IRS, SEC, MSRB, CDU and MCDC Oh, My! Staying Out of Trouble After Your Bonds are Sold

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1 IRS, SEC, MSRB, CDU and MCDC Oh, My! Staying Out of Trouble After Your Bonds are Sold April 30, 2015 Anne Noble, Stifel Nicolaus; (314) ; Kyle Harding, Chapman and Cutler LLP; (312) ;

2 Predictions of Default Municipal Bond Market: Post 2008 Banking Crisis Meredith Whitney, 60 Minutes, December 2010 Significant municipal bond defaults starting in 2011, totaling hundreds of billions of dollars in losses. Municipal Bankruptcies (Over 30 since 2010) Three California Municipalities: Stockton, San Bernardino and Monmouth Lakes Jefferson County, Alabama Detroit The Demise of Bond Insurers The Rise of the Regulators IRS audits (large increase in number of correspondence exams) SEC enforcement actions (West Clark Schools, Allen Park, Harvey) MCDC Initiative 2

3 What does this mean for you (the Issuer)? Increased scrutiny by deal participants preissuance (due diligence and disclosure) Increased scrutiny by regulators post-issuance (post issuance compliance) 3

4 Presentation Outline Federal Tax Issues Overview of IRS Enforcement Tax Considerations Recent SEC Enforcement Action Post Issuance Compliance Securities Law Issues Overview of SEC Enforcement Primary Market Disclosure: Official Statement Secondary Market Disclosure: Continuing Disclosure MCDC 4

5 FEDERAL TAX ISSUES 5

6 Overview of IRS Enforcement Increased enforcement by the IRS Compliance Checks (Record Retention, BABs, Advance Refundings) Information about compliance practices and post-issuance monitoring procedures related to all bond transactions of the issuer within a market segment Audits (including correspondence exams) Information related to a specific bond issue and return Assessed $84 million in fines and penalties between FY 2005 and FY VCAP Settlements in FY 2014; 24 stemmed from audits 6

7 Overview of IRS Enforcement (continued) What is the IRS looking for? Compliance with various tax rules related to tax-exempt bonds, including Arbitrage/rebate Private use/payment Reimbursement Refundings Anti-abuse rules, including hedge bond, federal guarantee and overissuance rules Record retention What are consequences of non compliance? Interest may be treated as taxable Issuer may lose BAB subsidy (if applicable) Additional arbitrage rebate may be owed Penalties may be assessed 7

8 Tax Considerations Basic Rules Private Use/Payment Restrictions Reason for tax-exemption is to provide a subsidy through lower borrowing costs for projects involving a public purpose Therefore, tax law restricts the use of bond proceeds by nongovernmental entities and the financing of projects that benefit non-governmental entities Arbitrage Rebate/Yield Restriction Federal government provides a subsidy for state and local governments by forgoing tax revenues from interest on state bonds, resulting in lower costs Federal government does not want to give a double benefit by allowing issuers to arbitrage 8

9 Tax Considerations Basic Rules (continued) Reimbursement Using bond proceeds to reimburse issuer for projects paid from funds on hand (not from borrowings) Time limits Official Intent Adoption Refundings Special rules for sizing, yield restriction, when bonds need to be called More stringent rules for advance refundings Not outstanding longer than reasonably necessary for governmental purposes 120% test 9

10 Tax Considerations Basic Rules (continued) Record Retention Issuers need to retain: Documentation relating to the bond transaction Bond resolution Bond counsel opinion Tax Compliance Certificate and Agreement Final Official Statement Transcript Documentation pertaining to any investment of bond proceeds Documentation evidencing expenditure of proceeds Documentation evidencing use of bond-financed property by public and private sources (e.g., leases, management contracts) Documentation evidencing record keeping policy is in place Generally, records should be kept as long as the bonds remain outstanding, plus 3 years 10

11 Recent SEC Enforcement Action South Miami (2013) City borrowed $6.5 million in 2002 and $5.5 million in 2006 in two pooled, conduit bond offerings to finance a parking structure City violated the private activity rules by leasing proceeds of the 2002 borrowing to a private developer and restructuring a lease agreement with the private developer In order to preserve the bonds tax-exempt status, the City entered into agreements with the IRS, paying $260,345 to the IRS and defeasing certain of the bonds SEC charged the City with failing to disclose the fact that the City had jeopardized the tax-exempt status of the bonds City settled with the SEC and agreed to retain third-party consultant to oversee its policies, procedures and internal controls for municipal bond disclosures 11

