The decision of Standard & Poor's (‘S&P") to downgrade the credit rating of the United States may have many yet unknown impacts on the economy in general and state and local governments in particular.  However, in the short term, state and  local governments should be aware that the downgrade by S&P may (1) lead to downgrades of state and local government debt and (2) affect the types of securities in which state and local governments can invest.

Downgrade of State and Local Government Obligations

Various types of state and local government obligations may be downgraded as a result of the U.S. downgrade.  Examples of these may include:  refunded bonds which are secured by escrow accounts invested in U.S. treasury securities, bonds backed by federal guaranties like some housing bonds, bonds backed by leases with the federal government, and bonds issued by state and local governments that depend on federal programs or federal revenues or with a high number of federal employees.
It is important for issuers to monitor the ratings of their outstanding obligations in order to comply with the applicable provisions of the continuing disclosure requirements of Rule 15c2-12 of the Securities and Exchange Commission (the "Rule").  Most state and local government bonds issued since 1996 are subject to the Rule, which requires the issuer (or another "obligated person" such as a conduit borrower) to enter into a continuing disclosure undertaking (the "Undertaking") at the time the bonds are issued.  The issuer (or other obligated person) must agree to provide audits and regularly updated financial information to the marketplace, as well as to file a "Material Event Notice" if certain listed events occur, including any rating changes.  The Material Event Notice must be filed with the Municipal Securities Rulemaking Board's Electronic Municipal Market Access system, or EMMA.

The Rule was amended for bonds issued on or after December 1, 2010.  For bonds issued prior to December 1, 2010, the Rule requires a Material Event Notice to be filed in a timely manner for a rating change, if material.   For bonds issued on or after December 1, 2010, the Rule requires a Material Event Notice to be filed within 10 business days of the occurrence of the applicable event.  A rating change is such an event, and for bonds issued on or after December 1, 2010, a Material Event Notice must be filed, regardless of whether it is  material.  It is likely that most investors will view a rating downgrade as material, so it is probably the best practice to file a Material Event Notice for any rating change, regardless of when the bonds were issued.  Issuers should review the relevant Undertaking to determine if there are any special provisions in addition to those set forth in the Rule.  An issuer should consult with counsel if the issuer has questions about the applicability of the Rule and the Undertaking to a particular situation.   For example, it is possible that the Undertaking and the duty to make a filing will have terminated if all of the bonds of an issue have been refunded, but the terms of the Undertaking should be evaluated and applied to the specific facts. 

Permitted Investments

The securities in which state and local governments may invest will be limited by a variety of documents, including:  state statutes; local ordinances, resolutions or policies; home rule charters; and bond documents including indentures, loan agreements and bond ordinances or resolutions.  Each of these documents must be consulted to determine whether a particular security is a permitted investment.  S&P has already announced that it is lowering certain issuer and related issue credit ratings for a number of government related entities, including  Fannie Mae, Freddie Mac, 10 of the 12 Federal Home Loan Banks and the Farm Credit System.  In evaluating permitted investments, state and local governments will need to consider both whether current investment holdings need to be sold and what are permitted future investments.  Depending on what the applicable documents say, it may be that a state or local government is not required to sell its current holdings.  Governments should consult with counsel to determine what applicable documents require.


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