[co-author: Jeff Higgins, Managing Director BLX Group LLC]
On March 10, 2014, the Securities and Exchange Commission ("SEC") announced that issuers and underwriters of municipal securities may voluntarily report materially inaccurate statements made in offering documents regarding prior continuing disclosure compliance through a program called the Municipalities Continuing Disclosure Cooperation Initiative (the "MCDC Initiative"). Issuers1 and underwriters can take part in the MCDC Initiative by completing a questionnaire and submitting it by no later than September 10, 2014. If a questionnaire is submitted and the SEC staff determines it should be processed under the MCDC Initiative, the SEC will abide by a predetermined schedule of terms for the reporting entity to settle its case. These terms are intended to be relatively lenient, particularly compared to the sanctions and monetary penalties imposed in two recent enforcement actions taken by the SEC in July 2013 against an issuer and an underwriter arising from false statements in an official statement that the issuer had complied with prior continuing disclosure obligations.2 The settlement terms included in the MCDC Initiative are set out in Attachment 1 to this Alert. The SEC makes clear that if an entity could have self-reported under the MCDC Initiative but failed to do so, and if the SEC later brings an enforcement action, it will seek more severe sanctions and penalties. Further, by pitting the interests of issuers and underwriters against each other, the SEC is creating significant pressure on both sides to self-report the maximum number of potential violations. The full release containing the terms of the MCDC Initiative and the Questionnaire can be accessed here:
What is the SEC’s Goal?
SEC staff members provided greater insights into the purpose and implementation of the MCDC Initiative at a conference in Boston on March 27-28, 2014, at which several Orrick attorneys were present. The SEC is convinced there is a large problem in the marketplace involving shoddy compliance with continuing disclosure undertakings, which have been required by issuers since 1994 under Rule 15c2-12 (the "Rule")3. Although the Rule by its terms only applies to underwriters, the SEC has shown through the West Clark Community Schools case (see footnote 2) that making a false statement in an official statement about continuing disclosure compliance makes an issuer directly liable for securities fraud (see footnote 3, part (ii)), and exposes underwriters to liability for inadequate due diligence and other potential violations. The SEC staff feels that the MCDC Initiative will allow issuers and underwriters to "clean up" past compliance lapses under a set of predictable terms, and allow the industry to "reset" into a mode of good compliance going forward.
Scope of the Initiative
Issuers and underwriters are asked to self-report bond offerings in which issuers "may have made materially inaccurate statements in a final official statement regarding their prior compliance with their continuing disclosure obligations..." The first question is, how far back does this go? The statute of limitations for SEC enforcement actions is five years, so the MCDC Initiative would cover potentially material misstatements or omissions4 about continuing disclosure compliance in official statements up to five years old. However, since a proper final official statement must have disclosed failures of compliance for the previous five years, the scope of investigation effectively goes back as much as ten years.
It is evident that a critical step in deciding whether to self-report is to assess whether a potential misstatement or omission regarding continuing disclosure compliance is material. The term is not defined in securities laws or regulations, and depends on the overall facts and circumstances of a situation. Increased scrutiny in this area since mid-2010 (when the SEC issued a release reminding underwriters to take more active steps to determine compliance) has revealed that there have been a wide range of errors made by issuers over the years, many of them of a very minor or technical nature which most lawyers would argue would not be "material." Thus, while an issuer or underwriter can make its own decision not to self-report certain violations on the ground that they are not material, the MCDC Initiative does provide a second level of review by the SEC staff. The SEC staff confirmed at the conference that the staff will review each submission and will only recommend taking the predetermined enforcement action if the misstatements (or omissions) were material. Staff further made the point that in self-reporting, an issuer or underwriter can argue that the circumstances set forth are not material and should not result in an enforcement action, but if the SEC staff determines otherwise, the reporting entity must be prepared to accept the sanctions included in the MCDC Initiative.
The Carrot and the Stick
As noted earlier, the SEC staff believes the predetermined schedule of settlement terms and sanctions (see Attachment 1) for entities which make use of the MCDC Initiative are relatively lenient, but they are very clear that if the SEC seeks enforcement action after September 10, 2014 for a situation which could have been self-reported and was not, they will seek more severe sanctions. First, they are more likely to bring an action under a scienter-based fraud standard rather than the negligence-based standard available under the MCDC Initiative. Second, monetary penalties likely will be sought against issuers (even if they have to be paid from general taxes), and underwriters likely will face higher penalties than the Initiative provides. Third, the entity subject to the action may have to admit liability as a condition of settling a case. Finally, the SEC may be more likely to seek enforcement action and penalties against individuals who may be culpable.
Given the potentially much more serious consequences for failure to self-report, and the possibility that more minor violations might not result in action by the SEC in any case, it would appear there is a strong impetus to "over-report" and then try to reduce or eliminate the sanctions at the SEC staff level. This leads to the real heart of the incentives created by the MCDC Initiative: the conflict between the interests of issuers and underwriters, and the conflict between institutional and individual interests.
The Prisoner’s Dilemma
At the Boston conference, the new Chief of the SEC’s Municipal Securities Enforcement Unit made explicit that the SEC deliberately wrote the MCDC Initiative in a way that creates a tension between issuers and underwriters, or what she called a "modified prisoner’s dilemma.5" Recall that there is only one underlying set of facts: was there a material misstatement or omission in a final official statement? If there was, both the issuer and the underwriter have potential securities law exposure, and to obtain the favorable settlement terms, each of them has to self-report. Needless to say, if one party self-reports and the other does not, a problem arises for the second party if the SEC staff determines that the facts warrant an enforcement action. The SEC looks at this tension as a way to incentivize more and fuller disclosures.
Furthermore, the MCDC Initiative makes clear that it only applies to issuers and underwriters as entities; even if a party self-reports and obtains a settlement under the predetermined terms, the SEC retains the right to seek enforcement action against individuals who may be culpable. This may include individuals working at the self-reporting entity itself, or at the other party, or at a third party, such as an attorney or financial advisor. This consideration will certainly increase the difficulty in deciding whether and what to self-report.
Attachments 2 and 3 to this Alert set forth some additional considerations which either issuers or underwriters may wish to evaluate as they consider what steps to take in response to the SEC’s MCDC Initiative.
Attachment 1 - "MCDC Initiative Standard Settlement Terms" CLICK HERE
Attachment 2 - "Considerations for Issuers" CLICK HERE
Attachment 3 - "Considerations for Underwriters" CLICK HERE