Understanding How the Federal Antifraud Laws Apply to Municipal Private Placements

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As “private placements” have emerged as common financing options for issuers and borrowers in the municipal securities market, we have seen a number of misunderstandings concerning how the federal antifraud laws apply to municipal private placements. Much of the reason for this is that the form of municipal private placements can differ significantly from a typical public offering and this change in form leads to some confusion concerning how the federal antifraud laws apply to private placements. In this article, we seek to outline a basic explanation of how the federal antifraud laws apply to private placements in the municipal securities market for both issuers and placements agents. In addition, we outline some approaches we have taken to not disturb the basic structure of private placements but also to develop more clarity of how federal antifraud laws will apply to the private placement.

What is a private placement?

In the municipal securities market, “private placement” is a broad term that encompasses a number of different kinds of transactions. In the corporate securities market, the term is a more precise term that just means that the transaction is exempt from the registration requirements of the Securities Act of 1933. Part of the problem with developing a clear understanding of how the federal antifraud laws apply to private placements is that “private placements” is really an umbrella term that describes a number of transactions—from really traditional bank loan arrangements to close-to-public offerings with complete offering documents that are limited to institutional investors. As we discuss below, the application of the federal antifraud laws to any transaction varies with the facts. Accordingly, one of the challenges in understanding how these laws apply to private placements is that the term refers to a wide variety of transactions and the application of these laws varies depending on the specifics of a private placement.

What federal antifraud laws apply to municipal securities?

Municipal securities are exempt from the federal securities law regime that regulates corporate securities (from the requirement to register public offerings with the SEC to the periodic reporting requirements of public companies), but municipal securities remain subject to the federal antifraud laws contained in Section 17(a)(2) of the Securities Act of 1933 and Rule 10b-5 under the Securities Exchange Act of 1934. While these two provisions are worded somewhat similarly, they actually are more different than they sound. Section 17(a)(2) has, for the municipal securities market, operated as a primary offering rule because Section 17(a)(2) only applies when the statements are made to obtain money or property. In addition, only the SEC may enforce Section 17(a)(2) whereas the United States Supreme Court has interpreted Rule 10b-5 to imply a private right of action that allows bondholders to directly sue issuers and other market participants. But, since liability under Section 17(a)(2) can be predicated on just negligence (whereas Rule 10b-5 requires “scienter” or knowledge of wrongdoing), among other factors, the SEC has been the primary enforcer of securities law liability in the municipal securities market and it has used Section 17(a)(2) to attack a broad array of activities that arguably would not be possible under Rule 10b-5.

How do the federal antifraud laws apply to private placements in the municipal securities market?

The federal antifraud laws are a “statements” based liability regime—which means that liability under Section 17(a)(2) and Rule 10b-5 is predicated when a person makes statements in connection with an offering and sale (or, in the case of Rule 10b-5, a purchase or sale) of securities. The federal antifraud laws do not directly regulate the form, timing, and substance of offering materials, as such. That is in contrast to other federal securities laws such as the registration requirements of the Securities Act of 1933, which governs the corporate securities market. There, the registration requirements very proscriptively dictate the form, timing, and substance of the content and delivery of offering materials. The same could be said, but to a lesser degree, of Rule 15c2-12, which does proscribe some degree of form and content of offering documents and when they need to be delivered. But the federal antifraud laws, by being “statements” based, have the effect of regulating any transaction regardless of the form of the transaction.

In addition, “statements” are made under the federal antifraud laws whenever communications are reasonably expected to reach investors. This impacts private placements in a couple of ways. First, it means that anything that is reasonably accessible to investors can in theory become statements that are tested under the federal antifraud laws. Second, “statements” do not necessarily need to be investor-directed communications and can include anything that can reasonably inform an investment decision such as financial or operational reports, the legal documents such as the indenture pursuant to which the municipal securities are issued, and any communication that is made in connection with the transaction.

