Over the last year, the U.S. Securities and Exchange Commission (the “SEC” or the “Commission”) has developed a new and aggressive focus on the municipal securities market. In 2012, the SEC established the Office of Municipal Securities (the “OMS”) as required by the Dodd-Frank Act. Since the establishment of the OMS, the SEC has intensified its scrutiny of issuers of municipal securities, particularly their disclosures. This year alone, the SEC has already charged six municipal issuers with securities fraud, which is more than it had in the 10 previous years combined. Four of these matters — West Clark Community Schools, Harrisburg, Pa., South Miami, Fla. and Miami, Fla. — are of particular interest because the SEC has taken legal positions that are significantly more aggressive than we are accustomed to seeing with municipal issuers. On the other hand, the SEC’s decision not to charge the state of Rhode Island after the state took strong remedial action to improve its disclosure controls suggests that the SEC’s approach to municipal enforcement is nuanced and reasonable and that municipal issuers can protect themselves from liability by taking the same measures that corporate issuers have long been employing. The recent guidance on continuing disclosure provided by the Municipal Securities Rulemaking Board (the “MSRB”) offers an additional resource to issuers seeking help responding to the new regulatory environment.
West Clark Community Schools
On July 29, 2013, the SEC charged the West Clark Community Schools District of Clark County, Indiana (“West Clark”), with securities fraud arising from material misstatements in its public offering documents for the $31 million municipal bond offering it conducted in December 2007. The Official Statement for the offering affirmatively stated that in the previous five years West Clark had complied with all material continuing disclosure undertakings from its earlier municipal bond offerings. The Commission found, however, that between 2005 and 2010, West Clark had not submitted any of its required disclosures. This is the first time the Commission has charged a municipal issuer for falsely stating in an Official Statement that it was in full compliance with its continuing disclosure obligations from earlier offerings.
The SEC found that in March 2005 West Clark completed a $52 million public offering of municipal bonds, and in connection with that offering agreed make the typical continuing disclosure filings for municipal bonds, including annual financial statements and notices of certain specified events, and to deliver notice if it was unable to file ithe annual reports. According to the Order, West Clark never filed any of the required annual reports, and it did not deliver the required notice of its failures to do so. When West Clark conducted its 2007 bond offering, the related Official Statement included a section titled “Compliance with Previous Undertakings”, in which West Clark affirmatively stated that, among other things, it had “never failed to comply” with the continuing disclosure undertakings from the 2005 offering. The SEC found that West Clark, including its school board president, had reviewed, approved and authorized this disclosure.
Accordingly, the SEC concluded that West Clark “knew, or was reckless in not knowing,” that it never made any of the required continuing disclosures, and that its affirmative statements to the contrary in the 2007 Official Statement constituted violations of Section 17(a)(2) of the Securities Act of 1933 (the “Securities Act”), Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder.
In settling the SEC’s charges, West Clark agreed to take a number of remedial steps, including ensuring that its future continuing disclosures are timely and accurate, adopting formal, written disclosure policies and procedures, implementing annual training for personnel involved in the offering and disclosure process, and making certain certifications to the SEC.
The SEC also charged the underwriter for the 2007 Offering and one of its principals with anti-fraud violations and certain other offenses in connection with this matter.
See the SEC order in the matter of West Clark Community Schools here.
On May 6, 2013, the SEC charged the city of Harrisburg with securities fraud, marking the first time the Commission has charged a municipality for making misleading statements outside of its official statements or continuing disclosure filings. The Commission found that from 2007 to 2011, Harrisburg failed to make required continuing disclosure filings, including its required annual financial reports, and that this failure forced investors to rely on public statements that city officials made in other settings, such as the 2009 city budget, State of the City address and mid-year fiscal report, all of which contained material misstatements and omissions. Through these inaccurate statements, Harrisburg officials provided a misleading picture of the city’s financial situation to investors who held hundreds of millions of dollars in bonds issued or guaranteed by the city.
