As reported by the Wall Street Journal, the SEC Enforcement Staff is one year into a wide-ranging review of disclosures made by financially stressed municipal bond issuers. This review has focused on whether municipalities made sufficient disclosures concerning the extent of their financial stress. The SEC announced that this review has already resulted in a number of investigations into municipal bond issuers.
This wide-ranging “sweep,” and the subsequent investigations, both raise several interesting issues with respect to enforcement of the securities laws against municipal issuers:
- Application of investigative techniques from other areas to municipalities. This review by the Enforcement Staff has at least two hallmarks of reviews and investigations it has conducted with respect to other industries and issuers. First, while this appears to be the first broad sweep of a sub-set of municipal issuers, such sweeps are no longer unusual with respect to other entities, such as hedge funds and investment advisers. Second, the Staff’s focus on municipalities experiencing financial stress is consistent with how the Staff sometimes initiates inquiries or investigations against public companies that experience declines in their stock price as the result of the disclosure of adverse news, such as an announced restatement or a failure to get FDA approval on a key drug. While some argue that these types of investigations are simply attempts to find “fraud in hindsight,” the SEC still looks into these scenarios to see whether the issuer had made adequate disclosures concerning the risk that ultimately materialized.
- Investors may be caught up in the sweep and investigations. In other investigations over the past few years, the Enforcement Staff has expanded the number of individuals and entities it contacts in its search for relevant information and documents. For example, when investigating a public company, the staff seems more likely now – depending on the facts and circumstances of a case – to reach out directly to that company’s customers or clients who may have relevant information about the issues under investigation. Likewise, as pointed out by the WSJ article, the Enforcement Staff has contacted at least one investment firm to gain more information about a meeting between a municipal officials and investors.
- An additional incentive for self-reporting? The timing of the Enforcement Staff’s announcement of its sweep and resulting investigations comes only a couple of weeks after the Staff rolled out its Municipalities Continuing Disclosure Cooperation Initiative, which expressly provides that parties currently under investigation who have not yet been charged may still be eligible for receiving the initiative’s benefits if they self-report. The Staff’s initiative seeks to provide an incentive to municipal issuers and underwriters to self-report inaccuracies in past disclosures. For example, to the extent that the Enforcement Staff decides to bring charges against any issuer that self-reported, it will recommend a settlement to the Commission that does not include payment of a civil penalty by the issuer. And to the extent that the Staff brings charges against an underwriter that self-reported, the recommended civil penalties are subject to a cap. During last week’s Tax and Securities Law Institute meeting in Boston, a SEC panelist stated that this initiative was intended to create tension between issuers and underwriters that could lead to more disclosures, as issuers and underwriters would face a “modified prisoner’s dilemma.” An issuer and underwriter — in this scenario — would theoretically each have a heightened incentive to self-report out of fear that the other party will self-report first and receive the more beneficial recommended settlement under the initiative and leave the party that did not self-report subject to potentially harsher terms.
- Collateral impact of SEC charges. The fact that several active investigations are taking place increases the possibility that the SEC could bring multiple enforcement actions against municipal issuers in the near future. The initiation of any actions will have several collateral consequences on the municipalities and investors alike. For example, will such actions help overcome the barriers that have historically made private litigation difficult to bring in this area? Will any SEC settlements name individual municipal officials and, if so, what will the political fallout be? Will there be a fair fund set up to compensate bondholders? These are just a few examples of the many legal issues that can arise for municipal issuers and bondholders if the SEC brings more actions in this area.
- Disclosures by municipalities of pending investigations. One issue that municipalities that are subject to these investigations face is whether they are required to disclose the fact of the investigation to their bondholders or in subsequent issuances. The SEC has not taken a position on whether such disclosures must be required, other than to point out that the decision should be made in consultation with counsel.