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11.7 Regulatory considerations for municipal bonds
Publication date: 30 Nov 2022
us NFP guide
Issuers of municipal bonds are subject to direct regulation by the IRS and indirect regulation by the SEC.
Municipal bonds issued in public offerings are broadly exempted from the registration and reporting requirements of the Securities Act of 1933 and the Exchange Act of 1934, except for the antifraud provisions of those Acts. Thus, regulation of these securities under federal securities laws differs significantly from the regulatory regime applicable to registered offerings. Because the SEC does not have direct regulatory authority, indirect regulation is accomplished primarily through requirements imposed on underwriters of these offerings by Exchange Act Rule 15c2-12.
Rule 15c2-12 establishes a regime for municipal securities disclosure at the time of the public issuance and thereafter throughout the life of the bonds. In connection with a new offering, underwriters must obtain and review the official statement prior to commencing sales to investors. Underwriters must also (with limited exceptions) ensure that the issuer has agreed to implement a system of continuing disclosure that will remain in effect as long as the bonds are outstanding. This entails:
- Providing certain financial information and operating data to the market at least annually. The specific information to be provided as well as the associated due date will be agreed upon by the parties to the financing transaction and enumerated in a “continuing disclosure agreement.” There is no prescribed reporting format for submission of the information.
- Agreeing to make timely disclosure of any failure to file the annual financial information by the agreed-upon deadline.
- Disclosing the occurrence of specific events enumerated within the Rule within 10 days.
Disclosure documents are submitted to the Municipal Securities Rulemaking Board via its Electronic Municipal Market Access (EMMA) data portal. Essentially, EMMA makes municipal disclosure information available to the market in a manner similar to the SEC's EDGAR system for corporate disclosures.
The SEC’s Office of Municipal Securities is responsible for coordinating the administration of the Commission’s rules pertaining to municipal securities. A specialized Public Finance Abuse Unit within the SEC’s Division of Enforcement investigates potential violations of the antifraud laws involving municipal securities issues and issuers.
For additional information, see Chapter 10 of AAG-NFP and Chapter 7 of AAG-HCO.
11.7.1 Municipal bonds—IRS oversight and enforcement
Issuers of tax-exempt municipal bonds receive benefits under the Internal Revenue Code that lower their borrowing costs. To qualify for and retain these benefits, issuers must comply with stringent federal tax laws and Treasury regulations related to issuance and refunding of bonds, appropriate use of bond proceeds and bond-financed property, and limitations on how bond proceeds may be invested (arbitrage yield restriction and rebate requirements).
Regarding the latter, IRS arbitrage rules ensure that NFP issuers do not attempt to benefit inappropriately from the low borrowing rates associated with tax-exempt bonds by investing bond proceeds in higher yielding investments. If the ultimate yield earned from investing tax-exempt bond proceeds is higher than the interest rate on the bonds, the issuer may be subject to an arbitrage rebate liability that must be paid to the US Treasury in order for the bonds to maintain their tax-exempt status. The arbitrage rebate liability may be substantial if the bond proceeds are not spent as quickly as planned (for example, if an NFP encounters a delay in a major construction project) or in volatile interest rate environments.
These rules are enforced by the IRS’s Tax-Exempt Bond office, primarily through its Examination program. For additional information, see AAG-NFP 10.54 through AAG-NFP 10.58 and AAG-HCO 7.40 through AAG-HCO 7.44.
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