The recent amendments to SEC Rule 15c2-12 (the “Rule”), which must be incorporated into continuing disclosure undertakings effective on or after February 27, 2019, have caused municipal underwriting firms to review existing due diligence processes and procedures. In this post, we provide a proposed approach to due diligence for the new aspects of the Rule that we believe would satisfy underwriters’ obligations under federal securities laws. We think a reasonable approach will, consistent with the SEC’s purposes, promote increased disclosure of and about “financial obligations,” without adding unnecessary costs and burdens to municipal issuers.
Some municipal market groups have suggested that issuers create and maintain lists of material financial obligations to promote compliance with the new event notice requirements. While we believe these lists may be helpful to certain issuers, particularly certain large issuers, we do not believe underwriters need to require issuers to maintain lists solely for the purpose of satisfying underwriters’ due diligence responsibilities, for the reasons discussed below.
For background on the recent amendments to the Rule, see the following:
- Prior Disclosure Notes post: Impact of Rule 15c2-12 Amendments
- MSRB Guide: 10 Things to Know: New SEC Rule 15c2-12 Requirements
- GFOA Member Alert: New Amendments to SEC Rule 15c2-12
In general, the amendments require municipal issuers and borrowers entering into continuing disclosure undertakings required by the Rule to agree to provide notice within 10 business days after the incurrence of a material “financial obligation” (referred to in this post as “Event 15”) and the occurrence of a default, breach, or similar event relating to a “financial obligation” that reflects financial difficulties (referred to in this post as “Event 16”). This post does not explore in any detail the processes or obligations involved in issuer compliance with these new requirements. We anticipate providing guidance on that topic in the near future.
Underwriter Responsibilities Regarding Continuing Disclosure
An exploration of underwriters’ general responsibilities with respect to continuing disclosure will provide helpful context for understanding diligence processes for Event 15 and Event 16. The combination of the Rule and the antifraud rules under the federal securities laws require an underwriter in a municipal securities offering to conduct a due diligence review of the issuer and the proposed financing. In addition, the underwriter must reach reasonable conclusions regarding the commitment by a municipal issuer to provide continuing disclosure, which includes assessing that issuer’s past compliance with prior continuing disclosure obligations. The Rule requires an underwriter in a municipal securities offering subject to the Rule to complete two specific actions before participating in the offering:
- Obtain and review an official statement containing:
- the information material to an evaluation of the offering;
- a description of the continuing disclosure undertaking;
- a description of any instances in which the obligated person has, in the previous five years, failed to comply, in all material respects, with prior continuing disclosure undertakings required by the Rule.
- Reasonably determine an issuer has undertaken in writing to provide annual financial information and notice of the occurrence of certain events to the market through the MSRB’s EMMA system.
These requirements are intended to assist an underwriter, in meeting its obligations under the antifraud provisions of the federal securities laws; namely, to have a reasonable basis for recommending municipal securities to investors. Implicit in this obligation, and as described in multiple SEC releases relating to the Rule, is a requirement that an underwriter review the official statement in a professional manner for accuracy and completeness.
The Current State of Underwriter Due Diligence
The settlements resulting from the SEC’s MCDC Initiative required most municipal underwriters to hire an independent consultant and follow the consultant’s guidance regarding the underwriter’s policies and procedures for conducting municipal securities underwriting due diligence. As a result, most underwriters have implemented extensive processes to assess an issuer’s past compliance with its continuing disclosure undertakings, require catch-up filings relating to any material deficiencies, and ensure appropriate disclosure of past material noncompliance in the official statement. Many underwriters have hired third parties to assist with this process or hired additional staff to conduct the review internally, which has resulted in most underwriters conducting thorough and granular reviews of past continuing disclosure compliance.
Most municipal underwriters are currently updating these processes to account for the addition of Event 15 and Event 16. Some are suggesting issuers must maintain a list of financial obligations to assist underwriters with their due diligence responsibilities. We believe, based on statements in SEC releases discussing amendments to the Rule, these lists are not necessary for an underwriter to satisfy its responsibilities under the federal securities laws.
SEC Interpretive Guidance on Continuing Disclosure Due Diligence
In a release describing and adopting amendments to the Rule in 2010 (the “2010 Release“), the SEC revisited prior interpretive guidance from the SEC with respect to underwriters’ diligence responsibilities regarding continuing disclosure. (The interpretive guidance discussion referenced in this post begins on page 88 of the 2010 Release linked on the SEC’s website here.) In its interpretive guidance, the SEC reiterated its view that an issuer’s description of its obligation to provide continuing disclosure is a key representation in an official statement, and that an underwriter must have a reasonable basis to believe the issuer will comply with its continuing disclosure obligations. The SEC stated that sole reliance on the representations of the issuer will not suffice, and provided a list of factors affecting the reasonableness of a review, including reliance on municipal officials and others whose duties have given them knowledge of particular facts and whether the bonds were sold at competitive sale or in a negotiated offering, among others.
