Letters on Escrowed-to-Maturity Securities

Letters on Escrowed-to-Maturity Securities

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Manager
Manager, Muni Department
Underwriting
Public Finance

Reprint of Letters

The Board is reprinting its letters to the SEC regarding escrowed-to-maturity securities and the SEC's responses.

Mr. Richard R. Lindsey
Director
Division of Market Regulation
Securities & Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

In 1987, the Municipal Securities Rulemaking Board (Board) wrote to the Commission about its concerns in regard to optional redemption of escrowed-to-maturity securities. On June 24, 1988, the Division of Market Regulation responded and noted, among other things, that a municipal issuer that wishes to reserve its contractual right to exercise optional redemption provisions in the bonds that are to be advance refunded should clearly and conspicuously disclose its intention in the defeasance notices and official statement for the refunding bonds.⁽¹⁾

As the Commission is aware, since 1988 a number of initiatives have refined disclosure practices for municipal securities. The Commission has issued interpretations of municipal underwriter responsibilities,⁽²⁾ as well as a statement regarding disclosure obligations of municipal securities issuers and others.⁽³⁾ So too, as a result of the adoption of and amendments to SEC Rule 15c2-12, a system for primary and secondary market disclosure has developed in the market. Finally, through rule G-36 (on delivery of official statements, advance refunding documents and related forms to the Board) and the Municipal Securities Information Library^Ž (MSIL^Ž) system⁽⁴⁾, the Board collects and disseminates to the market important primary and secondary market disclosure information in electronic format. Given these developments in municipal disclosure practices and requirements, we ask the Division of Market Regulation to: (1) review its statements regarding issuer disclosure obligations, as well as underwriters' responsibilities, in connection with optional redemption of escrowed-to-maturity securities, as set forth in its June 24, 1988 letter, (2) to confirm that these disclosure obligations still apply, and (3) to clarify how these disclosure obligations should be satisfied in the new disclosure system.

Christopher A. Taylor
Executive Director
Municipal Securities Rulemaking Board
1150 18^th Street N.W., Suite 400
Washington, DC 20036

In your letter of December 23, 1997, you ask the staff of the Commission to update certain advice previously given with respect to the optional redemption of escrowed-to-maturity securities.

In 1988, at the request of the Municipal Securities Rulemaking Board (MSRB), the staff provided advice regarding the application of the antifraud provisions of the federal securities laws to the disclosure by issuers of optional call features of escrowed-to-maturity securities (the "1988 Letter").⁽⁵⁾ In the 1988 Letter, the staff, among other things, stated that the presence or absence of optional redemption provisions is a material factor that may directly affect the yield received by investors. Accordingly, when bonds have been subject to advance refunding, and the proceeds of the refunding bond offering are deposited in an escrow account in an amount sufficient to make scheduled interest payments and to redeem the prior bonds at maturity, it would be misleading for the issuer to reserve optional redemption rights without disclosing this fact. The staff also noted in the 1988 Letter that a municipal issuer that wishes to reserve its contractual right to exercise optional redemption provisions in the prior bonds should clearly and conspicuously disclose its intention both in the defeasance notices and in the official statement for the refunding bonds.

With respect to the obligations of municipal securities dealers, the staff stated in the 1988 Letter that, before a security is sold as "escrowed-to-maturity" or "pre-refunded to first call," the dealer should have conducted a reasonable investigation to satisfy itself that the documents relating to the prior bond issue and the refunding bond issue, including the official statement and escrow trust agreement, support this characterization. In the event these documents are unclear, dealers should disclose this fact to their customers, along with other material information about the bonds.⁽⁶⁾

In your letter, you point out that since 1988 a number of initiatives have strengthened disclosure practices for municipal securities. Through Commission releases, as well as rulemaking by both the Commission and the MSRB, the disclosure obligations of municipal market participants have been clarified and an improved system for primary and secondary market disclosure has been created. Given these developments in municipal disclosure practices and requirements, you ask the staff to review its statements in the 1988 Letter regarding issuer disclosure obligations, as well as underwriters' responsibilities, in connection with the optional redemption of the escrowed-to-maturity securities, to confirm that these disclosure obligations still apply, and to clarify how these disclosure obligations should be satisfied.

As discussed below, we believe the guidance provided in the 1988 Letter as to the responsibilities of issuers and dealers generally remains applicable today. The improvements to the municipal securities disclosure system that have occurred over the past ten years may assist such persons in fulfilling their responsibilities, but do not change their fundamental obligations under the antifraud provisions of the federal securities laws to, among other things, neither make any untrue statement of a material fact nor omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.⁽⁷⁾ The question of whether a violation of the antifraud provisions of the federal securities laws has occurred will, of course, depend upon the facts and circumstances of a particular case.

