June 28, 2012
The Securities and Exchange Commission (SEC) released a National Examination
Risk Alert on March 19, 2012 (the “Alert”) that highlighted a number of failures
in the due diligence and disclosure process for municipal securities offerings.
The Alert highlights the SEC’s increasing emphasis on due diligence and
disclosure in the municipal securities markets and states the SEC’s belief in
the importance of a documented due diligence process for municipal securities as
well as the need for continuing disclosure under Securities Exchange Act Rule
15c2-12 (Rule 15c2-12). The Alert recognizes that many underwriters have not
established adequate procedures to ensure due diligence and disclosure
compliance in accordance with Rule 15c2-12, MSRB Rule G-27 and other federal
securities laws. The Alert urges underwriters as well as issuers of municipal
securities to implement these types of procedures and comply with the
requirements of the securities laws.
Underwriters’ Due Diligence Obligations and Compliance
When an underwriter participates in an offering or sale of municipal
securities, it is making an implied recommendation about the quality of the
security involved in the transaction. The SEC believes that one component of the
recommendation is that the underwriter has a reasonable belief in the
truthfulness and completeness of the key representations made in the disclosure
documents associated with the security. Failure on the part of an underwriter to
demonstrate that it has formed a reasonable belief could be grounds for a
violation of the antifraud provisions of the federal securities laws. Further,
Rule 15c2-12 requires that underwriters review the “deemed final official
statement” for accuracy and completeness and that the underwriter has reasonably
determined that an issuer will comply with its continuing disclosure obligations
under Rule 15c2-12. Finally, MSRB Rule G-27 requires that an underwriter have
supervisory procedures in place to ensure compliance with the securities laws
(including the antifraud provisions, Rule 15c2-12 and MSRB Rule G-27). While the
securities laws have no explicit requirement that an underwriter maintain
written evidence, the SEC has stated that maintaining proper records of due
diligence activities can be the basis of an affirmative defense when the SEC
charges the firm with failing to comply with its obligations.
In the Alert, the SEC rejects many current industry-held beliefs concerning
due diligence and disclosure compliance. The Alert states that due diligence
obligations should not be outsourced to underwriter’s counsel unless counsel
provides a written summary of diligence efforts and the reviewed items.
Additionally, underwriters are urged to retain due diligence records after the
closing of an issuance rather than discarding the materials or not collecting
them at all. The SEC provides the following examples of practices that
demonstrate compliance: written due diligence policies and practices, commitment
committees, due diligence checklists, due diligence memoranda, due diligence
calls (with accompanying agenda or minutes), on-site diligence examination and
recordkeeping checklists. The Alert indicates that firms should implement a
supervisory system for overseeing the due diligence and compliance efforts as
well as a system for reporting disclosure issues. The Alert further stressed
that an underwriter’s due diligence obligations do not end with the collection
and retention of the due diligence materials. The underwriter must review the
diligence items provided to it by the issuer, the offering statement and other
offering materials for completeness and accuracy.
Issuer’s Role in Securities Compliance
In a typical municipal securities offering, issuers are required by
underwriters to provide sufficient information to comply with the applicable
securities laws, and issuers should expect that such information will be
required of them. Issuers can comply with such requirements by maintaining
current financial and other material information usually disclosed in municipal
securities offerings, and by making key personnel available for diligence calls,
site visits and other reviews performed by underwriters. In addition, because
Rule 15c2-12 requires scrutiny of the issuer’s past compliance with continuing
disclosure requirements, issuers should implement compliance procedures as well
as maintain a continuing disclosure compliance record after the closing of an
issue. Issuer disclosures contained in the offering statement are also subject
to the antifraud provisions of the securities laws, which require that an issuer
disclose all material information and not make a material misstatement or
omission of fact in the offering documents. Public officials, just like
corporate executives, sign offering documents that are made public, and public
officials can be subject to SEC enforcement actions. To ensure compliance with
the antifraud provisions, issuers should implement internal procedures for due
diligence and offering document review.
Once an issuer has entered the market, it must comply with its continuing
disclosure requirements and should implement procedures to do so, just as
issuers have implemented tax compliance procedures. Failure on the part of an
issuer to comply with its continuing disclosure requirements within the previous
five years must be disclosed in the final offering document and, depending on
when the prior failure is discovered, an amendment indicating the
compliance failure may be required. Such a disclosure in the offering document
may not only affect debt pricing and timing, but also can be embarrassing.
Repeated failure to comply may preclude the underwriter from underwriting the
issue. Under MSRB Rule G-17, a municipal security cannot be offered for sale on
the secondary market without disclosing, among other things, an issuer’s past
continuing disclosure compliance record, which may affect the price of the
security on the secondary market and could in turn impact the pricing of future
offerings. Accordingly, issuers without proper compliance systems in place run
the risk of including incorrect or omitting material information or being
required to include negative disclosure (or have negative disclosure made about
them), which may ultimately result in a reduction in the overall value of that
issuer’s securities.
Conclusion
The financial crisis and increasing public concerns regarding the municipal
securities market have prompted the SEC to focus on due diligence and disclosure
aspects of municipal securities. With this increased focus, underwriters and
issuers should audit their current procedures and expect that changes will be
required of them to ensure future compliance. Underwriters and issuers with
written policies and procedures in place that foster due diligence compliance,
as well as compliance with continuing disclosure obligations, will remain
attractive in an increasingly competitive market and provide for a smoother and
successful financing process. We will continue to monitor changes to these
requirements; should you wish to discuss any of these items, please contact the
authors or visit the
McGuireWoods
LLP website.