The last several months have seen a notable uptick in municipal securities actions brought by the Securities and Exchange Commission’s Enforcement Division. Over that time, the SEC has brought more than half a dozen actions against issuers of municipal securities, ranging from the State of Illinois to the City of Miami. These cases, which have come with increasing frequency and regularity, have alleged fraudulent misstatements and omissions that have run the gamut from failing to disclose future pension obligations to lying about the intended use of bond proceeds. There is every reason to believe that these cases are not a blip. Indeed, the leadership of the SEC has said as much. One SEC Commissioner – Daniel M. Gallagher – has clearly stated that he expects the resources put into the Municipal Securities and Public Pension Unit in the SEC’s Enforcement Division (the Municipal Securities Unit) to yield a return of “high quality cases.”1 Prior to her recent departure, SEC Commissioner Elisse B. Walter, noted that “[t]here’s more [municipal securities cases] in the pipeline.”2
While the SEC’s enforcement efforts have thus far been mostly directed to issuers, recent actions suggest that the SEC may be shifting its attention to municipal underwriters. Most notably, on July 29, 2013, the SEC brought an action against a small municipal underwriter for failing to perform basic due diligence as to whether an issuer had submitted annual reports as represented in the offering documents, as well as improperly charging expenses, and providing inappropriate gifts to municipal officials.3 We believe that this action reflects the SEC’s current commitment to pursue municipal underwriters and may provide a window into some of the issues that the SEC is currently focusing on in enforcement investigations and exams.
The SEC’s focus on municipal securities and municipal underwriters is not new. In 1993, then-SEC Chairman, Arthur Levitt, Jr., expressed his concern about the integrity of the municipal securities market.4 The combination of increased involvement by retail investors, an “explosion in volume” (the municipal securities market at the time was in excess of USD1.2 trillion and as of December 2012, exceeded USD3.7tn), and scandals involving the underwriting process, led him to argue for improved disclosure. He cautioned that in the absence of further legislative steps in this area, the SEC would use the enforcement mechanisms at its disposal to improve issuer disclosure, namely by relying on the antifraud provisions of the Exchange Act.5
Shortly thereafter, Chairman Levitt’s predictions were given life by what was then the largest municipal bankruptcy – Orange County, California. In December 1994, Orange County declared bankruptcy largely because its investments were concentrated in a highly leveraged portfolio of securities whose value dramatically decreased as interest rates rose. As a result of the price decrease of its leveraged investments, collateral calls were made on the County that it could not meet and bankruptcy ensued.6 The County ultimately lost USD1.7 billion on investments of USD7.bn – a 22.3% loss.7
Over the year prior to its bankruptcy the County and related entities had issued more than USD1bn in securities to raise money to invest in the County’s investment portfolio. According to the SEC, the Official Statements related to those offerings failed to disclose the actual use of proceeds and failed to disclose facts known or ascertainable by the underwriters that would have been material to investors. Ultimately, the SEC brought several cases against municipal underwriters in connection with these offerings.8
While the Orange County actions against underwriters were significant at the time, the SEC’s attention soon changed to other enforcement priorities, namely financial reporting fraud at companies such as Enron, WorldCom, and Qwest Communications. With limited exception, the SEC has not seriously focused on underwriters since Orange County except in circumstances of improper gifts or political contributions.
A NEW WAVE OF ENFORCEMENT MATTERS
Recently, the SEC has increasingly dedicated attention and resources to the municipal securities market, and there has been a corresponding uptick in enforcement actions involving municipal securities market participants.9 This is not surprising considering the statements coming from the Commission. Echoing former
Chairman Levitt’s 1993 comments, Commissioner Gallagher recently stressed that, while the federal securities laws do not authorize the SEC to directly regulate municipal issuers, a lack of regulatory oversight does not limit the Commission’s “ability to apply the antifraud provisions of the federal securities laws to the actions of municipal securities issuers and other market participants.” 10 Commissioner Gallagher then specifically warned that the Commission has made “very clear” on several occasions that participants in the municipal markets must “understand their obligations under the antifraud provisions of the federal securities laws.”11 Recent enforcement actions have included:
In March, the SEC brought only its second case against a state for violating federal securities laws in its public pension disclosures against the State of Illinois.12 The crux of the allegations was based on amendments made by the state legislature to the funding plan for the pension system. The state allegedly failed to disclose the increased risk the amendments would have on the funding plan, resulting from the state’s inability to pay its obligations, and the risk to the state’s creditworthiness as a result of that underfunding.13 The SEC found the state lacked sufficient safeguards, such as controls, policies, and procedures to ensure information was disclosed and distributed to investors.14
