You may be surprised to learn that municipal bond issuers are not required to disclose bank borrowings. I’ve heard numerous estimates that such issuers have outstanding bank borrowings in the $200 to $300 billion range, which would amount to approximately 5-8 percent of the $3.7 trillion municipal bond market. A nine-member working group of banks, underwriters, financial analysts and attorneys recently released a white paper to provide guidance to states and municipalities on disclosure for bank borrowing. As discussed below, the white paper appears to be a blueprint for disclosing as little as possible.
It’s pretty astounding that a community or a state has no legal responsibility to notify its citizens or bondholders when it takes a loan from a bank. Securities laws give authority to the Municipal Securities Rulemaking Board to only regulate municipal bond underwriters and not cities or states. Since a bank loan does not require a securities underwriter, the MSRB has no authority to compel disclosure. There is a lot of commentary trying to parse if and when a bank loan is actually a bond and hence subject to securities regulation. From Richards Kibbe & Orbe’s Brian Fraser and Paul Devlin:
The MSRB acknowledged that it is difficult to distinguish between loans and securities and pointed to the multi-factor test established by the U.S. Supreme Court in Reves v. Ernst & Young, Inc., 494 U.S. 56 (1990), which we discuss in more detail below. In essence, the MSRB warned the market in the September 2011 notice that there is no “one size fits all” solution to the questions posed by the loan/security distinction and emphasized that the analysis is dependent on the facts and circumstances of individual transactions. The MSRB issued its third and most recent notice on April 3, 2012. In that notice, the MSRB encouraged state and local governmental issuers to voluntarily post information about their bank loan financings on EMMA in order to promote market transparency and efficiency.
Why would the MSRB, credit rating agencies, bondholders and now the nine-member working group encourage public issuers to disclose bank borrowing? Because it potentially affects the rest of the issuer’s capital structure and its bondholders. From the white paper:
• The bank loan may increase the issuer’s debt outstanding;
• The covenants and events of default for the bank loan may be different than those for the bonds, potentially allowing the bank to assert remedies before the outstanding bondholders;
• Certain assets previously available to secure bonds may be pledged to the bank as security for the bank loan; and
• The bank loan may be structured with a balloon payment at the end of its term and create refinancing risks that may impact the issuer’s ability to pay outstanding bonds.
I asked in a MuniLand post last April if the market trusted corporate issuers more than muni issuers:
The regime that the SEC imposes on corporate issuers is much more rigorous than that for municipal issuers and gives investors much more transparent information. For example, corporate issuers are required to file their quarterly financial reports 45 days after the end of the reporting period and their annual audited reports 90 days after the end of the reporting period.
In contrast, the most recent audited financials for the Commonwealth of Puerto Rico, whose debt is broadly owned, is June 30, 2010. So a municipal issuer is sharing financial data that is 22 months old, versus a corporate issuer whose data is three months old.
It’s easy to understand why the markets would charge additional yield for the uncertainty. And that does not even address the fact that certain very material events for municipal issuers, such as bank loans and derivative termination events, are not subject to mandatory disclosure, so investors need to guess about those events.
In times of low interest rates and plenty of liquidity, the opacity premium for muniland issuers is not that large. But as interest rates rise and investors seek more information and transparency for balance sheet items, like bank loan and derivative termination penalties, more questions will arise.
Miller Tabak, a registered investment advisor, discussed in a November 2011 note how JP Morgan and Citibank had teams of bankers actively searching for municipal loan business. Miller Tabak says much of the banks’ motivation is due to the excessively large amounts of cash on their balance sheets and difficulty in finding low-risk investments to put it to work. These are large tailwinds behind the push for muniland to adopt bank loans as financing.
The white paper struck me as a means to show issuers how to thread the law and disclose as little as possible. It shortchanges taxpayers and the general public by not encouraging full transparency. There is no call to change the very weak law that covers these areas. The white paper is a lukewarm paeon to openness (page 5):
The question whether to provide voluntary disclosure about incurrence of a bank loan cannot be decided as a matter of law. Each issuer, after weighing relevant considerations, will have the ultimate responsibility for deciding whether to voluntarily provide such information.
There are many real world examples of a public issuer disclosing only the bare minimum about its bank borrowings. I recently highlighted a $330 million transaction by Puerto Rico for which there was only one line of disclosure in EMMA. Puerto Rico had said that it would not be in the market until June, and then this issue popped up. Was it a bank loan? Who knows, but it certainly creates more questions about transparency.
An earlier version of this piece was published here with Reuters on May 4, 2013