On August 24, 2016, the Securities and Exchange Commission ("SEC") announced settlements with 71 state and local government issuers of municipal bonds and private sector borrowers of bond proceeds (collectively, "issuers") under its Municipalities Continuing Disclosure Cooperation ("MCDC") Initiative. In addition to representing the first of several likely waves of issuer settlements, these settlements are notable because they suggest a more aggressive approach by the SEC on what it views as material omissions from bond offering disclosure documents ("official statements") that may have repercussions beyond the scope of the MCDC Initiative.

BACKGROUND

Continuing Disclosures. Securities Exchange Act Rule 15c2-12 prohibits broker-dealers and banks from underwriting most municipal bond offerings unless the issuer agrees, typically in a continuing disclosure agreement, to file continuing disclosures with the Electronic Municipal Market Access (EMMA) system. Such disclosures include audited financial statements and other financial and operating data, to be provided on an annual basis (or, if not filed on a timely basis, then a notice to that effect), as well as notices of specified events as they may occur. Underwriters for new bond offerings must review official statements that include descriptions of instances in the previous five years in which the issuer failed to comply, in all material respects, with prior commitments to provide continuing disclosure for earlier issues.

Because Rule 15c2-12 applies to underwriters and not to issuers, market participants (with, in some respects, the tacit acquiescence of regulatory staff) had long viewed issuer compliance with continuing disclosure agreements to be a matter of contract enforcement rather than as a securities law matter. The MCDC Initiative has strongly repudiated that view.

MCDC Initiative. Launched in 2014, the MCDC Initiative served as a dramatic illustration of the indirect regulatory risk of failure to meet contractual requirements, with the SEC alleging widespread violations of the anti-fraud provisions of the federal securities laws by issuers and underwriters arising from public disclosures about continuing disclosure compliance. The SEC focused in particular on Section 17(a)(2) of the Securities Act of 1933, which prohibits sales of securities "by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading," even if due only to negligence and not with intent to defraud. The SEC believed that many issuers had failed to properly disclose in their official statements past material failures to comply with their continuing disclosure agreements or had made affirmative statements of compliance that were inaccurate. Under the MCDC Initiative, the violative action was not the failure to comply with the continuing disclosure agreement, but instead the failure to properly disclose such non-compliance.

The SEC offered favorable settlement terms for entities that self-reported "potentially inaccurate statements" in official statements regarding compliance. The SEC noted that these terms would be available only to entities that self-reported and future enforcement actions with more severe sanctions could be undertaken against entities that did not self-report, as well as against individuals involved with the making of the inaccurate statements.

Prior Underwriter Settlements. Previously, the SEC settled with 72 underwriting firms, estimated to represent 96% of the market share for municipal securities underwritings. The SEC found that the underwriters had violated Section 17(a)(2) by failing to form a reasonable basis, through adequate due diligence, for believing the truthfulness of issuers' statements contained in official statements about their continuing disclosure compliance. Although fines levied against individual underwriters were capped under the favorable MCDC terms, underwriters paid in the aggregate nearly $18 million in fines and were required to hire independent consultants to review and recommend changes to their underwriting due diligence policies and procedures.

ISSUER SETTLEMENTS

Terms of Settlements. In these most recent settlements, the SEC found that the issuers had made materially false or misleading statements, or had made material omissions, in official statements about their prior compliance with continuing disclosure agreements in violation of Section 17(a)(2). No fines were levied but the issuers were required, among other things, to establish policies and procedures and institute training on continuing disclosure obligations, disclose the terms of the settlement in official statements for offerings over the next five years, and cooperate with the SEC in any investigations of individuals or other parties involved.

Types of Issuers Involved. While the 71 settling parties constitute only a very small fraction of the approximately 50,000 governmental issuers and many thousands of private sector borrowers, they represent a broad cross-section of the municipal marketplace. The issuers consist of states, state agencies, counties, cities, towns, boroughs, school districts, a charter school, public and private universities, not-for-profit healthcare organizations, parks and utilities districts, an airport, and other public and private entities in 45 states. The settlements cover both negotiated and competitive offerings and include private placements and a remarketing.