As you note in your letter, municipal securities disclosure practices and requirements have evolved over the past ten years. Official statements, advance refunding documents, and defeasance notices all have become more readily available to the public. For example, MSRB rule G-36, adopted in 1990, generally requires an underwriter of a primary offering of municipal securities sold on or after January 1, 1990, to file with the MSRB copies of the final official statement.⁽⁸⁾ In addition, if the issue advance refunds an outstanding issue of municipal securities, rule G-36 generally requires the underwriter to file with the MSRB copies of the advance refunding documents (i.e., the refunding escrow trust agreement or its equivalent). The MSRB makes these documents publicly available through its Municipal Securities Information Library (MSIL) system.

Furthermore, in 1994 the Commission amended Rule 15c2-12 under the Securities Exchange Act of 1934 to require, in general, an underwriter of a primary offering of municipal securities to reasonably determine that the issuer (or obligated person) has entered into a written undertaking to provide to each nationally recognized municipal securities information repository (NRMSIR) or to the MSRB, and to the appropriate state information depository (SID), if any, notices of certain events, if material. One such event is a defeasance of the bond issue.⁽⁹⁾ Defeasance notices, like all material event filings, are made publicly available by the NRMSIRs or MSRB (and SID, if any). This provision of Rule 15c2-12 generally applies to issues of municipal securities where the underwriter was contractually committed to act as such on or after July 3, 1995.

Accordingly, persons wishing to confirm the status of the redemption features of municipal securities today may have at least three potential sources of information: (1) the description of the prior bonds contained in the official statement for the advance refunding securities on file with the MSRB, and possibly with the NRMSIRs; (2) the advance refunding documents on file with the MSRB; and (3) the defeasance notice on file with the NRMSIRs or MSRB (and SID, if any). These developments have broadened the opportunities for issuers to communicate effectively with the marketplace, with the result that official statements, advance refunding documents, and defeasance notices are now generally accessible.⁽¹⁰⁾

We believe that the guidance provided in the 1988 Letter as to the disclosure obligations of issuers with respect to the retention of optional redemption provisions in escrowed-to-maturity securities generally remains applicable today. The price and yield of an escrowed-to-maturity security may be significantly altered if, contrary to market expectations, an issuer attempts to exercise optional redemption provisions without having previously disclosed the reservation of its redemption rights.⁽¹¹⁾ Accordingly, the existence of optional redemption provisions is material to investors, and it would be misleading for an issuer of escrowed-to-maturity securities to reserve optional redemption rights without disclosing this fact.⁽¹²⁾

The questions of whether information has been effectively communicated to prospective buyers and the marketplace, and whether adequate disclosure has been made for antifraud purposes, are, of course, dependent upon the facts and circumstances of each particular case. In light of the developments in the municipal securities disclosure system, we believe that, for bonds escrowed to maturity today, issuers should clearly and conspicuously disclose any intent to retain optional redemption rights both in the advance refunding documents and in the defeasance notices filed with the MSRB and/or the NRMSIRs (and SID, if any). Given the increased public availability of the advance refunding documents and defeasance notices, disclosure in the official statement for the refunding bonds has become less crucial, although issuers may wish to continue disclosing the retention of optional redemption rights in this document as well.

We also believe the guidance provided in the 1988 Letter as to the obligations of dealers with respect to transactions in escrowed-to-maturity securities generally remains applicable today. As noted in the 1988 Letter, the Commission repeatedly has emphasized that a broker-dealer that recommends a security represents that it has conducted a reasonable investigation and has an adequate basis for the recommendation.⁽¹³⁾ When a dealer sells a security as "escrowed-to-maturity," the dealer's investigation, among other things, should be sufficient to satisfy it that the documents relating to the bond issue support that characterization.⁽¹⁴⁾ In addition, the 1994 amendments to Rule 15c2-12 imposed a requirement that, in general, before a dealer recommends a municipal security, it must have procedures in place that reasonably assure it will receive prompt notice of material event filings (including defeasance notices) with respect to that security.⁽¹⁵⁾ The receipt of these defeasance notices, as well as the increased availability of official statements and advance refunding documents from the MSRB, the NRMSIRs, and the SIDs, may assist dealers in satisfying their obligation to conduct a reasonable investigation into the securities they recommend.

I hope this letter clarifies our view of the issues presented in your letter. If you have any further questions regarding these matters, you may also contact Catherine McGuire at (202) 942-0061 or Paul S. Maco at (202) 942-7300.

Honorable David S. Ruder
Chairman
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549

The Municipal Securities Rulemaking Board (Board) is concerned about confusion in the municipal securities market concerning issuers' authority to exercise optional redemption features of escrowed-to-maturity municipal securities. As discussed below, this confusion has caused considerable disruption in the municipal securities market for escrowed-to-maturity securities which may cause harm to investors and which requires Commission intervention.