12 Post-Issuance Compliance Adopt and follow post-issuance compliance policy Key features: Designation of compliance officer Record retention Due diligence at regular intervals Procedures reasonably expected to timely identify and timely correct noncompliance How to correct compliance issues? Self-help (remedial action) What if self-help is unavailable? VCAP 12

13 SECURITIES LAW ISSUES 13

14 Overview of SEC Enforcement Nationwide inquiry into municipal market Focus on pension funding levels and continuing disclosure Increase in SEC enforcement actions West Clark Schools, Indiana Allen Park, Michigan MCDC Initiative 14

15 Primary Market Disclosure: Applicable Securities Law When issuing debt, school districts are subject to the antifraud provisions of the federal securities laws: Section 17(a)(2) of the Securities Act prohibits any person from, directly or indirectly, obtain[ing] money or property by means of any untrue statement of a material fact or misleading omissions. Section 10(b) and Rule 10b-5(b) of the Exchange Act prohibit the making of (1) a false statement or omission; (2) of material fact; (3) with scienter; (4) in connection with the purchase or sale of any security. Recklessness [ extreme departure from the standards of ordinary care, which presents a danger of misleading buyers or sellers that is either known [to the actor] or is so obvious that the actor must have been aware of it ] is sufficient to establish scienter. Anti-fraud provisions apply even if SEC Rule 15c-12 does not 15

16 When applicable? Rule 15c2-12 Underwritings (does not apply to direct or private placements) Par amount must be in excess of $1,000,000 What does it require? Enacted in 1989 to require that underwriters of municipal securities obtain and review a deemed final official statement before offering bonds to investors in a primary offering. Amended in 1995 to require underwriters to confirm that the issuer has entered into a written undertaking to provide continuing disclosures. Applies only to underwriters, but indirectly imposes disclosure and continuing disclosure requirements on issuers. 16

17 Primary Market Disclosure: Materiality A fact is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision. Basic Inc. v. Levinson. The omitted fact (or misleading statement) is material if it would have assumed actual significance in the deliberations of the reasonable investor. If known, would it change the price? Remember, materiality is often judged in hindsight. 17

18 Primary Market Disclosure: Official Statement The official statement is a document prepared by, or on behalf of, an issuer in connection with a primary offering of its bonds Pursuant to the antifraud provisions of federal securities laws, the official statement must disclose all material information related to the offering The obligation for the accuracy and completeness of the disclosure lies with the issuer Experts may assist, but cannot completely discharge, the issuer s obligation 18

19 Primary Market Disclosure Special Challenges for Municipal Issuers SEC rules do not provide form of official statement (as they do in corporate marketplace) Municipal market participants do not have regular interaction with the SEC on suitability of disclosure Only interaction comes from: Speeches/Conferences/Congressional Testimony Investigations Enforcement Actions How to protect against liability? Engage municipal finance professionals Establish and follow disclosure procedures 19

20 Due Diligence Calls Process: District is provided a copy of the Preliminary Official Statement (POS) in advance of the call for review Underwriter/FA, Disclosure and/or Underwriter s Counsel and the District on the Call Questions regarding: Accuracy of POS Changes in financial affairs since most recent audit Audits, investigations, litigation Employees and employee relations Major taxpayer status 20

21 Primary Market Disclosure SEC Enforcement Actions Allen Park, Michigan (2014) City sold $31M of Bonds in 2009 and 2010 to finance a now-failed movie studio SEC charged that the offering documents contained false and misleading statements about the scope and viability of the project, as well as the City s deteriorating financing condition and its ability to repay debt service. Without the planned revenues from the movie studio, annual debt payments on the bonds represented ~10% of the City s budget SEC sought to bar the Mayor and City Administrator from participating in any municipal bond offerings (and also sought monetary penalties). 21

22 Primary Market Disclosure Takeaways Emphasis on individual liability for involvement in fraud Disclosure should not be a routine procedure of inserting new numbers in the last official statement Issuers should adopt, and follow, policies and procedures for updating and reviewing disclosures Such policies and procedures: May involve formalization of existing procedures (e.g., hiring disclosure counsel or other municipal finance professionals to assist with disclosure) Should set forth responsibilities of staff (and perhaps) governing board with respect to disclosure Delegation of responsibility to staff and/or outside professionals must be reasonable 22

