The 2018 amendments to Rule 15c2-12 (the “Rule”) make the following additions to the continuing disclosure requirements applying to most publicly-held municipal securities:
(a) Amending the list of Event Notices to require disclosures, within 10 business days, of the following:
(i) Incurrence of a financial obligation of the issuer or obligated person, if material, or agreement to covenants, events of default, remedies, priority rights, or other similar terms of a financial obligation of the issuer or obligated person, any of which affect security holders, if material. 17 CFR 240.15c2-12(b)(5)(i)(C)(15).
(ii) Default, event of acceleration, termination event, modification of terms, or other similar events under the terms of a financial obligation of the issuer or obligated person, any of which reflect financial difficulties. 17 CFR 240.15c2-12(b)(5)(i)(C)(16).
(b) Defining the term “financial obligation” to mean a (i) debt obligation; (ii) derivative instrument entered into in connection with, or pledged as security or a source of payment for, an existing or planned debt obligation; or (iii) a guarantee of (i) or (ii). The term financial obligation does not include municipal securities as to which a final official statement has been otherwise provided to the Municipal Securities Rulemaking Board under the Rule.
The 2018 amendments to the Rule will become effective in February, 2019, meaning that underwriters will require new paragraphs (15) and (16) of the Rule to be included in issuers’ and obligated persons’ continuing disclosure undertakings entered into after that date.
Background/Rationale for the Amendments
In July 2012, the Securities and Exchange Commission (the “Commission” or “SEC”) issued a Report on the Municipal Securities Market which highlighted, among other things, market participants’ concerns that issuers and obligated persons were not properly disclosing the existence or the terms of their bank loans.
In 2016, the Municipal Securities Rulemaking Board (the “MSRB”) enhanced its Electronic Municipal Marketplace Access System (“EMMA”) to allow submitters of continuing disclosure to identify “Bank Loan/Alternative Financing Filings” as the type of filing. However, in a letter to the SEC in October 2017, the MSRB stated its concern that most issuers and obligated persons were not voluntarily reporting their bank loans, given that only about 1,100 bank loan documents had been posted to the EMMA website.
Although GASB requires certain information related to debt to be disclosed in notes to financial statements, such disclosure may not provide information about the particular covenants, events of default, remedies, priority rights, or the like in sufficient detail for market participants to make informed investment decisions.
Recent changes to federal tax laws have triggered provisions commonly found in direct placements relating to the rate at which a direct placement will bear interest. In the Commission’s view, these tax-related provisions are illustrative of the types of terms to which issuers and obligated persons agree when incurring financial obligations, but which were not previously required to be disclosed even though they could adversely affect existing bondholders.
Although in some cases existing bond documents prohibit the granting of superior lien rights to other holders of the issuer’s or obligated person’s debt, there is no set standard of what provisions are included in bond documents. Thus, bank loan covenants and events of default can be different from or set at higher levels than those applicable to outstanding bonds, thereby enabling the bank to assert remedies prior to other bondholders. This may effectively prioritize repayment of the bank loan and thereby adversely affect existing bondholders.
Scope of Notice of Debt Incurrence [15c2-12(b)(5)(i)(C)(15)]
A disclosure regarding the incurrence of debt (if material) should include a description of all material terms of the financial obligation, such as the date of incurrence, principal amount, maturity and amortization, interest rate (if fixed) or method of computation (if variable), and any default rates. Depending on the facts and circumstances, issuers and obligated persons may also decide to submit full transaction documents, term sheets, continuing covenant agreements or financial covenant reports to EMMA. Any such related materials, if submitted as an alternative to a description of the material terms of the financial obligation, should include all the material terms of the financial obligation. Provided the necessary disclosures are made, such documents may be redacted to avoid disclosure of confidential information such account numbers and personally identifiable information.
Scope of Disclosure of Defaults, Terminations and Modifications [15c2-12(b)(5)(i)(C)(15]
A default, event of acceleration, termination, modification of terms or other similar event under the terms of a financial obligation that occurs on or after the effective date of the Rule amendments must be disclosed regardless of whether such obligation was incurred before or after the effective date. However, no such event must be disclosed unless it “reflects financial difficulties.” This “financial difficulties” qualifier is included to help target the disclosure of information relevant to investors in making an assessment of the current financial condition of the issuer or obligated person.