The SEC stated it doubted an underwriter could meet the reasonable belief standard without affirmatively inquiring about an issuer’s continuing disclosure compliance history, and should base its belief on its independent judgment, not representations of the issuer regarding the materiality of any failure. The Commission acknowledged, however, that it may not be possible in some cases for an underwriter independently to determine whether some events have occurred, and suggested that asking questions and obtaining certifications may be appropriate to form a reasonable basis to believe representations about compliance with the obligation to provide notice of certain material events. An excerpt from pages 95-96 of the 2010 Release (with citations omitted) is below:
The Commission acknowledges that it may not be possible in some cases for an underwriter independently to determine whether some events, for which an event notice is necessary, have occurred. In order to obtain this information, an underwriter may take steps, such as asking questions of an issuer and, where appropriate, obtaining certifications from an issuer, obligated person or other appropriate party about facts, such as the occurrence of specific events listed in paragraph (b)(5)(i)(C) of the Rule (without regard to materiality), that the underwriter may need to know in order to form a reasonable belief in the accuracy and completeness of an issuer’s or obligated person’s ongoing disclosure representations. However, as discussed above, the underwriter may not rely solely upon the representations of an issuer or obligated person concerning the materiality of such events or that it has, in fact, provided annual filings or event notices to the parties identified in its continuing disclosure agreements (i.e., NRMSIRs, MSRB, and State Information Depositories). Instead, an underwriter should obtain evidence reasonably sufficient to determine whether and when such annual filings and event notices were, in fact, provided. The underwriter therefore must rely upon its own judgment, not solely on the representation of the issuer or obligated person, as to the materiality of any failure by the issuer or obligated person to comply with a prior undertaking.
In our view, this clearly means an underwriter must check EMMA to confirm filings known to be required—such as annual reports—were made. It should not be read to mean that an underwriter has a duty to independently verify things that cannot be independently verified. For example, an underwriter cannot know that a material non-payment related covenant default (a required event filing since 1994, which is quite similar to Event 16) has occurred with respect to securities subject to a continuing disclosure undertaking, without reviewing other publicly-available information or asking issuer officials during the normal due diligence process. Obviously an underwriter purchasing securities in a competitive sale will have little ability to conduct in-person due diligence, which should not be considered part of the reasonable diligence or professional review necessary before bidding to purchase securities in a competitive sale. The SEC made clear that an underwriter’s professional review included an objective, independent review of available information. As discussed below, we believe this objective, independent review with respect to outstanding material financial obligations and defaults reflecting financial difficulties has been occurring for years as part of the normal underwriter diligence review of an offering document before participating in a primary offering.
Leveraging Existing Diligence Processes
The review of compliance with these new undertakings will necessarily occur in the context of an underwritten offering of municipal securities. In that context, an underwriter will have already undertaken a review of the preliminary official statement to assess its accuracy and completeness. Presumably, a complete and not misleading preliminary official statement will include a discussion of all material financial obligations (whether expressly in the offering document or in the audited financial statements included as an appendix). With respect to Event 16, we expect the situations triggering Event 16 to be so rare and so impactful to the creditworthiness of a municipal issuer that they would necessarily be discovered during a reasonable due diligence investigation and professional review of an official statement conducted prior to an offering. The offering document should discuss any defaults or other situations described in Event 16 in the recent past that reflect financial difficulties. If the offering document does not describe material financial obligations or discuss recent defaults on financial obligations that reflect financial difficulties, it would likely be incomplete for primary offering purposes. Underwriter due diligence processes that have long been in place, including standard diligence questionnaires that address these issues, should be leveraged to assist with an underwriter’s assessment of an issuer’s compliance with Events 15 and 16.
Our Suggested Diligence Approach
First Undertaking Requiring Events 15 and 16
As a threshold matter, underwriters must confirm the new events are incorporated into any continuing disclosure undertaking entered into on or after February 27, 2019, and that the undertaking is properly described in the official statement. Beyond that, we believe it would be reasonable in most circumstances to conclude the issuer will comply with the written undertaking based solely on the issuer’s contractual obligation and representations in the official statement. Unlike situations described in SEC guidance where past material and persistent noncompliance should make an underwriter skeptical that an issuer would comply with its continuing disclosure obligations in the future, no issuer should be presumed unlikely to comply with respect to Events 15 and 16, absent extraordinary historical noncompliance. An underwriter could, to promote compliance and ensure the issuer understands its new responsibilities, adopt a process to confirm the issuer has access to training materials, resources and advisors to assist in compliance with Event 15 and Event 16.
After Event 15 and Event 16 are Required for an Issuer
Consistent with an underwriter’s long-standing obligation to review an official statement in a professional manner, we believe the following process would allow underwriters to reasonably conduct due diligence with respect to an issuer’s prior compliance with Event 15 and Event 16.
- Event 15
- Step 1 – Review audited financial statements, official statement disclosure, and other customary documents provided in the due diligence process to identify any material financial obligations incurred in the preceding five years.
- Step 2 (Negotiated Sale only) – Ask issuer officials to confirm the information generated in Step 1, and identify any additional material financial obligations not discovered in Step 1.
- Step 3 – Review EMMA to confirm required event notices, if any, were filed.
- Event 16
- Step 1 – Review audited financial statements, official statement disclosure, and other customary documents provided in the due diligence process for discussion of financial difficulties in general, with a particular focus on covenant violations and similar events described in Event 16 that reflect financial difficulties.
- Step 2 (Negotiated Sale only) – Ask issuer officials about the existence of financial difficulties in the preceding five years, including any resulting in occurrences described in Event 16.
- Step 3 – Review EMMA to confirm required event notices, if any, were filed.
At each step of the above process, the underwriter should make independent assessments of materiality, without reliance on determinations made by the issuer.
The new events are intended to improve timeliness and adequacy of disclosure to investors about the incurrence of material financial obligations, as well as defaults and other occurrences relating to financial obligations. We believe a practical approach by underwriters can assist issuers in complying with these new requirements, without adding time, cost, and complexity to the process for both issuers and underwriters.