In April, the SEC filed securities fraud charges against the City of Victorville, California and the city’s underwriter alleging that the defendants knowingly inflated the value of certain property securing the bond offering – nearly doubling the purported value of the underlying assets – which enabled the city to improperly issue substantially more bonds than it
otherwise could have.15 In addition, the SEC alleged that the underwriter engaged in a scheme to defraud the issuer by misappropriating millions of dollars in bond proceeds through unauthorized construction and project management fees.16
In May, the SEC entered into a cease-and-desist order against the City of South Miami for alleged material misrepresentations and omissions regarding the tax-exempt status of bonds offered to obtain financing.17 There, certain public officials allegedly took actions that jeopardized the tax-exempt status without disclosing that investors could have been forced to pay tax-related penalties for the interest earned on the bonds.18
That same month, the SEC issued a cease and desist order against the City of Harrisburg, Pennsylvania, relying upon alleged misrepresentations and omissions in the city’s financial disclosures and information available on the city’s website.19 The city had failed to provide information in its possession to investors, such as the multiple downgrades of Moody’s ratings.20
In July, the SEC charged the City of Miami, Florida, and its budget director with offering and disclosure fraud in connection with several municipal bond offerings. The SEC alleged that the city omitted the nature of certain funds transfers, which masked increasing deficits in the city’s primary operating fund and gave the false appearance that the city was in compliance with its reserve level requirements. The SEC also charged the city with violating a prior 2003 cease-and-desist order based on similar misconduct. 21
RECENT ACTION AGAINST UNDERWRITER
In addition to the action against an underwriter in the Victorville case discussed above, the SEC has brought another noteworthy case against a municipal underwriter. In July, the SEC brought a disclosure fraud action against the West Clark Community Schools in Indiana, its underwriter, and the head of the underwriter’s Public Finance & Municipal Bond Department alleging that the issuer falsely stated in bond offerings that it was in compliance with its disclosure obligations under prior offerings.22 Although the underwriter, City Securities Corporation, included in its Compliance Manual that the due diligence process should include verification that prior disclosures had been made, in practice, employees were unaware of this requirement.23 The SEC also alleged that the underwriter improperly provided lavish gifts and gratuities to personnel of municipal securities issuers, such as multi-day golf trips, and fraudulently obtained reimbursement for those gifts and gratuities by billing them against bond proceeds as operational costs. As a result, the Order included findings that the firm also violated MSRB Rules G-17 and G-20.24 The municipal underwriter agreed to pay nearly USD580,000 to settle the SEC’s charges, which included a USD300,000 penalty. In addition, the firm has undertaken or agreed to undertake significant remedial measures, including revisions of its policies and procedures, training, internal audits to assess compliance with amended policies and procedures, and retention of an independent compliance consultant.25
NOT AN ABERRATION
In our view, a combination of factors, including statutory reforms brought by Dodd-Frank, changes in personnel and leadership at the SEC, and significant macro-economic factors, suggests that this recent string of municipal securities cases may be indicators suggesting an increased focus on underwriter conduct. Those factors include:
The Dodd-Frank Act created a municipal securities office that reports directly to the Chairman.26 This office gives a prominent voice to municipal securities issues that has been absent since former Chairman
Levitt’s tenure. Also in 2010, the SEC created a new enforcement unit dedicated to municipal securities.27 The chief of the unit stated that she planned to develop “strong cases that send a resounding message about particular conduct – cases that will have an impact on the behavior of market participants.”28
The Dodd-Frank Act also provided incentives and protections to whistleblowers that voluntarily provide original information relating to the violation of the securities laws to the SEC, and if the tip leads to an action that results in monetary sanctions of more than USD1,000,000, the whistleblower may collect an award of ten to thirty percent of those monetary sanctions.29 This provision incentivizes whistleblowers to come forward and improves the likelihood of increased enforcement in this area by bringing potential cases to the Commission’s attention. In fiscal year 2012 alone, the SEC had received 64 whistleblower tips related to municipal securities and public pension allegations alone.30 For more information about the likelihood of increased enforcement due to the whistleblower provision of Dodd-Frank, please see A Time For Whistleblowers.31
The SEC’s Office of Compliance Inspections and Examinations issued a Risk Alert last year on Strengthening Practices for the Underwriting of Municipal Securities.32 The Office reiterated that an underwriter makes an “implied recommendation” when selling securities to the public and that it should have a reasonable belief in the truthfulness and completeness of the key representations made in disclosures. Failure to perform appropriate due diligence on which to base this reasonable belief may violate antifraud provisions of securities laws. A year has passed since this Risk Alert was published. If history is any guide, the SEC may use the positions it announced in this alert as a baseline in exams and enforcement actions.