One of the key principles of the federal antifraud laws is that when omissions of material facts are material for investors is determined by the circumstances of the statements made. For public offerings with a complete offering document, the circumstances of the statements made in those offering documents is somewhat clear—the issuer has prepared the offering document with investors as an intended audience, it purports to represent all material information an investor needs to understand to make an informed investment decision, and usually the document itself warns investors not to stray outside of the document for information to make an investment decision. Thus, with a public offering, the offering document itself purports to be the complete credit picture investors should read and understand. If there is any information that is in fact material to the offering and is not included in the offering document, this can raise the question whether the offering document omitted a material fact necessary to avoid making the offering document misleading because it purports to be complete.

All of this explains why the application of the federal antifraud laws to private placements in the municipal securities market can become confusing—it is so principled-based that it does not lend itself to simple decision rules to which we have become accustomed in public offerings. The federal antifraud laws evaluates the totality of statements that are made in connection with an offer and sale of securities and then tests whether those statements are materially accurate or whether they omit a material fact given the context of the statements. So, based on that, this is what is clear when private placements involve municipal securities:

Both Section 17(a)(2) and Rule 10b-5 apply to private placements—there is no exception for non-public offerings.
Private placements can involve a host of “statements” that can be made that would be measured under these federal antifraud standards.
Unless the parties bring some order to what “statements” are being made, a private placement can involve a host of “statements” that may not be intuitive and can open up liability to some communications the parties were not expecting to be a part of the offering.

How all of this works in a specific private placement will differ on the facts. Where a private placement does not involve a formal offering memorandum and a lot of information is reasonably available to the investor that the issuer and the placement agent wouldn’t expect to be a part of what the investor is relying on, there can be uncertainty whether that information is a part of the offering or not and that may come as a surprise to an issuer or a placement agent.

Understanding the value of an offering document in private placements.

Since the federal antifraud laws apply as much to private placements involving municipal securities as public offerings, it becomes important for issuers and placement agents to bring some clarity as to what statements the investor will be relying on in connection with the private placement to make an investment decision. This can vary depending on the form of the private placement but there are usually somewhat easy ways to bring that clarity to a transaction. Where there is a limited offering memorandum or some other sort of complete offering document, that clarity should be embedded within the contents of that offering document. Even if there is a data room or other source of information, the drafting of that limited offering memorandum should take into consideration the array of information about the issuer and the offering that is reasonably accessible to the investor and take steps to disabuse the investor from relying on communications that are not appropriate for investment decisions. For example, even in a private placement, where a municipal issuer such as a county or city maintains a general website with a host of information not related to the private placement, the limited offering memorandum should warn the investor not to rely on this information.

Where parties to a private placement should be the most concerned about the uncertainty of the application of the federal antifraud laws is where no offering document is prepared for the private placement, and the issuer or placement agent solely provides the investor with raw information such as financial statements and bond documents in order to make an investment decision. It can be unclear whether the investor was relying on other information as well. In addition, if there is no real effort to step back and consider the totality of that information and how that information may omit other information that is important, it may open the door to an argument that the information as a whole was misleading. In these circumstances, while there may be no complete offering document, issuers and placement agents can use a shorter, simpler document to bring that information into order and intentionally make clear what information is intended for the investor, provide any disclaimers of information that are necessary so that investors may not reasonably rely on any information that is reasonably available but not appropriate for investment decisions.

The point is that, even if private placements of municipal securities are exempt from Rule 15c2-12, an offering document or some shorter document that establishes the context of the information that investors should consider in making an investment decision can be crucial in terms of creating clarity around what information the investor is relying on and ensuring that information is not misleading.

What are the due diligence responsibilities of placement agents in municipal private placements?

One of the more common misunderstandings in the municipal securities market is that dealers in the municipal securities market only have a due diligence responsibility when they are acting as underwriters and not as placement agents. Perhaps a source of this confusion is that due diligence responsibilities of municipal securities underwriters may be conflated with liability of underwriters under Section 11 of the Securities Act of 1933, which would not apply in a private placement.