According to the SEC’s order, Harrisburg is nearly bankrupt and under state receivership largely due to $260 million in revenue bond debt that the city guaranteed for upgrades and repairs to its municipal waste-to-energy (“WTE”) facility. In 2008, Moody’s Investor Services downgraded the city’s general obligation bonds to a “Baa1” rating, citing Harrisburg’s guarantee of the WTE facility debt as the primary reason, but the city's 2009 budget, made public on the city website, misstated its credit as still being rated “Aaa”. When Harrisburg administrators proposed the 2009 budget, they were aware of the projected WTE facility cash flow deficits, but the city budget as adopted did not include funds for debt repayment, nor did it report the Moody’s downgrade. The SEC also found that Harrisburg’s Comprehensive Annual Financial Report (“CAFR”) for the year 2007, which was not filed on EMMA until 2009, omitted $4 million in guarantee payments that it had paid on the WTE facility debt. Between 2008 and 2009, Harrisburg issued or guaranteed $87 million in bonds that traded without investors having the benefit of this material information regarding Harrisburg’s financial condition.
Accordingly, the SEC found that Harrisburg made “reckless” material misrepresentations and omissions about the city’s financial health, in violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Significantly, the violating statements were not made in the city’s formal disclosure filings, but in general public statements and reports not previously scrutinized by the SEC.
Harrisburg agreed to adopt remedial measures similar to those adopted by West Clark.
See the SEC order in the matter of Harrisburg, Pa., here.
South Miami, Fla.
On May 22, 2013, the SEC charged the city of South Miami with defrauding bond investors about the eligibility for tax exemption of bonds that financed the construction of a parking structure being built in its principal downtown commercial district. The structure included both a parking facility that was to be publicly financed and maintained and a privately-developed retail facility. The Commission found that in 2002 and again in 2006, South Miami borrowed a total of approximately $12 million in two pooled, conduit bond offerings through the Florida Municipal Loan Council (“FMLC”), which enabled the city to borrow these funds at advantageous tax-exempt rates. The tax-exempt rates were available because of the city’s participation in the garage’s development and management.
The SEC’s investigation uncovered that bond counsel had advised South Miami city officials that the tax-exempt status of the bonds would be lost if any of the bond proceeds were used to finance the privately-developed retail portion of the garage project. The investigation found that although city officials at the time understood this constraint, subsequent city officials were unaware of counsel’s advice. Therefore, when the city revised the lease with the developer in 2005 to give the developer primary control over the entire project — both the retail portion and the public parking garage — the tax-exempt status of the bonds was jeopardized. In addition, the SEC found that the city had impermissibly lent $2.5 million directly from the proceeds of the 2002 bond offering to the private developer, which also threatened the bonds’ tax exemption.
In 2006, the city sought to raise an additional $5.5 million to complete the garage project, but it still did not disclose to the FMLC that it had significantly revised the project lease or that it had lent the developer the $2.5 million from the proceeds of the 2002 bond offering. The Commission found that in several documents submitted to the FMLC, South Miami misrepresented that its participation in the 2006 bond offering complied with the requirements for the exemption and that based on these material misrepresentations and omissions, the FMLC, explicitly relying on the city’s representations, incorrectly offered and sold the 2006 bonds as exempt from federal income tax.
The SEC found that South Miami’s conduct was negligent and violated Sections 17(a)(2) and (3) of the Securities Act. South Miami, jointly with the FMLC, settled with the IRS to preserve the tax-exempt status of the 2002 and 2006 bonds. The settlement included nearly $1.4 million in costs to the city. South Miami also agreed with the SEC to remedial sanctions, including the following:
- Retaining an independent third-party consultant for three years to annually review and improve the city’s policies, procedures and internal controls regarding its disclosures for municipal securities offerings.
- Hiring additional internal personnel or outside experts for disclosure functions.
- Implementing active and ongoing training programs for key city authorities.
- Adopting the third-party consultant’s recommendations and certifying in writing to the SEC that the city has adopted and implemented the recommendations.
- Complying with any reasonable SEC requests for further evidence of compliance.
See the SEC order in the matter of South Miami, Fla., here.
On July 19, 2013, the SEC charged the city of Miami and its former budget director with violating anti-fraud provisions of federal securities laws, repeating an action it took against Miami a decade ago. The Commission also charged Miami with violating the 2003 SEC cease-and-desist order that was entered against the city based on similar misconduct, marking the first time the Commission has alleged further wrongdoing by a municipality subject to an existing SEC cease-and-desist order.
