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outdated."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
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
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
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
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
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
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
other items of interest from the world of directors & officers liability,
with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
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