The due diligence responsibilities of dealers who act as placement agents is somewhat nuanced given some of the legal developments in the municipal securities market. In 1988, the SEC adopted an interpretative release that essentially established an affirmative due diligence responsibility of underwriters of municipal securities—which is somewhat at odds with the corporate securities regime where due diligence is commonly understood as a defense. In this 1988 interpretative release, the SEC used its interpretative powers of the federal antifraud laws to create this due diligence responsibility by saying that since an underwriter has an implied recommendation under broker-dealer rules, a failure of the underwriter to conduct a reasonable investigation (the scope of which varies depending on the facts) would represent a breach of the federal antifraud laws. While going back to the 1950s there is case law to support that a dealer has some responsibility to be aware of the facts of an offering if it is making an implied recommendation, the SEC’s use of this implied recommendation as a federal antifraud law principle in order to establish an affirmative responsibility on the part of underwriters of municipal securities somewhat created new law that did not exist before the 1988 interpretative release. While some did argue that the SEC had exceeded its authority, any such argument ended when the Federal Court of Appeals for the D.C. Circuit upheld the 1988 interpretative release in 2008.

The challenge for placement agents is that, unlike Section 11 of the Securities Act of 1933, the SEC did not establish an affirmative responsibility to perform due diligence on the basis of the form of the transaction but instead of the basis of the implied recommendation. Unfortunately, there is little guidance concerning when a dealer makes an implied recommendation—only a couple of FINRA interpretations exist. Generally, even in a private placement, if a dealer both finds an investor and acts assists in arranging, negotiating or structuring the private placement, dealers treat that as an implied recommendation. In that situation, the 1988 interpretative release should apply to that transaction—which means that, just like with the federal antifraud laws themselves, the mere fact that the form of a transaction is a private placement does not obviate the dealer’s due diligence responsibility to conduct a reasonable investigation.

How should this impact how we approach private placements?

As a practical matter these responsibilities under the federal antifraud laws should be manageable in ways that do not fundamentally alter the structure of private placements. The most important element is to ensure that the issuer and placement agent have a basic understanding of these responsibilities and reasonably account from them. To this end, we suggest the following steps:

Bring some clarity to what “statements” the investor should consider in making an investment decision in the private placement.

As we discuss above, given that the federal antifraud laws will test “statements” reasonably available to investors in private placement transactions that are securities and that the “circumstances” of those statements will impact how those are tested, issuers and placement agents can obtain considerable legal clarity by using some approach to clarify what “statements” the investor should consider in connection with an investment decision. This can be accomplished by preparing a complete offering memorandum, but it also does not necessarily need to be a complete offering document from a strictly legal perspective. The key is that it needs to be clear from what is provided to the investor what statements are being provided for its investment decision and use that opportunity to exclude information that may be available that should not be considered.

Take reasonable steps to ensure that those “statements,” taken as a whole” do not omit important information that can render what is provided misleading.

Often times with private placements where there is no formal offering document, the investor is provided with a combination of general financial reports (such as audited financial statements) and legal documents and the investor is frequently not provided with offering narratives that have taken into consideration what the investor needs to know in order to put this information into context. In these circumstances where the “raw data,” as it were, is just handed over to the investor, some thought should be given as to ways that raw data may be misleading to investors. For example, if audited financial statements that are handed over to investors include funds or credits that are not related to the municipal securities at issue, then it may be that framing how the investor should consider those audited financial statements can help investors from being misled by information that is only tangentially relevant to the transaction. The raw data, in these circumstances, may speak for itself for the issuer or placement agent but from a legal perspective if the investor could be misled by information, then that can potentially create a problem under the federal antifraud laws.

Placement agents should make a reasonable effort to establish that it performed a reasonable investigation.

As we discuss above, a placement agent probably has a due diligence responsibility in private placements where the dealer is making an implied recommendation to investors. Accordingly, placement agents should develop a process for how to approach due diligence in private placements. This should involve a few steps. First, the placement agent should go through the process we discuss above—what statements are being provided to investors and what needs to be done to ensure that the statements are not wrong or misleading. Second, the placement agent should conduct a reasonable investigation into the offering, the issuer, and the credit to ensure that no other information should be part of what the investor receives. Finally, the placement agent should consider what opinions and certificates should be provided to ensure that the transaction is documented appropriately. One approach we have taken is that, unless the circumstances provide a good reason to do something differently, we try to follow due diligence approaches from public offerings.