Despite the warm spring weather, industry concerns over the SEC's Municipal Continuing Disclosure Cooperative Initiative have begun to snowball. MCDC is a program by which the SEC is encouraging issuers and underwriters to self-report-by September 10th-instances when official statements for bonds sold since 2009 misrepresented issuers' compliance with continuing disclosure agreements of material events. In exchange, the SEC will recommend favorable settlements when violations are found.
For issuers, "favorable" means no financial penalties but a public agreement to cease and desist from bad practices. For underwriters, there will be dollar penalties up to a cap of $500,000. The SEC makes a compelling case for compliance given the "ton of bricks" penalties reportedly waiting for violators not coming clean.
The principal near-term concerns are workflow (there have been more than 80,000 bond series produced since 2009, many of which may warrant review), cost of compliance (banking firms are hiring temporary workers and issuers will likely choose to consult counsel) and reputation (for issuers not wanting to be publicly portrayed as having provided poor disclosure). On the last point, MCDC creates a potential conflict between issuers-who have paid for bond counsel opinions on what is and is not disclosable-and their underwriters-who will reasonably seek to report as many deals as possible under the $500,000 penalty by applying a more simplistic test of compliance.
If an issuer sold bonds during or after 2009 they are affected and should contact their underwriter immediately. Issuers should also commence their own processes to verify whether their disclosures were accurate at the time of bond sale. Tests likely should look to disclosures connected to mass rating changes via Moody's Investors Service rating recalibration in 2010 and the dozens of bond insurer downgrades between 2009 and 2011. If these events changed a rating, it should have been disclosed. Similarly, filings late by only a few days-in particular when the issuing government's credit quality was in flux-should be viewed critically.
We expect most bond buyers and the rating agencies will take minor revelations of lapses in stride-in particular if current, very tight market conditions persist -but more meaningful discoveries may have repercussions to both. Making things more challenging, we expect the media to compile lists of the best and worst performers with the output of the program.
Apart from the one-time hits to industry budgets and issuer reputations, there are more meaningful implications from MCDC:
1. By failing to exactly define which events are material enough to have warranted prior notice, MCDC militates against the traditional, lawyerly approach issuers have used to determine what should or shouldn't be disclosed. In its place, a brighter-line, kitchen sink approach (as favored by risk managers, regulators, and credit analysts) may arise with, we expect, favorable consequences for borrowing costs but a bigger burden for public market borrowers.
2. We expect the program's implications for underwriters will be more acutely felt for competitive deals-where dealers may simply chose not to bid for lack of time or financial incentive to conduct a full disclosure review ahead of a deal award-and for smaller bond issues. As a result, we expect somewhat higher yields for issuers that fall into these categories.
3. Direct lending, an already growing field in the industry stands to see more use as issuers avoid new disclosure requirements.
4. Further, the SEC's safe harbor does not apply to FINRA or private parties: major new disclosures now could incite new lawsuits from both-and individual government managers found to have intentionally committed fraud could face SEC charges.
5. In concert with the imminent implementation of the SEC's Municipal Advisor rule, MCDC continues to re-shape the issuer/banker relationship from advisory and planning to one primarily focused on execution and compliance. This is not necessarily a negative for the industry or the state of infrastructure finance, but it is a clear one for current investment bankers.
Matthew Posner is a managing director at Municipal Market Advisors. This is an extract from MMA's weekly Municipal Issuer Brief, a free report for municipal issuers.