Ceresney on the Impact of SEC Enforcement on Public Finance
Those of you who know me know that I am hugely interested in public finance. I have written several articles about the municipal securities market, municipal finance distress, and municipal bankruptcy, and I believe that reform is essential if our communities are to continue to fund and provide essential infrastructure and public health and safety services. Last week, SEC Director of Enforcement Andrew Ceresney gave the keynote address at the 2016 Securities Enforcement Forum. The text of Ceresney’s speech, entitled “The Impact of SEC Enforcement on Public Finance, is available via https://www.sec.gov/news/speech/speech-ceresney-10132016.html#_edn4 . In this post, we provide background about the municipal securities market and summarize certain of Ceresney’s remarks.
Municipal securities are securities issued by states and their political subdivisions. The term subdivision encompasses both local governments (e.g., cities and towns) and public authorities (e.g., entities formed by a state or local government to operate public infrastructure projects such as airports, power plants, water systems, public housing and other community services). The municipal securities market is enormous, diverse and complex. It currently consists of securities valued at over $3.7 trillion. The number of municipal issuers is estimated to be about 44,000. Issuers range from the nation’s largest states to its smallest towns and school districts. And, municipal securities issuers use a range of securities with varied credit structures.
Although the municipal securities market is critical to public health, safety and welfare, it is substantially less regulated than many other segments of the market. Municipal securities are exempt from the registration and reporting requirements of the federal securities laws. This means that while the Municipal Securities Rulemaking Board (MSRB) establishes rules, which the SEC reviews, approves and, along with FINRA, enforces, for the municipal securities firms, banks and municipal advisors that engage in municipal securities and advisory activities, issuers are not required to registered with the Commission, nor are they required to make the sort of disclosures present in the public company area — e.g., disclosures contained in registration statements, quarterly and annual reports, and the like. This regulatory structure exits because the Tower Amendment — named after the late Senator John Tower of Texas — prohibits the Commission and the MSRB from requiring municipal securities issuers to submit information to them prior to the sale of securities. The Tower Amendment further prohibits the MSRB from requiring any municipal issuer to furnish it, or any purchasers or prospective purchasers, with any information either before or after the sale of securities. Instead, the Commission indirectly regulates municipal securities offerings through its Rule 15c2-12, which requires underwriters of municipal securities offerings to obtain issuers’ disclosures for the securities they intend to sell and provide them to purchasers.
In terms of market structure, the municipal securities market is both more decentralized and more opaque than its corporate counterpart. Municipal bonds are not traded on any exchange; instead, they trade in a decentralized, over-the-counter dealer market. In the secondary market, investor access to pre-trade pricing information has historically been limited compared to the market for corporate bonds. As Ceresney observed, the lack of transparency, coupled with a lack of liquidity for certain issuances, can make it difficult for investors to determine whether they are getting a fair price.
SEC Enforcement Initiatives
In 2010, the SEC created a specialized enforcement unit to address perceived abuses in the public finance/ municipal securities market space. As Ceresney noted, the unit’s stated focus is on misconduct in the large municipal securities market and in connection with public pension funds including: offering and disclosure fraud; tax or arbitrage-driven fraud; pay-to-play and public corruption violations; public pension accounting and disclosure violations; and valuation and pricing fraud. According to Ceresney, “since the beginning of 2013, the Commission has brought enforcement actions against 76 state or local government entities (including 4 U.S. states), 13 obligated persons and 16 public officials.” Ceresney highlighted several recent cases and initiatives:
- In August 2015, the Commission brought an action against Edward Jones concerning the firm’s practice of selling municipal bonds to customers out of inventory. When underwriting municipal bonds, dealers are required to offer bonds to their customers at an initial offering price which has been negotiated with the issuer. This is so that investors pay the price at which the issuer intends to sell the bonds. This rule also serves to limits the underwriter’s compensation. Instead of selling the bonds to its customers, however, Edward Jones took the bonds into its own inventory and then sold the bonds to its customers at a markup. This practice allowed Edward Jones to overcharge its retail customers by at least $4.6 million. It also put valuable tax subsidies at risk, according to the Commission. To settle the charges, Edward Jones paid a little more than $20 million in disgorgement and civil penalties.
- More recently, the SEC charged State Street Bank and Trust Company in connection with a pay-to-play scheme involving custodial services for public pension funds. Pension funds require a custodian to hold their assets and effect settlement of securities transactions. The Commission found that State Street and its then-senior vice president entered into an agreement with the State of Ohio’s then-deputy Treasurer to make improper campaign contributions and payments in exchange for State Street being awarded contracts to serve as subcustodian for three Ohio pension funds. To resolve the action, State Street agreed to pay $12 million in disgorgement, prejudgment interest and civil penalties, and its former vice president paid approximately $250,000.
- In addition to these enforcement actions, Ceresney also detailed the Commission’s recent MCDC initiative. The initiative targeted what the Enforcement Division perceived was likely a widespread problem in the market — namely, that municipal issuers had undertaken in offerings to provide investors with important financial and other information – known as “continuing disclosure” – but were failing to provide that information in a timely fashion, or sometimes, failing to provide it at all. The Enforcement Division also was concerned that underwriters were failing to conduct sufficient due diligence on representations made by the issuers and were selling bonds to their customers using offering materials that contained false statements. According to Ceresney, the initiative prompted a large number of underwriters and issuers to conduct self-reviews and to self-report potential misconduct. The Enforcement Division found widespread failures of due diligence by underwriters, and eventually charged 72 broker-dealers (representing about 96% of the market for municipal underwriting). The Commission also charged 71 municipal issuers for making false statements or misleading omissions in their bond offering documents.
Ceresney highlighted several other actions to emphasize the Commission’s “commitment to use the legal theories and remedies available to us.”
- The Commission recently used controlling person liability for the first in the municipal securities context in a case involving the former mayor of Allen Park, Michigan.
- In 2013, the Commission enjoined an offering involving the City of Harvey, Illinois, citing concerns surrounding an alleged scheme involving the city’s former comptroller to divert the proceeds of bond offerings for improper and undisclosed uses. After a hearing, the City agreed to a temporary restraining order barring it from offering any bonds for a period of time. Then, December 2014, the City agreed to a final judgment which prohibited it from offering any municipal bonds for three years unless, among other things, it retained independent disclosure counsel.
- In 2013 and 2016, the Commission obtained civil penalties against two municipal issuers after finding that the issuers had misled investors. In both cases, the Commission sought to mitigate impacts on taxpayers.
- Finally, the Commission recently brought its first enforcement actions against municipal advisors, a new class of registrant under Dodd-Frank. Municipal advisors provide advice to municipal entities or obligated persons with respect to municipal financial products or the issuance of municipal securities, or undertake certain solicitations of municipal entities or obligated persons. Beginning in 2010, Dodd-Frank required municipal advisors to register and comply with regulations issued by the MSRB. Dodd-Frank also established that municipal advisors owe a fiduciary duty to their municipal clients. In the first case to enforce the Dodd Frank fiduciary duty, the Commission charged registered a municipal advisor and three of its employees with breaching their fiduciary duties and violating certain MSRB rules. The Commission found that the municipal advisor failed to disclose that while serving as a municipal advisor to a city, the advisor’s employees also were providing the underwriting services for the same offerings.
Ceresney cited these an other initiatives to argue that there is a “change in tone” regarding enforcement in the public finance and municipal securities market space. While time will tell whether the Commission’s attention remains focused in this area, the size and continued importance of public finance and the municipal securities market to retail investors and community infrastructure and public health and safety suggests that public finance and municipal securities will remain an area of focus for the foreseeable future.
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