Nature of Disclosure Failures. Each settlement order included brief descriptions of the disclosure failures found by the SEC. In summary:

• Nearly all violations, just as in the underwriter settlements, involved failures to disclose that filings of audited financial statements or other financial or operating data were made after the contractual deadlines, or not at all. The shortest delayed filing was one month late and the longest delay was nearly six years late.
• In virtually every case, the issuer did not provide notice of its failure to meet the filing deadline.
• Only three violations related to failures to provide event notices, consisting of two failures to provide notice of defeasance of outstanding bonds and one private sector borrower's failure to cross-reference at EMMA its corporate Form 8-K filed with the SEC's EDGAR system regarding a corporate acquisition.
• In two cases, an issuer and a private sector borrower failed to disclose failures to provide certain quarterly reports that they had committed to make in their continuing disclosure agreements even though such quarterly reports are not within the scope of disclosures enumerated in Rule 15c2-12.

Nature of Fraudulent Statements and Omissions. As noted above, it was the failure of proper disclosure in the official statement of past non-compliance with the continuing disclosure agreement, and not the non-compliance itself, that was cited as a violation of the anti-fraud provisions. The official statement disclosure failures can be divided into two general categories:

• Incorrectly describing past compliance, such as stating that (i) the issuer had complied when it actually had not, or (ii) the only cases of non-compliance were disclosed in the official statement when in fact other cases of non-compliance existed.
• Omitting a description of past non-compliance, such as (i) providing an incomplete list of disclosure failures without affirmatively stating that no other failures existed, or (ii) remaining silent as to past compliance in circumstances where non-compliance existed.

THE CASE OF THE SILENT FRAUDSTER

As noted above, the omission from a disclosure document of information may be considered fraudulent if such information is material (that is, there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision) and is necessary to make the statements that were in fact made in the disclosure document, in light of the circumstances under which they were made, not misleading.  In those MCDC settlements where the issuer remained silent about past non-compliance, it is worth considering which statements in the official statement may have been misleading to the reasonable investor because of the lack of such compliance information.

• Does the SEC view the issuer's silence on past performance as fraudulent based on the existence of the Rule 15c2-12 requirement applicable to the underwriter, not the issuer? Does this assume that a reasonable investor is knowledgeable of the Rule 15c2-12 requirement and its indirect contractual impact on issuers, and the issuer's silence is to be considered in light of this assumed knowledge? What impact could such a theory have beyond the scope of Rule 15c2-12 compliance, or even beyond the scope of the municipal securities market, where an issuer may feel the impact of another party's regulatory obligations? Note that there is currently a split of authority on the potential for anti-fraud liability for failure to include certain required information items in registered corporate securities offerings, where such requirement falls directly on the issuer (as opposed to the more attenuated indirect impact of the Rule 15c2-12 obligation on issuers).
• Does the SEC view such silence as fraudulent based on the mere existence of the description of the issuer's new continuing disclosure agreement in the official statement? Does this assume that, whenever describing a new commitment, the failure to describe past failures to comply with similar but different agreements is fraudulent? What impact could such a theory have more generally with respect to other disclosures in official statements - for example, could the SEC allege fraud if an official statement included a summary of the trust indenture without describing a prior failure to comply with a provision of a different trust indenture?
• Does the SEC's rulemaking rationale for requiring disclosure of past non-compliance in Rule 15c2-12, and the five-year timeframe it established in the rule, govern the determination of materiality of silence on past performance under these two theories - one of which only indirectly arises from the rule and the other is wholly unrelated to the rule? Note, for example, that in one of the MCDC settlements involving silence on performance in a 2011 official statement, the only past failure cited by the SEC was an approximately 5-month delayed filing of the issuer's 2006 audited financial statements. Absent the regulatory rationale and rule-based timeframe of Rule 15c2-12, would a reasonable investor view such failure - even under the theories described above - as material, assuming as the settlement agreement implies on its face that there may have been no other failures in the many more recent years prior to the 2011 official statement?

WHAT SHOULD ISSUERS DO?

Issuers should be giving serious consideration to establishing their own policies and procedures with respect to both continuing and primary market disclosure practices, regardless of whether they self-reported under the MCDC Initiative. Many issuers likely have already experienced heightened focus by the underwriters of their recent new issues on determining strict compliance with past disclosure obligations, providing more extensive official statement disclosure of past failures, and confirming the existence of such issuer policies and procedures. Issuers are cautioned that failure to have, and to enforce, such policies and procedures may create additional barriers to market access and could have significant negative consequences should an issuer be found by the SEC to have materially failed in its disclosure obligations, notwithstanding the lack of any regulatory requirement to have such policies and procedures.