In two administrative enforcement actions last month, the SEC charged two municipalities – Harrisburg, Pa. and South Miami, Fla. – with securities fraud. These high-profile actions sounded alarm bells and raised concerns about possible securities violations involving other state and local governments. But while these two actions have grabbed a great deal of attention, the unfortunate fact is that allegations of securities law violations against local governments are nothing new. However, the recent problems do raise serious concerns for state and local government bond investors, which in turn raise concerns about what the liability implications may be for the government entities and their officials.
On May 6, 2013, in the first of the two most recent actions, the SEC instituted settled administrative proceedings against Harrisburg, charging the city with securities fraud for its “misleading public statements when its financial condition was deteriorating and financial information available to municipal bond investors was either incomplete or outdated.” The SEC’s press release describing the action and the city’s entry into a consent cease and desist order details the misleadingly reassuring or incomplete statements the city provided at a time when its financial woes were well known to city officials.
The press release states that the Harrisburg action “marks the first time that the SEC has charged a municipality for misleading statements made outside of its securities disclosure documents.” The agency’s administrative order was accompanied by a separate report addressing the disclosure obligations of public officials and “their potential liability under the federal securities laws for public statements made in the secondary market for municipal securities.”
The Harrisburg action was followed a few days later with a separate settled administrative action against the City of South Miami. As detailed in its May 22, 2013 press release, the agency charged the city with “defrauding bond investors about the tax-exempt financing eligibility of a mixed-use retail and parking structure being built in its downtown commercial district.” Post-offering changes to the project’s lease arrangements jeopardized the offering’s tax exempt status by, among other things, providing offering proceeds directly to a private developer. The agency alleged that in annual certifications following the offering the city incorrectly stated that it was in compliance with terms of the offering and that there had been no events that would affect the tax-exempt status. The city avoided possible harm to the bond investors by entering into separate settlement with the IRS and by restructuring a portion of the offering.
It is not just municipalities that are having difficulties with the securities laws. In March 2013, the SEC lodged settled administrative proceedings against the State of Illinois, in which the agency alleged that the state “failed to disclose that its statutory plan significantly underfunded the state’s pension obligations and increased the risk to its overall financial condition. The state also misled investors about the effect of changes to its statutory plan.”
In August 2010, the agency entered settled administrative proceedings against the State of New Jersey, alleging that the state failed “to disclose to investors in billions of dollars worth of municipal bond offerings that it was underfunding the state's two largest pension plans.” According to the SEC’s August 18, 2010 press release, New Jersey was “first state ever charged by the SEC for violations of the federal securities laws.” Interestingly in the consent order, the state neither admitted nor denied the agency’s allegations.
As the statements quoted above make clear, the SEC’s recent actions represent new developments, as the agency expands its reach and exerts its authority in new ways. However, there is nothing new about the agency’s assertion of securities law violations against local governments. Over the years, the SEC has pursued a number of high profile enforcement actions in connection with municipal bond offerings. A lengthy list of the SEC’s enforcement actions against municipalities between 2003 and 2010 can be found here, including actions against issuers, public officials, and offering underwriters. Earlier cases can be found here and here.
A recurring issue that has led to allegations of securities law violations has been disclosures relating to pension obligations (as the Illinois and New Jersey actions demonstrate). One of the highest profile securities enforcement actions involving a municipality prior to the more recent actions described above was the securities complaint the SEC filed in April 2008 against five former San Diego officials, in which the agency alleged that the officials had “failed to disclose to the investing public buying the city’s municipal bonds that there were funding problems with its pension and health care obligations and these liabilities placed the city in serious financial jeopardy.”
As discussed in greater detail in Steve Malanga’s June 1, 2013 Wall Street Journal op-ed column entitled “The Many Ways That Cities Cook Their Bond Books” (here), pension obligation reporting deficiencies are likely to continue to plague local governments, which is an area that the SEC is giving “special scrutiny.” These and other financial reporting shortcomings may put bond investors at risk, as local officials struggling with financial woes attempt to put their local government’s other obligations ahead of the locality’s obligation to honor the commitments it made in the bond offering.
All of these developments suggest that bond investors “should be practicing a stronger form of ‘buyer beware’” – but, as Malanga notes, even a heightened level of investor caution may be “difficult if governments issue reports designed to disguise their true financial condition.” If investors were to “finally catch on to this,” it might “put an especially deep chill on the market for municipal securities.” Local governments that are “less than forthcoming” will “deserve the consequences.”
It is certainly the case that investors who lack confidence in the accuracy of a locality’s financial reports can try to protect themselves by avoiding investments in the locality’s bonds. But that does little for investors who have already invested and believe they were misled. Even the SEC’s various enforcement actions, which are designed to enforce the securities laws and vindicate the principles they represent, do little directly for investors who were harmed by the alleged misrepresentations.