An outstanding issue of municipal securities is described as "escrowed-to-maturity" when it is refinanced by a new issue of refunding securities, the proceeds of which are invested in other securities⁽¹⁶⁾ that are deposited in an escrow account in an amount sufficient to pay the principal and interest of the refunded (i.e., refinanced issue of) securities on the original interest payment and maturity dates.⁽¹⁷⁾ Since bondholders receive payments derived solely from the escrowed securities, the issuer "defeases" the refunded issue thereby terminating the rights of bondholders under the original indenture and their lien on revenues derived from the refunded issue.⁽¹⁸⁾ The refunded bonds are no longer considered outstanding by the issuer and its financial statements are adjusted accordingly. The issuer's refunding resolution and the escrow agreement contain the details of the refunding arrangements. These documents are not routinely provided to holders of the escrowed-to-maturity securities. The official statement for the refunding issue, however, generally summarizes these documents, and the documents usually are available to interested persons from bond counsel or the underwriters of the refunding issue on request.

CONFUSION OVER STATUS OF ESCROWED-TO-MATURITY SECURITIES AND RESPONSES OF MSRB AND INDUSTRY GROUPS

In late 1986, a municipal issuer announced its intention to redeem high-coupon escrowed-to-maturity securities prior to their maturity dates. The announced refunding, which subsequently was withdrawn, raised a number of legal and policy issues including whether investors were aware of the possibility of the early call. Apparently, the escrow and refunding documents stated that the securities would be paid according to a payment schedule that did not include the optional call date. As a result, the market had been pricing at a substantial premium the escrowed-to-maturity securities to maturity; the proposed transaction would have shortened the maturity date and resulted in a significant drop in price creating immediate losses to bondholders of the issue. The Board understands that there have been other recent instances in which issuers have sought to call escrowed-to-maturity securities prior to their maturity dates. These incidents have created ongoing confusion whether other escrowed-to-maturity issues of municipal securities might be subject to earlier calls and has engendered considerable pricing inefficiencies which may cause harm to investors.

On February 6, 1987, the Executive Committee of the Public Securities Association's (PSA) Municipal Securities Division unanimously adopted a resolution urging issuers not to call escrowed-to-maturity issues unless the refunding documents clearly reserve the right to do so. The PSA referred to the longstanding definition of escrowed-to-maturity and stated that the attempt to call escrowed-to-maturity securities had severely disrupted pricing of, and trading in, all escrowed-to-maturity securities and predicted that investor confidence in the municipal securities market would be damaged.

On March 17, the Board sent letters to the PSA, the Government Finance Officers Association (GFOA), and the National Association of Bond Lawyers stating that it is essential that issuers note in official statements for refunding issues and in defeasance notices whether they are reserving the right to call escrowed-to-maturity securities. The Board stated that the absence of such disclosure would raise concerns whether the issuer's disclosure documents adequately explain the material features of the issue. In addition, while the Board has no regulatory authority over issuers, at its July 1987 meeting, it interpreted rule G-17, the Board's fair dealing rule, to require a dealer that assists an issuer in preparing disclosure documents relating to escrowed-to-maturity securities to alert the issuer of the need to disclose whether it has reserved the right to call the securities prior to maturity. The Board also interpreted its confirmation rules, rules G-12(c) and G-15(a), to permit securities to be described as escrowed-to-maturity only when no optional call features have been reserved.

In response to the Board's March 17, letter, the GFOA incorporated into its draft revisions of the Guidelines for the Timely Provision of Information on a Continuing Basis a recommendation that issuers make adequate disclosure in this area and provide the disclosures to holders of the refunded securities.

The actions taken by the Board and industry groups do not appear to be sufficient to allay confusion whether outstanding escrowed-to-maturity issues of municipal securities are subject to early redemption. There continues to be pricing inefficiencies, and many issues are being described as callable in the absence of any express disclosure by the issuer. This has lead to many disputes between dealers and customers. The Board is concerned that this issue is having a deleterious effect on investor confidence in the municipal securities market and believes that Commission intervention is necessary. Accordingly, the Board respectfully requests the Commission to issue an interpretative notice addressing the application of the antifraud provisions, Section 10(b) of the Securities Exchange Act, and rule 10b-5 thereunder, to disclosure by issuers in escrow agreements and other refunding documents pertaining to optional call features of escrowed-to-maturity municipal securities.

If the Board or its staff can be of any assistance in the Commission's consideration of this request, please do not hesitate to contact Angela Desmond, General Counsel for the Board.

H. Keith Brunnemer, Jr.
Chairman
Municipal Securities Rulemaking Board
1818 N Street, N.W.
Washington, DC 20036-2491

Chairman Ruder has asked that I respond to your letter of September 18, 1987 regarding the optional redemption of escrowed-to-maturity securities. Your letter reflects the concern of the Municipal Securities Rulemaking Board (Board) and other members of the securities industry about problems that have occurred in the secondary market for municipal securities subject to advance refunding.

