Issuers are choosing to avoid analyzing which of their financial obligations might be material to bond investors and instead disclose more broadly in response to the Securities and Exchange Commission's recently-implemented Rule 15c2-12 amendments, lawyers said.
The amendments became effective in late February, adding two new events to the list of occurrences issuers must agree to disclose to bondholders on an ongoing basis. Hundreds of Event 15 disclosures have filed in since that time, with just a handful of Event 16 filings. Under this revised 15c2-12, issuers have to enter into more wide-ranging continuing disclosure agreements aimed at providing investors a more complete picture of an issuer's debts.
Interviews with several public finance attorneys highlighted the anxiety many issuers feel when evaluating whether information is material to investors or not. Materiality has been defined by the courts as information that a reasonable investor would most likely consider important when making an investment decision, but in reality that analysis is often muddy. The pitfall is that failing to disclose ongoing material information can have serious consequences for an issuer and underwriter, in some cases even leading to offering fraud charges later.
Event 15 of Rule 15c2-12 says issuers have to disclose when they incur financial obligations, if material, as well as agreements to covenants, events of default, remedies, priority rights, or other similar terms of a financial obligation of the issuer that could affect security holders.
Event 16 says that in connection with those financial obligations, issuers have to disclose events which “reflect financial difficulties,” such as a default or modification of terms.
The interviews also demonstrated that some issuers are unsure of what the amendments require, even months after their effective date.
The big questions issuers are asking is whether or not they have to comply with the new events disclosure if they’re not required in old continuing disclosure agreements (CDAs) said Lori Smith-Lalla, a bond lawyer in Broward County, Fla.
Smith-Lalla said an issuer recently asked whether they should disclose loans, if their old CDA’s didn’t require it. The issuer wanted to voluntarily disclose them.
Many clients are voluntarily disclosing their loans, Smith-Lalla said. For example, in the past, if issuers enter into a loan, such as a state revolving fund, after the issuance of bonds, issuers wouldn’t usually have to disclose that unless it’s required as part of the annual information filing in their continuing disclosure agreements.
“A lot of the issuers are like, ‘I don’t want to worry about if it is or isn’t required in the CDA, I’m just going to voluntarily do it,’” Smith-Lalla said.
There is confusion on whether issuers have to disclose everything in their loan agreements or only certain terms of the agreements.
“We get questions all the time as to materiality and what needs to be disclosed,” Smith-Lalla said. “Especially when it comes to the covenants in the loan agreement.”
Smith-Lalla said issuers have asked whether to include a copy of the entire loan agreement, even if some of it doesn’t seem to be material.
“Some of these loan agreements can be quite large but if they’re on the smaller side, I would usually advise them to just post the whole thing,” Smith-Lalla said. “But if it’s a very large document then you may not want to post the entire document because may be difficult for investors to go through.”
The municipal bond market is still in its education phase after the recently implemented events, said Rod Kanter, a partner at Bradley law firm.
“Up til now it’s mostly been let’s get ready so we can comply,” Kanter said. “It’s been the difficult discussion with the issuer of why it is that they need to go and pull all their old loans and other arrangements that could be considered financial obligations and look at them.”
In Event 16, issuers need to disclose for any of their financial obligations, defaults, accelerations, modifications and similar events which reflect financial difficulties. This could be, for example, a current covenant breach on a bank loan, even if that loan was closed several years earlier, Kanter said.
Therefore, issuers now need to go back and look at their financial obligations to see if such events are occurring, and be ready to disclose should it arise down the road.
“In some respects, the new rules operate as if there’s a bond lawyer sitting with the issuer in their day to day life,” Kanter said.
Kanter is telling his clients who have issued bonds since the Feb. 27 effective date of the amendments to pull their financial documents for anything that could be considered a financial obligation that they’ve already entered into, and to keep the same records for financial obligations entered following the bond issue.
“We need to keep that index live and we need to keep copies of those documents live,” Kanter said.
Traditionally when issuers thought about continuing disclosure, they thought about publicly-sold issues and major events relating to them such as draws on reserve funds, and not about a bank loan they may have closed 10 years ago.
“It’s getting issuers to get their arms around the fact that they’re going to have to scrub, understand and report things about all their financial obligations, not just debt sold in the public bond market,” Kanter said.
Issuers sometimes cock their heads at first when Kanter discusses pulling all sorts of financial documents, since they’re accustomed to reporting on publicly-sold deals, he said.
Under Event 15, issuers have to first decide whether the new financial obligation is a material one and, secondly, if that obligation materially affects security holders.
“These are two materiality questions, and in both cases it is very hard to know where to draw the line because we don’t have any clear guidance on what material is, at least not in this context,” Kanter said.
He said he suspects this err on the side of caution approach may come about as disclosure decisions are made under two new material events, partly because of the absence of guidance from the SEC and the Municipal Securities Rulemaking Board regarding what is material.
“I can see some kicking the materiality discussion to the side,” Kanter said. “They’re going to say it’s hard to determine what’s material so yes, disclose it.”
Before the events’ implementation, some issuers were already disclosing bank loans in anticipation of the new rules, especially since they knew the SEC was looking for transparency.
It’s going to take time for issuers to know when there would be a potential disclosure issue, Kanter said.
“It’s going to take them time to develop that sense,” Kanter said.
Lawyers are getting lots of questions from issuers on what a financial obligation is, said Christine Reynolds, a partner in the public finance department at Orrick.
“The new rules require each issuer to evaluate their specific set of facts and circumstances, so the questions that are coming up are unique to each issuer and how they manage their debt portfolio,” Reynolds said.
Before the new events were enacted, issuers were opting to make voluntary filings and are continuing to do so now, even if they’re not yet required to under a continuing disclosure agreement that includes the new material events under the rule, Reynolds said.
Questions have also swirled around commercial paper. Commercial paper, a type of financing instrument used by issuers to have access to short-term capital and then later roll the notes into a longer term debt issuance, is typically exempt from continuing disclosure because it has a maturity of nine months or less.
Once an issuer enters into a continuing disclosure agreement that includes the new material events, the question becomes whether or what to disclose concerning commercial paper programs under Event 15.
Reynolds is also looking to the SEC to provide more guidance on materiality.
“The market continues to be interested in hearing from the SEC about their views on the exemption to the definition of ‘financial obligation’ and to get guidance from them on the ever present question of what the SEC is looking for with respect to materiality,” Reynolds said.