The Commission believes that there are defaults that may reflect financial difficulties even if they do not qualify as “events of defaults” under transaction documents. Typically, if a monetary default occurs, or a non-payment related default is not cured within a specified period, such default becomes an “event of default” and the trustee or counterparty to the financial obligation may exercise legally available rights and remedies for enforcement, including an event of acceleration. Under the amended Rule, a default must be disclosed even if it is subject to an unexpired cure period, so long as the default “reflects financial difficulties” of the issuer or obligated person.
The Rule also requires disclosure of “other similar events” under the terms of a financial obligation of the issuer or obligated person reflecting financial difficulties. The Commission states that, in order to be subject to disclosure, such other events must necessarily share similar characteristics with one of the preceding listed events (e.g., a default, event of acceleration, termination event, or modification of terms).
The Commission believes that including a materiality qualifier in the amendments is appropriate as it provides a framework for issuers and obligated persons to assess their disclosure obligations in the context of the specific facts and circumstances.
What constitutes materiality can vary by entity based on the size of the overall balance sheet, the size of existing obligations, or the size of the overall bond portfolio. Regardless of size, it is possible that a financial obligation payable from one source of revenues might not be material to security holders of municipal securities payable from a separate or distinct source of revenues.
Declining to adopt any specific guidance, the Commission indicates that materiality determinations should be based on whether the information would be important as part of the total mix of information made available to a reasonable investor.
Timing of Disclosure
The Commission believes that 10 business days is a reasonable period of time for compliance with the new Event Notice requirements. Issuers and obligated persons should be able to begin the process of assessing, in advance of any debt incurrence, whether the new obligation should be disclosed under new paragraph (15) of the Rule.
If an issuer or obligated person enters into an agreement providing for a draw-down bond, or an agreement that contains material terms or covenants that may become effective upon the occurrence of certain events, the issuer or obligated person generally should provide notice at the time the agreement is executed, instead of each time a draw is made or a covenant is triggered. That having been said, the triggering of a covenant that results in a default, acceleration, termination event, or modification reflecting financial difficulties, must be independently disclosed upon its occurrence under new paragraph (16) of the Rule.
Definition of Debt Obligation
The term “debt obligation” is intended to include the short-term and long-term loans or debt securities of an issuer or obligated person that will be repaid over time, regardless of the length their repayment period. In the context of the Rule, the Commission is not limiting the term “debt obligation” to debt as it may be defined for state law purposes, but instead is applying the term more broadly to circumstances under with an issuer or obligated person has borrowed money. Based on the circumstances, a lease arrangement may be reportable as a “debt obligation” to the extent entered into as a vehicle to borrow money. The types of leases that could be debt obligations include, but are not limited to, lease-revenue transactions and certificates of participation transactions. Examples of leases that are typically not vehicles to borrow money include, but are not limited to, commercial office building leases, airline and concessionaire leases at airport facilities, and copy machine leases.
Definition of Derivative Instrument
The term “derivative instrument” includes any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument to which an issuer or obligated person is a counterparty, provided that such instruments are related to an existing or “planned” debt obligation. To determine whether a derivative instrument is covered by the amended Rule, it is reasonable to distinguish derivative instruments designed to hedge against the risks of a related debt obligation (i.e., debt-related derivatives) from derivative instruments designed to mitigate investment risk.
A debt obligation is considered “planned” at the time the issuer or obligated person incurs the related derivative instrument if, based on the facts and circumstances, a reasonable person would find it likely or probable that the issuer or obligated person expected to incur the related yet-to-be-incurred debt obligation at a future date. For example, in a forward starting interest rate swap transaction, an issuer or obligated person typically incurs the forward starting interest rate swap in advance of the incurrence of a debt obligation. A forward starting interest rate swap must be disclosed within 10 business days of its incurrence because the issuer’s or obligated person’s contingent obligation to make payments, post collateral, and the like begins at the point of incurrence of the swap, not when the planned debt obligation is incurred.
Definition of Guaranty
The term “guarantee” includes any contingent financial obligation of the issuer or obligated person to secure any person’s debt obligation or derivative instrument (each as defined above). The Rule only covers guarantees that relate to debt, debt-like, or debt-related obligations. A guarantee provided for the benefit of a third party, or a self-liquidity facility or other contingent arrangement, would be a guarantee under the Rule amendments.