Tax-exempt bonds are a common financing tool for state and local government issuers and nonprofit organizations, such as colleges, universities, and healthcare systems. Although municipal securities generally are exempt from federal securities laws, borrowers that benefit from these municipal securities are subject to the anti-fraud provisions of the Securities and Exchange Act of 1934, Section 10(b) (“Anti-Fraud Provisions”). Any statements made to potential investors may not mislead investors by omitting material facts. One area that borrowers should focus on when reviewing any offering document related to these municipal securities is the “Risk Factor” section.
The National Association of Bond Lawyers recently published a report, Disclosing Risk Factors in Municipal Securities Offerings, that explores the legal and practical considerations associated with identifying and disclosing risk factors in offerings of municipal securities, and with developing policies and procedures for disclosing such risk factors, including:
- What Is a Risk Factor? Risk factors are risks about an entity or the particular financing that either (i) may be present or (ii) cannot be inferred without disclosure. For example, an entity should disclose to an investor that its investment may not be paid if the entity does not appropriate the funds needed to pay it.
- Why Are Risk Factors Included in Offering Documents? Under recent case law and Securities and Exchange Commission (SEC) orders, a borrower’s liability under the Anti-Fraud Provisions can be reduced if material risk factors are disclosed to potential investors—for example, when disclosing financial information about the borrowing entity, including a statement that such data may not be indicative of future results or is not a forecast of future performance can ensure that the financial information is only used for its intended historical purpose.
- Assessing and Disclosing Risk Factors: Because municipal securities are not regulated like corporate securities, there are no specific drafting requirements for risk factors. But, under the Anti-Fraud Provisions, a borrower must provide information to investors regarding why an investment may be speculative or risky. In addition, Regulation S-K provides a useful framework in drafting risk factors, which includes ensuring that a risk factor is included in an offering document if the information otherwise could be misleading or deceitful, even if the security itself is not risky or speculative.
- Written Policies and Procedures: Under recent SEC actions, if a borrower adopts a written policy and procedure for disclosing certain risks pertaining to the borrower in an offering document, the SEC has cited such policies and procedures as a reason for settling as opposed to moving forward with the administrative proceeding.
- Providing Examples of Risk Factors: Common risk factors in offering documents include (i) the risk of the loss of the tax-exempt status of the security, (ii) the risk of flooding on the property that will be acquired with the security, and (iii) the decline, due to the COVID-19 pandemic, in attendance and dormitory occupancy and in the associated revenue derived therefrom.
This report was published by NABL and written by members of NABL’s Risk Factors Disclosure Subcommittee, members include McCarter Public Finance partner, Sarah Smith, and special counsel, Sheila Kles.