The Commission charged that Miami, through its former budget director, included false and misleading information in the city’s continuing disclosure filings, such as its fiscal year 2007 and 2008 CAFRs that were distributed to broad segments of the investing public, including investors in previously issued city debt. The former budget director transferred approximately $37.5 million from the city’s Capital Improvement Fund to its General Fund to hide increasing deficits in the General Fund that he knew would be viewed by investors and bond rating agencies as an important indicator of financial health. The investigation also found that the city made material misrepresentations and omissions to rating agencies concerning the city’s projected operating deficit for its fiscal year 2009 General Fund.
The SEC seeks injunctive relief and civil money penalties against Miami and the former budget director, as well as an order commanding the city to comply with the Commission’s 2003 order.
See the SEC complaint in the matter of Miami, Fla., here.
While the SEC’s focus on the municipal securities market has greatly intensified, the Commission appears willing to forego enforcement action if the municipality under investigation demonstrates a commitment to effective remedial measures. On July 9, 2013, Rhode Island Treasurer Gina M. Raimondo announced that the SEC had completed its investigation of that state’s pension financial disclosures and would not pursue any enforcement action. The SEC began its probe of the financial statements and disclosures about the $7.7 billion Employees' Retirement System of Rhode Island in early 2011, concentrating on disclosures in bond offering documents related to pension finances from 2007 to 2011. Rhode Island fully cooperated with the investigation and implemented Treasurer Raimondo’s “Truth in Numbers” remedial legislative initiative seeking to bring pension reform to the state. Rhode Island also committed to state-of-the-art financial disclosure, training and certain disclosure best practices.
Illinois and Victorville, Calif.
On March 11, 2013, the SEC charged the state of Illinois with violating Sections 17(a)(2) and (3) of the Securities Act. In connection with multiple bond offerings raising over $2.2 billion from 2005 to early 2009, Illinois misled investors by omitting material information in preliminary and final official statements regarding the structural underfunding of its pension systems and the resulting risks to the state’s financial condition. The SEC found that Illinois also misled investors about the effect of changes to the Statutory Funding Plan, including substantially reduced pension contributions in 2006 and 2007. In its settlement with the SEC, Illinois has implemented a series of remedial measures to correct its negligent conduct, including retaining disclosure counsel, enhancing disclosure controls and developing training materials and programs.
Weeks later, on April 29, 2013, the SEC charged the city of Victorville, Calif., a city official, the related Airport Authority and the bond underwriter with nine counts of securities fraud arising from the use of inflated valuations of property securing an April 2008 municipal bond offering. In addition, the Commission charged the bond underwriter with misappropriating more than $2.7 million in bond proceeds that were supposed to be used to build airplane hangars for the Airport Authority but were instead used in a scheme to keep the underwriter afloat. The SEC seeks financial penalties, the return of ill-gotten gains and permanent injunctions against all of the defendants.
See the complaint in the matter of Victorville, Calif., here, and the order in the matter of the state of Illinois here.
Implications for Municipal Bond Issuers
Both the nature and the number of these recent actions suggest that the enforcement environment for municipal issuers has fundamentally changed. Prudent issuers of municipal securities should assume that in the future they will be subject to at least the same level of SEC scrutiny that corporate issuers have long endured. While this scrutiny presents significant challenges, the SEC’s decision not to charge the state of Rhode Island shows that municipal issuers can benefit from the approaches to SEC compliance that careful corporate issuers use. Most importantly, municipal issuers should have robust, formal compliance programs in place, including written policies, regular training and disclosure controls and procedures that cover all information that might affect their securities — not just financial data. Such programs genuinely help issuers avoid many violations, and when violations do occur, regulators tend to be more lenient with issuers who have effective compliance programs in place.
The Municipal Securities Rulemaking Board (the “MSRB”) has also responded to the SEC’s heightened enforcement interest in municipal issuers by providing issuers written guidance “to assist them in achieving more efficient, accurate and timely” continuing disclosure filings. Issued on August 12, 2013, “MSRB Market Transparency Advisory – Suggested Practices In Submitting Of Financial Disclosures To Emma” (MSRB Notice 2013-18) describes the continuing financial disclosure requirements for municipal issuers and offers suggested practices for complying with them. Although this guidance is not mandatory, issuers will be well-advised to review the notice and implement its suggestions where possible.
See MSRB Notice 2013-18 here.