The Securities and Exchange Commission (SEC) recently completed settlements with the greater part of municipal underwriters and an initial group of issuers under the recent MCDC (Municipalities Continuing Disclosure Cooperation) initiative.
However, for the issuers who may not have come forward during the MCDC’s self-reporting period, the incremental cost of non-compliance with the continuing disclosure requirements will be high. Most of that cost will manifest itself in the form of additional risk premium paid on bonds or loans, which will be paid for by future revenue contributors or tax-payers as a result of the issuers’ past non-compliance in their continuing disclosure requirements. This is in addition to the possible civil penalties that the SEC may charge institutions and the public officials as the agency recently has been placing extra emphasis on the responsibilities of individual officials and imposing more significant civil penalties on municipal officials and governmental entities outside the MCDC.
The SEC’s MCDC Initiative and Beyond
When the SEC launched the MCDC initiative, it recommended lenient settlement terms for the issuers and underwriters who voluntarily self-report possible violations involving materially inaccurate statements not compliant with the continuing disclosure obligations of Rule 15c2-12.
The SEC’s enforcement actions against underwriters under the MCDC in three sets of settlements covered 96 percent of the municipal underwriting market. Its first round of settlements with issuers in August 2016 covered a small, but diverse group of only 71 muni issuers, including six colleges and universities or their affiliates (Arkansas Tech University, Montgomery College and its Foundation, Southern New Hampshire University, Syracuse University and Ohio State University).
The SEC is expected to announce more cases as this first wave of 71 settlements is not extensive enough to cover the municipal issuers’ market—especially since some ongoing cases might involve more complicated or severe infringements. The SEC is also expected to conduct more comprehensive reviews and focus more on enforcement actions against issuers which didn’t or chose not to self-report violations under the MCDC initiative. The settlements with underwriters and issuers provide insights about what the SEC considers as material with an extra emphasis on the responsibilities of individual officials. These instances do not necessarily involve only fraud or misrepresentations, but also include negligence, conflicts of interest or even violations in public statements in a mayor’s public speech appearing together with the issuer’s annual financial statements.
A major concern among issuers is the possible impact of settlements on credit ratings of bonds and the cost of borrowing. Recently, Standard and Poor’s (S&P) indicated that MCDC would not immediately lead to downgrades by effectively limiting it to issuers’ proactive response to address disclosure deficiencies. However, worries still remain as S&P maintained that severe disclosure deficiencies or violations involving malfeasance would lead to rating downgrades.
Various public finance rating criteria documents from the leading rating agencies indicate that the disclosure practices of issuers does affect the rating agencies’ consideration of the management and governance of issuers. In particular, they are influenced via a non-trivial weight on the scoring grid or additional qualitative overlay that could potentially trigger a downgrade up to three notches and considerably increase issuers’ future cost of borrowing, manifesting itself as increased spreads or coupon rates.
Cost of Downgrades
We recently analyzed the possible impact of a one-notch downgrade on the rating of a high investment grade (Moody’s-Aa/S&P-AA range) issuer also considering to issue a new series of bonds at or close to par. Our statistical analysis showed that such a downgrade would increase the coupon rate on a notional $75 million series of newly to be issued bonds by 1/8 percent (0.125 percent), thus, increasing the cumulative coupon payments over the life of the new bonds by more than 5 percent.
In another but similar engagement, the impact on a lower rated but still investment grade muni issuer (Moody’s-Baa/S&-BBB range) became more pronounced; with an increase of 0.30 percent in newly to be issued bonds’ coupon rates. Our analysis indicated that the cumulative coupon payments would increase close to 9 percent for a notional $5 million, 5-year simple series of bonds.
For institutions, or their officials, that did not self-report prior to the December 2014 deadline, they should first check the nature of infringements in the settlements disclosed so far between the SEC and both underwriters and issuers against their own disclosure infringements. Their next step should definitely be to get their internal and external counsel reach out to the SEC before it becomes too late, and too costly, for them before being captured in the SEC’s more stringent examination web.
Despite expectations for a more lenient enforcement climate from the Trump administration, the points raised by Andrew Ceresney, the Director of the SEC’s enforcement division, at a keynote speech on October 13, 2016, indicate that the SEC may pursue penalties, revenue or taxpayer sourced, on issuers.
Ozgur Kan is a managing director with Berkeley Research Group and leads the Credit Analytics practice. The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.