As described in our Legal Update of May 7, 2013 — the Securities and Exchange Commission’s (SEC or Commission) scrutiny of disclosures by municipalities is intensifying and expected to increase. That update followed the SEC’s report of investigation concerning, and administrative proceeding against, the city of Harrisburg, PA. The Harrisburg action is the first time the SEC found a municipality had committed securities fraud by making misleading statements outside securities disclosure documents.
Fewer than three weeks since the Harrisburg matter, the SEC has found that yet another municipality — this time the city of South Miami, FL — committed securities fraud in connection with municipal securities disclosures. The South Miami action confirms this growing trend and underscores the SEC’s commitment to expand its municipal securities enforcement presence.
On May 22, 2013, the SEC charged the city of South Miami, FL (South Miami or the City), with defrauding bond investors about the tax-exempt status of two municipal offerings. According to the Commission, South Miami sought to develop a public parking garage in its principal downtown commercial district. The project ultimately became a mixed-use retail and public parking structure that was to be developed by a for-profit developer (the Developer). Under the terms of the lease, the City was to be responsible for the cost to develop the parking garage (and was to retain full control over the operation and maintenance of the parking garage and all parking revenues) and the Developer was to be responsible for the cost to develop the retail space. This division of responsibilities and benefits was critical for the City to be eligible for tax-exempt financing.
In 2002, to finance the project, the City borrowed $6.5 million in a tax-exempt bond offering. The Tax Certificate executed in connection with the loan contained representations that the City would not use the funds for private use and that the project would be owned and operated in compliance with IRS regulations. The Certificate of Borrower and Loan Agreement contained similar representations. Notwithstanding these representations, South Miami undertook actions in direct contradiction to the representations and that jeopardized the tax-exempt status of the bonds. In particular, the City loaned the Developer $2.5 million of the bond proceeds and revised the lease in order to lease the parking garage to the Developer and to allow the Developer to share in the profits of the parking garage.
In 2006, the City sought to borrow an additional $5.5 million to continue construction on the project. In connection with those efforts, the City failed to disclose the $2.5 million loan to the Developer or the lease revisions. Further, on several occasions, the City affirmatively represented that the 2006 bond offering complied with tax-exempt requirements.
The Commission found South Miami’s misrepresentations and omissions material because they jeopardized the tax-exempt status of the municipal bonds, which would have caused investors to pay tax-related penalties. Moreover, the bonds traded at prices that assumed the bonds were tax-exempt. Without admitting or denying the Commission’s findings, South Miami was ordered to cease and desist from committing or causing any violations and any future violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, and to comply with certain undertakings, including retaining an independent third-party consultant to oversee and annually review its policies, procedures and internal controls for municipal bond disclosures for the next three years.
The City’s violations, as evidenced by the nonscienter-based fraud charges, stemmed from a breakdown in communication and a lack of effective internal policies, procedures and training concerning disclosure obligations. Exacerbating these breakdowns was the high turnover in the City’s Finance Department, which resulted in the signing of annual certifications by at least four different finance directors who had no previous experience, training or guidance on disclosure requirements or tax issues in bond offerings.
As the SEC’s press release announcing the South Miami matter makes clear, a lack of internal procedures or experience in municipal securities offerings provides no protection from fraud charges by the SEC. As such, it is prudent for municipal issuers to periodically review their policies, procedures and internal controls for municipal securities offerings, including: (1) disclosures made in financial statements; (2) disclosures made pursuant to continuing disclosure agreements and disclosures regarding credit ratings; (3) public statements regarding financial condition and credit ratings; (4) the hiring of internal personnel and external experts for disclosure functions; (5) the designation of an individual responsible for ensuring compliance with such policies, procedures and internal controls; and (6) the implementation of active and ongoing training programs regarding compliance and disclosure obligations.