Recently, the Securities and Exchange Commission brought actions against 71 municipal bond issuers for failure to comply with their disclosure obligations. It also obtained a jury verdict in a case against the City of Miami for violations of the antifraud provisions of the federal securities laws. The SEC’s continued focus on enforcement actions against municipal bond issuers and underwriters, and the absence of investor activity in this area, underscores the limited role for investors in policing compliance with securities law in the municipal bond markets. This article provides a brief overview of the securities law framework in which municipal bond issuers operate, followed by a discussion of the SEC’s recent enforcement actions and finally some observations regarding enforcement of the securities laws against municipal issuers.
Securities Law Principles
Liability for Misstatements
Debt securities issued by states and municipalities enjoy a broad exemption from the registration requirements of Securities Act of 1933, and as a consequence the private rights of action under Sections 11 and 12 under the Securities Act are unavailable to investors aggrieved by issuer misrepresentations in municipal bond offerings. The Securities Act exemption for municipal bonds does not extend to the antifraud provisions of Section 17(a) of the Securities Act. However, as opposed to Sections 11 and 12, which operate on a strict liability standard, a minimum showing of negligence is required to establish a violation of Section 17(a).1 More importantly, most federal circuit courts, including the Second Circuit, do not recognize a private right of action under Section 17(a).
Municipal issuers are also exempt from the continuous reporting requirements of the Securities Exchange Act of 1934, and do not file Forms 10-K, 10-Q and 8-K. They are subject to other provisions of the Exchange Act, including in particular the general antifraud provisions of Section 10(b) and Rule 10b-5. Section 10(b) and Rule 10b-5 require showings of both scienter, that is either knowing or reckless misconduct, and reliance. Class action and similar litigation brought under these provisions typically rely on the “fraud-on-the-market” theory to establish reliance, which requires showing that the security is traded in an efficient market. See Halliburton Co. v. Erica P. John Fund, Inc. , 134 S. Ct. 2398 (2014).2 Establishing that a debt security trades in an efficient market can be difficult, however, because debt securities tend not to trade in established markets.3 This problem is compounded for municipal securities. In its 2012 Report on the Municipal Securities Market, the SEC described the municipal bond market “as a ‘buy-and-hold’ market” with a secondary market that is a “decentralized over-the-counter dealer market that is illiquid and opaque.”4
Under both the Securities Act and the Exchange Act, persons who control a municipal issuer may be liable for violations by the issuer of the antifraud provisions of Section 17(a) and Section 10(b) and Rule 10b-5. For example, in SEC v. Burtka (E.D. Mich. Jan. 28, 2015), the SEC brought control person charges against the former mayor of Allen Park, Michigan (and direct charges against the former city administrator) for misstatements made in connection with a municipal bond offering by the city. The case was settled with an imposition of monetary and injunctive relief upon the mayor (and injunctive relief upon the city administrator).
While the SEC does not directly regulate the reporting requirements of municipal issuers, it has used its authority to regulate deceptive conduct of broker-dealers to require certain ongoing disclosures by these issuers. Under Rule 15c2-12, prior to participating in an offering by a municipal issuer, an underwriter must have reasonably determined that the issuer has undertaken in a written agreement—commonly referred to as a continuing disclosure agreement—to publish annual financial information, which must be audited if available. In addition, an issuer must undertake to publish within ten business days the occurrence of the following events:
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Offering documents must disclose instances during the preceding five years in which the issuer failed to materially comply with its continuing disclosure obligations.
Market experience has shown that issuers have historically failed to comply with their continuing disclosure obligations under Rule 15c2-12. See, for example, the SEC’s 2012 Report on the Municipal Securities Market. Acknowledging the shortfall in compliance with Rule 15c2-12, in 2014 the SEC launched its Municipalities Continuing Disclosure Cooperation Initiative, which provides municipal issuers and underwriters an opportunity, through self-reporting, to obtain more favorable settlement terms for securities laws violations than would have otherwise been obtained if the SEC’s staff independently discovered the violations.
Recent Enforcement Actions
In August 2016, the SEC settled with 71 municipal issuers who had made materially inaccurate statements about their compliance with their continuing disclosure obligations. For example, in In the Matter of State of Minnesota (Securities Act Release No. 10182, Aug. 24, 2016), the SEC alleged that the State of Minnesota had violated Section 17(a)(2) of the Securities Act by stating in bond offering documents that there were no instances in which it failed to comply with its continuing disclosure obligations in the past five years. This was untrue, as the state had failed to file a 2008 audited financial report for certain outstanding bonds and had failed to file required notices of late filings for its 2010 audited financial report. The State of Minnesota settled these charges by agreeing to non-monetary penalties. Other allegations were made, and settled, against each of the other 70 municipal bond issuers.
In SEC v. City of Miami, Florida (S.D. Fla. Verdict Sept. 14, 2016), the SEC won a jury trial against the City of Miami and its former budget director for violating Section 17(a) of the Securities Act and Section 10(b) and Rule 10b-5 of the Exchange Act. In its complaint, the SEC had alleged that the city made numerous material misrepresentations in its bond offering documents about the inter-fund transfers that were intended to mask deficits in the city’s general fund. Interestingly, the inter-fund transfers came to light in connection with a report issued by the city’s Office of Independent Auditor General.
Takeaways for Municipal Bond Investors
Even though investors in municipal securities enjoy a private right of action under Section 10(b) and Rule 10b-5, private claims against municipal issuers are rare for a variety of reasons. First and perhaps foremost, 10b-5 plaintiffs must establish that they relied upon an issuer’s false information in connection with a purchase or sale of municipal securities. This is difficult in the absence of the availability of the “fraud-on-the-market” theory, whose use courts have denied to debt plaintiffs in certain cases, as noted above. Also, the structure of the municipal securities market, with a high percentage of retail “buy and hold” investors and a concentrated distribution of active municipal bond dealers, as noted above, tends to discourage lawsuits.
Aside from suits under the antifraud provisions of federal securities laws, investors could theoretically file actions to require municipal bond issuers to satisfy their disclosure obligations under continuing disclosure agreements. These agreements typically provide an express right of action in favor of bondholders, but only to compel disclosures, not to recover damages.5 Not surprisingly, there do not appear to be cases in which investors have sought to enforce their rights to compel disclosure.
Given the landscape, the SEC has pretty much been the exclusive watchdog in the municipal securities market. Absent changes in the law, or structural changes in the municipal bond markets, we would expect this state of affairs to continue. For its part, the SEC's interest in the municipal bond market is not abating. In a recent speech, the Director of the SEC’s Division of Enforcement noted the critical importance of the SEC’s continued enforcement efforts in this area.6 With the private sector continuing to watch from the sidelines, the SEC remains the only municipal securities enforcement game in town (and city and state) for the foreseeable future.