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Municipal Markets
BY Nixon Peabody LLP

Disclosing the Future: Foundational principles to make sure we do it right

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One of the recurring areas of confusion within the municipal securities market concerns whether and how municipal issuers should provide investors with forward-looking information. This confusion became most apparent during the COVID-19 pandemic when municipal issuers became paralyzed by the economic uncertainty and inability to provide anything like customary financial projections or assessments of future financial performance. This resulted in the Chair and Director of the Office of Municipal Securities of the United States Securities and Exchange Commission providing a statement encouraging municipal issuers to voluntarily provide investors with what they know about the circumstances affecting revenues and expenses supporting bonds. In that statement, they reference a case-law doctrine called the “bespeaks caution” doctrine—which was also received with some confusion by municipal market participants. One of our lessons learned from this experience is that much of the confusion by municipal market participants concerning forward-looking disclosures stems from a lack of familiarity with some of the foundational securities law principles that are more commonly known in other markets—particularly the corporate securities market that have to follow the registration statement requirements of the Securities Act of 1933 and related SEC rules.
In this article, we outline three areas of securities law that can help our market understand (1) how the SEC views forward-looking statements and what the SEC expects for forward-looking disclosures to include, and (2) ways that the law encourages and protects issuers when they make forward-looking disclosures.

1. Item 10(b) and the SEC’s policy on projections.

Before the early 1970s, the SEC prohibited public companies from including financial projections in their disclosures filed with the SEC. In response to criticism, the SEC changed its policy in the early 1970s to not only permit them but to encourage them. This policy is codified in Item 10(b) of Regulation S-K. (Regulation S-K details the disclosure items that are used for SEC disclosure filings by public companies, and Item 10 of Regulation S-K lists specific disclosure-related policies and other overarching provisions germane to Regulation S-K matters). Item 10(b) provides valuable insight from the SEC concerning its views of the value of projections and how to properly prepare projections. Here is a summary of those insights:

  • The SEC encourages public companies to include projections in their disclosure filings.
Item 10(b)’s first sentence reads: “The [SEC] encourages the use in [disclosure documents filed with the SEC] of management’s projections of future economic performance that have a reasonable basis and are presented in an appropriate format.” In our experience this position by the SEC comes as a surprise to many in the municipal securities market. From the perspective of many in the municipal securities market, they perceive financial projections to be risky disclosure that would be frowned upon by the SEC. While the SEC is focused on how the projections are presented, which we will discuss more below, the SEC encourages the use of financial projections in disclosure. There is a good reason for this—and it stems from when the SEC changed its policy on this topic. Financial projections, when properly done, provide investors with how management of the issuer perceives its trends and prospective results. That perspective, as such, is valuable to investors because they have an opportunity to see what management is looking at both in terms of what it knows but also in terms of the kinds of management decisions that they will make. Accordingly, the SEC starts its policy with an encouragement to use financial projections in disclosure documents.
  • Management must have a reasonable basis for the projection.
While the SEC encourages the use of financial projections in disclosure documents, it states that, “Management, however, must have a reasonable basis for such an assessment.” The SEC then discusses that historical performance can be part of that basis and management can use an expert to review the financial projections, and other related factors.
  • The financial projections should be presented in an appropriate format.
The SEC states, “In determining the appropriate format for projections included in [SEC] filings, consideration must be given to, among other things, the financial items to be projected, the period to be covered, and the manner of presentation to be used.” The SEC’s point is that management should step back from the projections and consider whether the format of the projections has obfuscated something investors should know and understand. For example, if line items are consolidated such that a trend becomes effectively buried or if the number of years presented leaves out a significant known impact that falls outside of those years, then management should re-consider that format to avoid misleading investors.
  • Material assumptions need to be disclosed and considerations of other matters investors need to know.
The SEC finally stresses that investors need to be able to understand the assumptions the financial projections are based on. As the SEC states, “The [SEC] also believes that investor understanding would be enhanced by disclosure of the assumptions which in management’s opinion are most significant to the projections or are the key factors upon which the financial results of the enterprise depend and encourages disclosure of assumptions in a manner that will provide a framework for analysis of the projection.” It is important for investors to be able to know and review the material assumptions of the projections to provide them an opportunity to evaluate those assumptions in connection with the investment decision. In addition, the SEC makes other valuable insights, such as considering whether prior projections were materially incorrect and whether investors should know that to understand the projections.
From our perspective, the SEC’s policy in Section 10(b) provides a framework to preparing and disclosing financial projections. First, we should not treat the projections as inherently risky but understand that it provides valuable information to investors. Second, however, the key is in how the issuer prepares the projections. The issuer needs to have a reasonable basis and disclose the material assumptions. In addition, the issuer should look at the format of the projections and make sure something is not being lost due to the format of the projections.

2. Item 303: Disclosing financial trends is not the same as predicting the future.

Item 303 of Regulation S-K requires a management’s discussion and analysis of its financial condition, and a central part of that discussion of each of the major topics is a discussion of “known trends” within the issuer’s financial condition. As the SEC has stated in interpreting this requirement, “Required disclosure is based on currently known trends, events, and uncertainties that are reasonably expected to have material effects. . . . In contrast, optional forward-looking disclosure involves anticipating a future trend or event or anticipating a less predictable impact of a known event, trend or uncertainty.” In other words, trends are different than projections in that trends relate to information that is known today—facts that are in existence now that establish material probabilities of events in the future. In that sense, failure to disclose a material trend is ultimately a failure to disclose material facts that exist now as a way for investors to understand how those existing facts change the probability of the prospective trajectory of the financial condition of the issuer.
Over the years, the SEC has brought enforcement actions under Item 303 and the fact patterns of these actions are similar. The public company announces a major loss or other negative financial news and it becomes apparent that the negative news, while ostensibly recent, was the culmination of a financial trend that was known long before the public company ever disclosed it. A way to look at it is that a failure to disclose what management thinks its future revenues will look like (which would be voluntary forward-looking information) is not the same thing as failure to disclose a material fact that establishes a high likelihood that future revenues will look differently than they might look today.
What we learn from this for the municipal securities market is that it is easy for us to confuse forward-looking disclosure like projections with trend disclosure, which is really the disclosure of a current, existing fact that has changed the prospective trajectory of the financial condition of the issuer.

