August 2, 2010
SEC Steps up Financial Disclosures Applicable to Bond Borrowers
Background
SEC Rule 15c2-12 generally requires borrowers with publicly traded bonds outstanding to provide ongoing financial disclosure to the financial market. In particular, under the Rule, bond borrowers must generally provide: (a) annual financial information and (b) notice of the occurrence of certain listed events. The Rule is in addition to any specific covenants to provide financial information to trustees and bondholders. The Rule is designed to provide current borrower information to the secondary bond market - potential purchasers of the bonds following the original issuance. Many borrowers with fixed-rate bonds outstanding are familiar with these reporting requirements and have been complying with the current form of the Rule, by providing information directly or through a disclosure agent, often a trustee, who in turn forwards the information to the MSRB's Electronic Municipal Market Access ("EMMA") database.
On May 26, 2010 the SEC announced amendments to the Rule, to become effective December 1, 2010. The two key changes to the Rule from the borrower's perspective are: (a) the elimination of an exemption to the Rule that had applied to many borrowers and (b) tightening of the requirements related to event notices.
Elimination of Exemption for Letter of Credit-Backed Bonds
The existing Rule includes an exemption for any bonds issued in denominations of at least $100,000 and subject to tender by the owner at least every nine months. In practice, that exemption has applied to letter of credit backed bonds, which are subject to tender on a regular basis (usually weekly or daily). Given the popularity of LOC-backed, variable rate demand obligations or "VRDOs," the exemption was widely applied. That exemption to borrower disclosure made practical sense, to the extent the VRDO market relied solely on the LOC bank and could obtain current LOC bank financial information from regulatory agencies. For many years however, senior SEC officials have expressed reservations about the ongoing exemption from the Rule for VRDOs. Recognizing the SEC's concerns and responding to investor demand for borrower financial information, many underwriters have recommended that borrowers issuing VRDOs voluntarily comply with the Rule. Therefore many borrowers otherwise exempt from the disclosure requirements, have already voluntarily agreed by contract to provide annual disclosure and event notices.
In announcing the amendments to the Rule, the SEC noted several reasons for eliminating the exemption for VRDOs, including the significant growth of the market for VRDOs, citing an increase from $13 billion issued in 1989 to approximately $32 billion issued in 2009, with a total current outstanding of approximately $400 billion. Additional factors noted by the SEC were the recent "market meltdown" in the fall of 2008 and related bank downgrades and pressure on banks and the specific request for additional disclosure by representatives of the money market funds.
Increased Focus on Event Notices
The existing Rule includes a list of 11 events which trigger a specific notice to the market if the events are deemed to be "material." Currently, the event notice must be filed "in a timely manner." The amendments to this portion of the Rule: (a) eliminate the "materiality" qualifier for several of the listed events, (b) establish a deadline for filing notices of 10 days from the occurrence of the event and (c) expand the list of events triggering a notice filing from 11 to 14, as follows (the three new events are shown in italics):
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Principal and interest payment delinquencies;
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Non-payment related defaults, if material;
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Unscheduled draws on debt service reserves reflecting financial difficulties;
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Unscheduled draws on credit enhancements reflecting financial difficulties;
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Substitution of credit or liquidity providers, or their failure to perform;
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Adverse tax opinions, the issuance by the IRS of proposed or final determinations of taxability, Notices of Proposed Issue or other material notices or determinations with respect to the tax status of the security or events affecting the tax-exempt status of the security;
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Modifications to rights of security holders, if material;
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Bond calls, if material and tender offers;
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Defeasances;
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Release, substitution or sale of property securing repayment of the securities, if material;
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Rating changes;
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Bankruptcy, insolvency, receivership or similar event of the obligated person;
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The consummation of a merger, consolidation, or acquisition involving an obligated person or the sale of all or substantially all of the assets of the obligated person, other than in the ordinary course of business, the entry into a definitive agreement to undertake such an action or the termination of a definitive agreement relating to any such actions, other than pursuant to its terms, if material; and
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Appointment of a successor or additional trustee or the change of name of a trustee if material.
The changes to the materiality standard should not prove too difficult to apply. For example, a payment default (#1 above) is by definition always material. On the other hand, a sale of collateral securing the bonds (#10 above) may be material or insignificant. When in doubt, it will be better practice to disclose. There is typically no cost to filing additional disclosure statements with the disclosure agent. It is a good idea to get in the habit of reviewing material corporate events, such as the signing of a significant affiliation agreement, for purposes of disclosure under the Rule (#13 above). The addition of a 10 day deadline for filing event notices leaves less room for error in filing. The change to the Rule essentially eliminates the argument that a filing 30 days after the fact is "timely."
Noncompliance with the Rule
Failure to comply with the Rule does not constitute an Event of Default under the bond documents. The SEC's sanction for noncompliance is that the borrower must report its non-compliance in connection with any new public offering. For example, if it is determined during the due diligence process that a borrower failed to file annual report and/or an event notice was not filed, the filings must be updated and a notation of the noncompliance will be noted in the offering document for the new issue.
Effective Date and Application
The revised Rule will become effective for publicly traded bonds issued on or after December 1, 2010. For borrowers with fixed rate bonds and VRDOs outstanding as of that date, there will be no change with respect to those bonds. The SEC provided a limited grandfather provision applicable to outstanding VRDOs. Going forward, publicly traded bonds issued on or after December 1, 2010, whether fixed rate or VRDOs, will be subject to the Rule. The Continuing Disclosure Agreement with respect to such bonds will incorporate the new standards outlined above. Borrowers will need to be diligent with respect to monitoring the occurrence of the listed events and the timely filing of event notices.
For additional information concerning the SEC's continuing disclosure requirements or changes to SEC Rule 15c2-12, please contact any of the following members of Hall Render's Commericial, Health Care and Public Finance group:
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