23 Secondary Market Disclosure: Applicable Securities Law SEC Rule 15c2-12 Prohibits an underwriter from underwriting bonds unless the Issuer has agreed to provide certain information and event disclosures to the market (CDU) CDU filings must be made on EMMA (Electronic Municipal Market Access) portal Bondholders may sue for specific performance Issuers must disclose CDU non-compliance in official statements (five year look back) Primary Market Penalty for Secondary Market Disclosure Failure? Access to market: underwriter must reasonably believe Issuer will comply with CDU in order to underwrite bonds 23

24 Secondary Market Disclosure: Rules If new issue is less than $1,000,000: No CDU If new issue is sold directly to a bank: No CDU (generally) If new issue is at least $1,000,000 and Issuer has over $10,000,000 of debt, Issuer must agree to provide: Annual financial information Audited financial statements Reportable events If new issue is at least $1,000,000 and Issuer has less than $10,000,000 of debt, Issuer must agree to provide: Audited financial statements Reportable events 24

25 Secondary Market Disclosure: Rules (continued) Annual Financial Information (AFI) Defined in reference to certain information and charts in the Official Statement, such as: Debt Service Extension Base (DSEB) Financial Information: Trend of EAV, Tax Rates, Tax Extensions and Collections, Outstanding Debt, Debt Ratios Short Term Financing Record and Future Financing Summary of Operating Results: General Fund Revenue Sources, Working Cash Fund Summary, Budget Summary School District Financial Profile Audit (and AFI, if applicable) must be filed with EMMA typically 210 days after fiscal year close (January 26) 25

26 Secondary Market Disclosure: Rules (continued) Reportable Events There are 14 Reportable Events Most common: Payment delinquencies Non-payment defaults Bond calls Adverse tax opinions Rating changes Must be filed with EMMA within 10 business days of the occurrence 26

27 Voluntary Disclosures to the MSRB EMMA system allows for voluntary disclosures Financial/Operating Disclosures Event-based Disclosures Bank Loan Disclosure: MSRB issued regulatory notice on January 29, 2015 calling for timely disclosure of bank loans by state and local governments MSRB believes this information is important for market transparency and to promote a fair and efficient market 27

28 Primary/Secondary Market Disclosure SEC Enforcement Action West Clark Schools (Indiana) (2013) School District entered into a CDU in connection with a 2005 bond issue School District represented it was fully compliant with the 2005 CDU in an official statement for a 2007 bond issue SEC charged School District with falsely representing its CDU compliance in the official statement SEC also charged the underwriter of the 2007 bonds with failing to conduct sufficient due diligence to determine if the School District s representation was true CDU non-compliance was a fact [the underwriter] could easily have verified School District, Underwriter and SEC entered into a settlement agreement; Underwriter paid $580,000 in fines and disgorgement; School District agreed to certain remedial actions 28

29 Secondary Market Disclosure: Takeaways SEC clearly expects underwriters to to enforce market access penalty for CDU non-compliance Issuers that repeatedly fail to make CDU filings may not be able to access public market Issuers that fail to make CDU filings may also face SEC action for other statements that reach the market, if materially misleading Statements that are reasonably expected to reach the securities market, even if not prepared for that purpose, cannot be materially misleading 29

30 MCDC, Continuing Disclosure and SEC Rule 15c2-12 Rule 15c2-12 requires disclosure of any instances in the previous five years in which the issuer/obligated person failed to comply in all material respects with any previous continuing disclosure undertaking (CDU). The SEC Municipalities Continuing Disclosure Cooperation Initiative (the MCDC Initiative ) was focused on this disclosure. materially false statements about CDU compliance violate the anti-fraud provisions. 30

31 MCDC Initiative SEC effort to encourage self-reporting by issuers/ obligated persons and underwriters of securities law violations related to materially inaccurate statements in official statements regarding CDU compliance. Announced on March 10, 2014; underwriters deadline to self-report was September 10, 2014; Issuers deadline to self-report was December 1, Standard settlement terms for those who self-reported. 31

32 MCDC Review Guidelines MCDC Initiative covers inaccurate statements in official statements regarding continuing disclosure compliance not compliance with the undertakings themselves. Time frame: Disclosure regarding CDU compliance in official statements for the last five years, and Rating changes, and NRMSIR filing history for the last ten years. 32