3. When properly framed, the “bespeaks caution” doctrine can protect forward-looking statements.

In the statement by the Chair and Director of the Office of Municipal Securities during the COVID-19 pandemic discussed above, they said, “we believe that a municipal issuer’s approach to forward-looking disclosures should be informed by the judicially developed “bespeaks caution” doctrine.” We found that some municipal market participants were not familiar with this doctrine—and the point of the statement, we believe, is that a lot of concerns about forward-looking information stems from a lack of understanding of this doctrine. In his treatise The Securities Laws of Public Finance, Robert Fippinger (which the statement itself cites) provides a good explanation of this doctrine: “The federal courts of appeals have been developing the “bespeaks-caution” doctrine that economic projections, estimates of future performance, and similar forward-looking statements in a disclosure document are not actionable when meaningful cautionary language elsewhere in the document adequately discloses the risks involved.” The point of the doctrine is that forward-looking information is inherently unpredictable and therefore results may differ from projections. Thus, if the disclosure is clear that the information is forward-looking, the risks inherent in future performance are disclosed, and the disclosure cautions investors that this is forward-looking disclosure, then those statements are not actionable under the federal antifraud laws. In other words, when forward-looking information “bespeaks caution” to the investor and is appropriately handled in the disclosure, then the maker of that statement is not liable when actual results differ from that forward-looking information.
This explanation of the “bespeaks caution” doctrine helps to see why the SEC would want the municipal securities market to have a better understanding of this doctrine. Courts have recognized the need to protect issuers who make forward-looking statements because the very nature of those statements are subject to future events and that mere fact cannot mean that the statements are misleading. Thus, the courts have focused on what kind of disclosure needs to surround forward-looking statements so that investors are not misled and, with appropriate disclosure, the issuers are not then liable for those statements merely because future performance differs. In this sense, some of the basic bedrock of Item 10(b) is really just pulled from these cases to understand when disclosure has correctly alerted investors about the nature of the disclosure (it is forward-looking) and what needs to accompany that disclosure to avoid being misleading (known material risks that could produce a different result).

What does that mean for the municipal securities market?

These foundational principles to forward-looking statements have informed how we advise clients concerning forward-looking statements:
  • The key to forward-looking information is how it is disclosed and that should be our emphasis:
We do not need to have an aversion to financial projections or descriptions of future financial performance and such an aversion really does not comport with how the SEC views disclosure. All disclosure should be intended to be forwardly oriented since the entire value of the disclosure is to assess the future performance of an issuer to pay debt service on bonds. But, at the same time, these core principles of Item 10(b) and the “bespeaks caution” doctrine need to be followed as well. When we provide this kind of disclosure, ensuring that we accompany that disclosure with appropriate disclosure that identifies material risks and limits to what the issuer can know is essential to prevent the disclosure from being misleading. Thus, the key to financial projections is not whether we should provide them if they would be helpful, it is the way they are presented and disclosed.
  • We need to look for and identify financial trends and not confuse trends with projections.
The several enforcement actions the SEC brought against municipal issuers for pension disclosure related to this very issue. Municipal issuers confused providing projections with disclosing a known fact that there was a structural imbalance in the pension fund that, while there were various assumptions, established a very high likelihood that the issuer would encounter a significant financial challenge during the life of the bonds. While some issuers used projections to explain this fact, the issuer needed to present a fact that existed at the time of disclosure (the amount of assets of a pension plan were not sufficient to pay benefits when the actuary expected those benefits to be due, and the issuer would have to fund the difference). But issuers found themselves paralyzed by being unable to know what they were going to be required to contribute to the pension plan in the future while the key was that the facts that were then known and in existence were material facts and the nature of those facts established a prospective probability that mattered to investors.
The pension plan enforcement actions show that there is a danger in placing such an emphasis on historical financial information without at least investigating what we know about the future. While pension plan disclosure is one area where this can occur, it is also important to look into trends in revenues, expenditures, liquidity, and other key areas to see if there are known facts that establish these trend lines that could surprise investors down the road.
  • Sometimes, the most protective disclosure is to provide financial projections.
We saw this particularly in the COVID-19 pandemic where there were circumstances that the crushing uncertainty could only effectively be explained through projections for a few reasons. First, financial projections offered the issuer the opportunity to provide detailed assumptions that could explain very precisely what the issuer knew and did not know. Second, financial projections gave investors a clear sense of how management viewed the prospective financial condition of the issuer. Third, financial projections could clearly isolate troubling trends or how the pandemic might result in serious problems for the issuer. Of course, as we discuss above, any of these projections needed to caution investors about the limits of the issuer’s knowledge, and clearly explain what the projections assumed. But some issuers found that, due to the uncertainty, it was hard to say anything effective without having financial projections to show what management knew and did not know. Sometimes we try to explain trends through a narrative and it does not lend itself to the kind of clear, precise disclosure that can be obtained through financial projections.

Concluding Thoughts

Our experience is that some of the aversion that seems to exist in the municipal securities market to discuss the future financial condition of the issuer stems from a misunderstanding of how the federal securities laws think about and protect those kinds of statements. With a fuller understanding of these principles, especially these three we have discussed in this article, financial projections and discussion of future financial performance becomes less intimidating.