Municipal Bond Market Disclosure: Through The Legal Looking Glass

This article is the second of a six-part series on investor disclosure in the municipal bond market. For decades, the issues surrounding disclosure in this $3.9 trillion market have vexed municipal bond borrowers and investors alike. Now, with both governments and nonprofits reeling from the adverse financial effects of Covid-19, municipal bond disclosure is back on the front burner. The public health crisis may prove the tipping point needed to finally resolve the market’s disclosure issues.

Today I delve into the legal roots of disclosure in the municipal bond market.

Through the Legal Looking Glass

Within the municipal bond market, the issues of disclosure—real, perceived or self-imposed—can only be understood in the context of the laws and regulations that govern it. Whereas there is relative clarity surrounding the content, structure and process of disclosure, in the municipal bond market is a Gordian’s knot of legal rabbit holes. Mixed metaphor intended.

Rabbit Hole #1: Disclosure Defined. Sort Of.

What is the legal definition of disclosure, exactly? Search all you want, but there is no one definitive legislative source that establishes what disclosure is or what it should consist of. Rather, over time, a framework has evolved from case law and regulatory interpretation and a general consensus has formed around a working definition. This definition is two-fold: first, disclosure entails the duty to make public that information a reasonable investor considers important to an investment decision; second, disclosure of information is expected to have a material effect on the value of the security.

In short, material public information contains a “material fact” affecting decision-making and valuation. Material fact is the original term used in the establishing legislation and is the basis of the Security and Exchange Commission’s “Doctrine of Materiality.” Feel free to poke around in the Securities and Exchange Act of 1934 (17 CFR Sect. 240.10b-5) and the subsequent Exchange Act Release No. 34-34961 (November 10, 1994) to dwell on the small details.

As an aside, one must note—with some irony—that there is more literal guidance from the lengthy legal vetting of material non-public information and the ways in which it can be wielded. However, yet again, there is no single ‘Eureka!’ case ruling or standard legislative definition to point to. If anything, the matter seems to fall under Supreme Court Justice Potter Stewart’s timeless phrase, “I know it when I see it” (Jacobellis v. Ohio 378 U.S. 184 (1964). That too had to do with certain information being made public, albeit closer to prurient personal decision-making than prudent investment decision-making.

Rabbit Hole #2: What, Exactly, Should Be Disclosed?

This “Doctrine of Materiality” guides the SEC in its “principles-based” approach” regarding municipal bond market disclosure. This is not to say, however, that there is no regulatory memorialization for municipal borrower disclosure. That governing language can be found in SEC Rule 15c2-12, Municipal Securities Disclosure (1989).

Sort of. Rooting around in its sometimes intensely dense legalese and stupefyingly complex organization, a reader desiring more specificity gets only vague and limited practical guidance. Case in point: “Annual financial information” is defined as “financial or operating data, provided at least annually, of the type included in the final official statement” (the intrepid reader can find it under Definition 9 in the Rule). Presumably, the “type” this refers to are audited financial statements, which usually can be found in an official statement. But that is never explicitly stated.

Be it legislation or regulation, hardly any of the language is decisive or explicit. Granted, there is good reason to use generalized language in legislation and regulation, as it allows for necessary flexibility, in both interpretation and application. Precise language has its place, but codifying rules addressing specific circumstances, particularly in fast changing capital markets, comes with risks. If too tightly worded, such stringency might exclude otherwise important circumstances, or incentivize behaviors that undermine or evade the rule’s intent by finding a way around its rhetorical structure. Additionally, the slightest change in the markets—be it behavior, technology or financial instruments—could render a rule irrelevant or dated the minute after the ink dries.

However, when it comes disclosure in the municipal bond market, the lack of specificity relative to what exists in other markets can be frustrating for those seeking clarity.

But there is a reason for that: It’s the law.

Rabbit Hole #3: Sovereignty Vs. Materiality

While some in the municipal bond market wish the SEC and MSRB could end this seemingly endless disclosure circumnavigation by putting on the ‘Parent Hat’ and just tell the market, “Because we’re the Regulators, that’s why!”, they can’t.

They can’t because of the same Securities Act of 1933 and Securities Exchange Act of 1934 that gives basis to the principle of materiality. While the corporate equity and bond market disclosure standards are au courant in the 21^st century, the municipal bond market remains more or less still stuck in the Great Depression of the 1930s. Rooted in constitutional arguments over federalism and state sovereignty, among other legal issues, Congress exempted offerings of municipal securities from registration and reporting requirements. Correspondingly, there is an “absence of a statutory scheme for municipal securities registration and on-going reporting requirements for municipal issuers” (Office of Municipal Securities Legal Staff Bulletin No. 21).

This was reinforced in 1975 by the oft-cited Tower Amendment. The Tower Amendment, named after its advocate, the late Senator John Tower of Texas, was passed as part of a review of the Securities Act of 1933.

[Historical Aside: it was not coincidence that the review came in 1975. That was the year the City of New York almost went bankrupt, to the market’s near-total surprise. With little to no ongoing financial disclosure, the market had been unable to anticipate New York City’s financial collapse. Apparently, responding to a crisis with disclosure improvements is is nothing new to the municipal bond market.]

Rabbit Hole #4: Legislated Contradiction

The Tower amendments to the Securities Act produced an inherently contradictory result. On the one hand, the Municipal Securities Rulemaking Board was created. The MSRB was given the mandate to promote a “fair and efficient” market as well as “market transparency.” With that came ample power to regulate broker-dealers, municipal advisors, and other financial businesses serving the market.

On the other hand, the Tower amendments effectively denied the newly established entity the authority to institute rules for accurate and timely disclosures on bond issuers. In a contradiction worthy of a thousand law review articles, the legislation effectively blocked the MSRB from directly regulating that cornerstone of market fairness, efficiency and transparency: Information.

The previous article in this series, Covid-19: The Tipping Point For Municipal Disclosure?, discussed the most recent joint statement on this subject by the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB).

Next in the series: Municipal Bond Market Disclosure: A Framework Evolves. Legislated limitations on disclosure in the municipal bond market has not limited the Municipal Securities Rulemaking Board from applying the powers they do have to doggedly pursue workarounds to improve disclosure in the municipal bond market.