33 Life After MCDC Disclosure Considerations Events of material non-compliance with prior CDUs should be described with a reasonable level of detail in future Official Statements. Issuers are not required to disclose in Official Statements that they have self-reported under the MCDC, but must include the required disclosure of material noncompliance with prior CDUs. Issuers that enter into an MCDC settlement with the SEC are required to disclose the settlement terms in a clear and conspicuous fashion in their Official Statements for five years. 33

34 Pitfalls to Avoid/Steps to Take Review your official statement and don t just assume that is the job of your professionals it is your document! Think about what you would want to know about your District if you were buying the District s bonds and make sure that is in the official statement Implement policies and procedures and training for bond issuance and post bond issuance, especially continuing disclosure Identify individuals responsible for CDU items & have a succession plan Review your CDUs and consider including all the required tables in your audit Add your required CDU tables to your request for services needed in your audit contract Subscribe to EMMA for reminders Consider hiring a Dissemination Agent Know what you are signing 34

35 Resources Disclosure- Preparing- to- Submit.pdf 35

36 Reminders & Resources HOW? 36

37 Ø Ø Ø Reminders & Resources EMMA Dataport webpage = Manual for Continuing Disclosure Submission (PDF) EMMACDManual.pdf FAQsAboutMSRBsContinuingDisclosureSub missionprocess.pdf MSRB s Market Information Department: EMMAOnline@msrb.org Municipal Securities Rulemaking Board 1900 Duke Street, Suite 600 Alexandria, VA Fax: Information and screenshots derived from the Municipal Securities Rulemaking Board ( 37

38 Stifel, Nicolaus & Company, Incorporated ( Stifel ) has prepared the attached materials. Such material consists of factual or general information (as defined in the SEC s Municipal Advisor Rule). Stifel is not hereby providing a municipal entity or obligated person with any advice or making any recommendation as to action concerning the structure, timing or terms of any issuance of municipal securities or municipal financial products. To the extent that Stifel provides any alternatives, options, calculations or examples in the attached information, such information is not intended to express any view that the municipal entity or obligated person could achieve particular results in any municipal securities transaction, and those alternatives, options, calculations or examples do not constitute a recommendation that any municipal issuer or obligated person should effect any municipal securities transaction. Stifel is acting in its own interests, is not acting as your municipal advisor and does not owe a fiduciary duty pursuant to Section 15B of the Securities Exchange Act of 1934, as amended, to the municipal entity or obligated party with respect to the information and materials contained in this communication. Stifel is providing information and is declaring to the proposed municipal issuer and any obligated person that it has done so within the regulatory framework of MSRB Rule G-23 as an underwriter (by definition also including the role of placement agent) and not as a financial advisor, as defined therein, with respect to the referenced proposed issuance of municipal securities. The primary role of Stifel, as an underwriter, is to purchase securities for resale to investors in an arm s- length commercial transaction. Serving in the role of underwriter, Stifel has financial and other interests that differ from those of the issuer. The issuer should consult with its own financial and/or municipal, legal, accounting, tax and other advisors, as applicable, to the extent it deems appropriate. These materials have been prepared by Stifel for the client or potential client to whom such materials are directly addressed and delivered for discussion purposes only. All terms and conditions are subject to further discussion and negotiation. Stifel does not express any view as to whether financing options presented in these materials are achievable or will be available at the time of any contemplated transaction. These materials do not constitute an offer or solicitation to sell or purchase any securities and are not a commitment by Stifel to provide or arrange any financing for any transaction or to purchase any security in connection therewith and may not relied upon as an indication that such an offer will be provided in the future. Where indicated, this presentation may contain information derived from sources other than Stifel. While we believe such information to be accurate and complete, Stifel does not guarantee the accuracy of this information. This material is based on information currently available to Stifel or its sources and is subject to change without notice. Stifel does not provide accounting, tax or legal advice; however, you should be aware that any proposed indicative transaction could have accounting, tax, legal or other implications that should be discussed with your advisors and /or counsel as you deem appropriate. 38

39 This document has been prepared by Chapman and Cutler LLP attorneys for informational purposes only. It is general in nature and based on authorities that are subject to change. It is not intended as legal advice. Accordingly, readers should consult with, and seek the advice of, their own counsel with respect to any individual situation that involves the material contained in this document, the application of such material to their specific circumstances, or any questions relating to their own affairs that may be raised by such material Chapman and Cutler LLP 39" 39