At least some investors in these circumstances have tried to take matters into their own hands, by initiating their own actions to try to redress their injuries. For example, as discussed here, in May 2010, bond investors initiated a securities class action in the Southern District of Florida against the city of Miami, Florida, alleging that the city had made “fraudulent material misrepresentations and omissions regarding the City of Miami’s then-current financial condition and future prospects.” Among other things, the plaintiff alleged that the city was “improperly and illegally shuffling money between various City of Miami accounts in an effort to cover up its existing fiscal crisis.” (As noted here, in 2012, following document discovery in the case, the plaintiff voluntarily dismissed her action with prejudice to herself but without prejudice to the class.)
In addition, as I noted in an earlier post (here), investors in certain municipal revenue anticipation notes filed an action in the Central District of California against the city of Alameda, California and related municipal entities, alleging that the city officials knew that the funding mechanism for the notes “was not economically feasible.”
All of these developments suggest that local governments and their officials could face increased exposure to the possibility of litigation involving alleged securities law violations, whether from enforcement authorities or from investors.
Readers of this blog may well wonder whether there are insurance products that could protect municipalities from these kinds of risks. Certainly, Public Official Liability Insurance includes liability protection not only for individual public officials but also for the public entities themselves. But many of these policies include an express exclusion precluding coverage for claims arising out of any debt financing. Some public entities have procured insurance designed to provide protection for these kinds of claims, but many municipalities have not, even if they otherwise purchases public official liability insurance. Given the developments described above, it may be increasingly important for local governments to seek to procure this type of protection. On the other hand, as regulators and claimants more aggressively pursue these types of claims, obtaining this type of coverage could prove increasingly challenging and costly.
The local governments’ troubled financial condition and the absence of insurance in many cases does raise the question of what investor claimants’ litigation objectives may be. The taxpayer base of a beleaguered city hardly represents an attractive target. It may be that the claimants’ true targets are not the city or its officials; for example, in the city of Alameda case noted above, the defendants in the case included not only the various municipal entities, but also the offering underwriters that sponsored the city’s note offering.
Whatever the case may be, it seems clear that given an increasingly active SEC and the apparently growing willingness of investors to pursue private securities litigation, there is a growing risk that state and local governments facing pension funding challenges and other budgetary woes could also find themselves facing proceedings alleging securities law violations. These developments have a number of risk management implications for these local governments, including considerations of risk transfer through insurance, where available.
Grading Securities Enforcement: In an interesting and provocative May 16, 2013 New York Law Journal article (here, subscription required) , Columbia Law Professor John Coffee grades the private securities enforcement activity of the plaintiffs’ bar and the public enforcement activity of the SEC. His grade for the plaintiffs’ bar is relatively high but his grade for the SEC is far less favorable.
In grading the plaintiffs’ bar, Coffee notes a bifurcation that has developed among the plaintiffs’ securities law firms. Securities class action activity is increasingly concentrated among a few established law firms. The recent rise of M&A litigation is in part a reflection of the fact that smaller plaintiffs’ firms lack institutional clients and the resources to carry a big securities case. The elite plaintiffs’ firms tend to be involved in securities cases that result in “mega-settlements” while the smaller firms, to the extent they are involved in securities class action cases at all, tend to be involved only in the smaller cases that result only in smaller settlements that bring down annual settlement averages and medians.
For Coffee, the bottom line for the plaintiffs bar is that the “big league” plaintiffs’ law firms had “a good year” in 2012, while the smaller firms “limped through 2012.” Coffee concludes his grade report for the plaintiffs’ firms by noting that even the elite plaintiffs’ firms should “gather ye rosebuds while ye may, as the plaintiffs’ bar needs to worry about where future cases will come from.”
Coffee’s review of the SEC is far less flattering. He notes that the agency’s enforcement activity is increasingly concentrated in three areas: insider trading cases; Ponzi scheme; and financial services misrepresentations (mostly involving broker-dealer fraud). What is missing is enforcement activity involving public company misstatements. Coffee assesses this absence as due to the fact that the agency “lacks the ability to handle the large, factually complex case,” noting that when the agency attempts to take on large corporate defendants, “it must either decline to sue or settle cheaply.” Coffee states that “truly complex factual cases against a major financial institution are probably beyond the SEC’s practical capacity.” Coffee suggests that the SEC should borrow a page from the FDIC’s play book and start “hiring private counsel to handle the cases that are too big or burdensome for it.”
Coffee concludes by giving the SEC an enforcement grade of “B-“ because the agency is “in denial” – “it will not admit that it cannot handle complex cases, will not refer to private counsel, and so must settle on a basis that often seems inadequate.”
Special thanks to a loyal reader for sending me a link to Coffee’s article.