The Commission unanimously issued a report on the municipal securities market, which included a number of legislative and regulatory recommendations designed to further protect investors.33 The Report explains that “the Commission’s investor protection efforts in the municipal securities market have been accomplished primarily through . . . “enforcement of
the antifraud provisions of the federal securities laws.”34
Converging market forces may also lead to greater risk for investors in this area – namely, the inevitable increase in interest rates combined with the increased likelihood of municipality credit default or bankruptcy – which means the SEC should be more active in its enforcement in this area.35 Traditionally, municipal bankruptcies were rare occurrences reserved as an option of last resort, but they are occurring with greater frequency. In the past few years alone, the following municipalities have declared bankruptcy: Detroit; San Bernadino, Stockton, Vallejo, and the Town of Mammoth Lakes, California; Central Falls, Rhode Island; Jefferson County, Alabama; and Harrisburg, Pennsylvania. The nationwide attention that the Detroit bankruptcy has received and the high-profile legal battles have only increased the public scrutiny. As a result, the public pressure on regulators to examine municipal finances, including the underwritings of municipal bonds, is greater than ever.
Finally, the increased regulatory focus on municipalities is not limited to disclosures in connection with municipal underwriting. The Dodd-Frank Act directed the MSRB to regulate municipal advisors to protect municipal entities, investors, and the public interest.36 As a result, the SEC is expected to promulgate a final definition of the term “municipal advisor” in the near future. The MSRB will then act to strengthen existing rules to cover municipal advisors, such as G-17, requiring fair dealing in municipal advisory activities; G-20, restricting gifts, and G-36, providing a fiduciary duty on municipal advisors.37
CONSIDERATIONS FOR MUNICIPAL UNDERWRITERS
In light of the SEC’s focus on municipal securities and municipal underwriters, in our view municipal underwriters should take the following thoughts into consideration.
(1) There are several disclosure areas that have been the subject of recent enforcement actions and that are currently receiving enhanced scrutiny from the SEC. Those areas include: disclosure of facts related to pension obligations; valuation of municipal assets; facts underlying tax exempt status; stale or out of date financials in Official Statements; and the adequacy of disclosure related to the municipalities’ financial condition.
In each of these areas, firms should consider:
(a) Reviewing and strengthening existing policies and procedures relating to due diligence in these areas, including the creation of specialized due diligence checklists.
(b) Creating or expanding a due diligence memorandum that memorializes the steps taken to analyze each of the areas listed above. Documentation will be crucial in an exam or enforcement investigation.
(c) Reviewing and strengthening supervision and monitoring of due diligence in these transactions including considering implementing a random review by compliance of due diligence documentation.
(2) In conjunction with firms reviewing their due diligence practices as set forth above, this is also an opportune time to reconsider more broadly whether existing
supervisory and compliance procedures are still effective or whether changes in the business have made them obsolete.
(3) There is currently close cooperation between the OCIE exam staff and the enforcement staff in the SEC’s Municipal Unit. Indeed, it is not uncommon for the enforcement staff to assist examiners in planning exams, reviewing results, and planning follow up. Firms need to be aware of this dynamic and act accordingly. For example, when drafting responses to exam questions or exam letters, firms should understand that they are writing to two distinct audiences. As a result, communications should be tailored to particular issues raised by the exam staff, but should also include the necessary context along with any other information that will make potential issues less likely to be viewed suspiciously by the enforcement staff.
(4) SEC exams and at least one of the recent enforcement cases against an underwriter has focused on disclosure about expenses. Firms should have in place policies and procedures concerning how expenses are classified and how they are disclosed. The SEC views almost all facts surrounding expenses to be material and a violation of Rule 10b-5 if the requisite state of mind is met. In light of the SEC’s focus on expenses in exams and in enforcement actions, in our view this is a good time to review those policies and procedures to insure that they are robust and that sufficient supervisory and compliance review is being performed. Firms may want to consider random testing of a number of underwritings to verify that the firms’ procedures and supervisory structure are effective.
(5) Gifts to municipal officials remain a significant issue in SEC exams and enforcement cases. While firms undoubtedly have in place policies and procedures related to the gift rules contained in MSRB Rule G-20, this is a good time for firms to review those policies and procedures to make sure that they are sufficiently robust, including considering whether policies should
require preapproval of any such gifts. In this area in particular, it is important for firms to consider enhancing existing supervision and compliance monitoring of gifts.
(6) Employee training should be reviewed. In light of the focus on municipal underwriters, firms should review and enhance training to alert staff to the issues described above and also to ensure that employees fully understand and are following the firms’ policies and procedures
Our team has significant experience in the municipal securities area, including representing municipal underwriters, financial advisors, issuers, and other market participants in enforcement investigations, internal investigations, and compliance counseling. In addition to significant private practice experience, many of our partners have worked at the Securities and Exchange Commission on municipal securities issues in the Divisions of Enforcement, Trading and Markets, and Investment Management, and the Office of Compliance Examinations and Inspections. In particular, Bill White has represented parties in municipal securities investigations while in private practice and while at the SEC was one of the leaders directing the SEC’s investigation and litigation arising out of the Orange County bankruptcy.
We represent certain SIFMA Committees on various municipal securities issues arising from the Dodd-Frank Act. We also have a market leading political law practice that focuses on, among other things, issues related to campaign contributions and gifts to municipal officials.