEC said the state’s bond documents did not accurately reflect the pension plans’ current value, because they failed to fully reflect the effect of market declines.

In its guidance, the BDA recommends that senior and sole managers independently evaluate the credit supporting bonds to understand the strengths, weaknesses and risks of investing in the them, including the industry or type of credit supporting the bonds, their structure and tax treatment, and the issuer’s finances and operations. Each credit is different and studying these factors will require an underwriter to appreciate its “unique strengths and weaknesses,” it said.

Separately, in a section entitled, “Don’t Ignore Red Flags,” the BDA said underwriters should not overlook problems with an issuer’s “working culture,” which might indicate “bigger problems” with an issuer’s disclosure. Such cultural red flags include an issuer that intimidates working group members, strongly discourages meaningful questions, or is notably careless or does not provide consistent, accurate answers.

The group also recommends that underwriters ask “the right questions” and elicit “the right kind of information.”

For example, the group notes, underwriters should inquire whether the issuer has developed procedures and instituted employee training on disclosure. Failure to develop such programs could be a “red flag,” according to the BDA.

In addition, it suggests underwriters should ask about “unique characteristics and weaknesses of a credit,” as well as known material trends within an issuer’s financial and operating conditions, not just the accuracy of historical information.

With respect to disclosure documents, the BDA suggests that underwriters review an issuer’s official statement and financial statements, as well as any studies or reports that evaluate financial or operational feasibility, problems or prospects. For pension disclosure, they should also review actuarial valuations, the guidance says.

The group also recommends that underwriters familiarize themselves with “any major policy disputes or issues” within the issuer to evaluate whether the offering document omits material facts about its financial or operating condition. Such a review could entail reading the issuer’s website and local newspapers, as well as conducting Internet searches.

Finally, the BDA said underwriters should receive an appropriate set of letters, opinions and certificates, including negative assurance letters from disclosure counsel, underwriter’s counsel and others. Otherwise, the SEC can “cast doubt” on whether the underwriter acted reasonably.

The group also suggests that underwriters obtain closing certificates from an authorized officer of the issuer — someone who knows the issuer’s finances and operations and can certify about the official statement’s material sufficiency.

Underwriters should also consider obtaining a consent letter from a certified public accountant about the information in the official statement, the BDA said.

A bond attorney agreed that the SEC’s New Jersey settlement reflects an important trend.

“Historically, with respect to municipal securities, the commission was reluctant to establish violations other than by proving intent,” said Andrew Kintzinger, a partner at Hunton & Williams LLP in Washington. “However, in more recent enforcement actions pertaining to municipal securities, the SEC has shown an increased willingness to establish violations based on merely negligent conduct under section 17 [of the Securities Act of 1933].”

That section bars the making of any untrue statement of material fact or omitting to state a material fact in the offer or sale of securities.

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