As your letter explains, advance refunding is a device commonly used by states, municipalities and other political subdivisions. Municipal securities are frequently issued with fixed maturities, but also allow the municipal issuer to exercise early call provisions that are clearly disclosed in the official statements provided to investors and in the indenture of trust. When municipal bonds are advanced refunded, the issuer will offer refunding bonds to the public. The proceeds of the refunding bond offering are generally used to purchase government securities or certificates of deposit that are placed in an irrevocable escrow account, or trust, in an amount sufficient to pay both principal and interest on the prior bond issue. Bondholders of the prior bond issue then receive payments solely from income generated by the securities placed in the escrow account or trust. The agreement between the municipal issuer and the trustee for the prior bond issue sets the terms of the refunding, specifying payment schedules for the prior bonds and providing for any substitution of securities.

Once bonds have been advance refunded, the market determines the yield based upon the stated interest rate to a fixed point in time. Where bonds are labeled by municipal securities dealers as "escrowed-to-maturity," the market prices the securities based on the assumption that bondholders will be paid interest and principal on the original interest payment and maturity dates. In contrast, where the securities have been labeled "pre-refunded to a call date," the market will price the securities on the assumption that they will be redeemed on the call date. In some cases, however, you note that sinking fund call features maintained in the escrow trust agreement may result in refunded bonds being both "escrowed-to-maturity" and "callable."

As the Commission has noted in the past, yield is perhaps the single most important piece of information to an investor in debt securities.⁽¹⁹⁾ The yield, or dollar price, at which a transaction in a debt security is effected in the secondary market will be directly related to the anticipated maturity or call date. Thus, any features that cause a fixed coupon debt security to pay at a different time than expected will alter the actual yield that investors receive.

You indicate that recently some confusion has developed in the markets for municipal securities as a result of attempts by certain issuers to exercise optional redemption provisions in bonds that have been traded as escrowed-to-maturity. Investors purchasing such bonds anticipate receiving yields based upon the bonds being redeemed at the maturity indicated by the dealer. As you note in your letter, Rule G-17 has been interpreted by the Board to require a dealer that assists an issuer of a refunding bond offering in preparing disclosure documents to alert the issuer of the need to disclose whether it has reserved the right to call the prior bonds before maturity. In addition, the Board has interpreted its confirmation rules, Rules G-12(c) and G-15(a), to permit securities to be described as escrowed-to-maturity only when no optional redemption features have been reserved.

The Commission has repeatedly emphasized that a broker-dealer who recommends a security represents that it has conducted a reasonable investigation.⁽²⁰⁾ The obligation of a broker-dealer to be familiar with the securities in its inventory extends to municipal as well as corporate securities.⁽²¹⁾

In light of the recent problems experienced in the municipal securities industry, dealers in municipal securities should be particularly attuned to their responsibilities under the general anti-fraud provisions of the federal securities laws. Before a security is sold as "escrowed-to-maturity" or "pre-refunded to first call," the dealer should have conducted a reasonable investigation to satisfy itself that the documents relating to the prior bond issue and the refunding bond issue, including the official statement and escrow trust agreement, support such characterization. The staff recognizes that provisions of the refunding bond documents relating to prior bond issues may be unclear in some cases. Where there is a lack of clarity, dealers should disclose this fact to their customers, along with other material information about the bonds. Where information is material, the anti-fraud provisions of the federal securities laws require that the investor be informed at the time he or she makes an investment decision.

In addition, it is important that the underwriters of the refunding bond issue, as well as the issuer, and attorneys drafting the bond documents, take special care to clarify the status of the prior bonds that are being refunded. Where either the issuer or underwriter makes a statement about the prior bonds, there is an obligation to speak accurately. While special considerations are relevant in the municipal markets, the obligation of the issuer is particularly acute in referring to prior bonds in the refunding bond documents, since the market may be expected to rely upon the issuer's statements.

The presence or absence of optional redemption provisions is a material factor that may directly affect the yield received by investors in the prior bonds. When bonds have been subject to advance refunding, and the proceeds of the refunding bond offering are deposited in an escrow account in an amount sufficient to make scheduled interest payments and to redeem the prior bonds at maturity, it would be misleading for the issuer to reserve optional redemption rights without disclosing this fact.⁽²²⁾ A municipal issuer that wishes to reserve its contractual right to exercise optional redemption provisions in the prior bonds should clearly and conspicuously disclose its intention in the defeasance notices and official statement for the refunding bonds.

I hope that this letter clarifies our view of the issue presented in your letter. If you have any further questions in this regard, you may also contact Robert L.D. Colby or Edward L. Pittman at (202) 272-2848.

When an issue is refunded to a call date, the call date becomes the maturity date for the refunded issue. These issues are described as "prerefunded to (the call date)."