Recent events in the world of public finance continue to highlight and reinforce the requirements and duties imposed on municipal officials to actively participate in - and be responsible for - the disclosure made to investors who buy issues of municipal bonds and notes. These duties exist whether or not the municipality’s credit supports the bonds or notes, e.g., whether the obligations are general obligations (GOs) or pure conduit “industrial development” or “hospital” bonds. In fact, in writing to Ohio municipal attorneys in October, Robert Doty, a distinguished commentator, stated the following:

Recent actions demonstrate that securities law responsibilities of issuers (and officials) are continuing to evolve significantly, and at times dramatically, through SEC enforcement and private litigation. One repeated crucial message is that the SEC expects issuers to take responsibility for their disclosure documents. While other parties continue to have their own responsibilities, that does not relieve issuers or officials of their important roles . . . . [O]fficials should become more active in their own interests and for their own protection. For example, issuer officials need not only to review, but also to understand, the documents they approve and sign. Yet, that is not enough by itself . . . . [I]t is not sufficient to ask for general assurances from bond professionals that all appropriate disclosures have been made and that the an issuer’s official statement is materially accurate and complete . . . . [O]fficials also need to ask questions and receive assurances on specific disclosure issues, and on particularly important ones, receive written formal opinions and advice . . . . [I]ssuers are welladvised to consider carefully the information known or readily available to them, whether that information may be potentially material to investors, and if so, whether that information is disclosed appropriately.

Doty, Expanding Responsibilities: Recent Disclosure Actions Involving Municipal Securities Issuers, Ohio Municipal Attorney, October, 2004, No. 10, at 46,47.

Background

The U.S. Securities and Exchange Commission (SEC) enforces the securities laws of the United States, including anti-fraud provisions that apply to every issuance of municipal bonds and notes. Ohio’s State securities laws have similar provisions protecting investors. More and more private cases have been brought, and SEC enforcement actions initiated against, municipal officials in the last 10 years than in any similar period. A watershed event with respect to this subject matter occurred on December 6, 1994, when Orange County, California filed for bankruptcy after a $2 billion loss in its investment pool. Investigations by the SEC and others revealed that Orange County had not disclosed to investors in the offering materials for its bonds and notes the material risks inherent in the investment strategy that the County employed. The Orange County debacle followed shortly on the heels of similar problems here in Ohio with the so-called “SAFE” fund of investments operated by the Treasurer of Cuyahoga County. That fund held not only money deposited by Cuyahoga County, but also investments made by many other Ohio cities and counties.

Cuyahoga County was able to return all of the principal invested by other cities and counties, and although it suffered significant losses on its own investments, today it is economically healthy and highly rated.

The Orange County catastrophe prompted bond attorneys and securities attorneys to remind municipal issuers of their disclosure responsibilities as described by the SEC:

[I]ssuers are primarily responsible for the content of their disclosure documents and may be held liable under the federal securities laws for misleading disclosure…Because they are ultimately liable for the content of their disclosure, issuers should insist that any persons retained to assist in the preparation of their disclosure documents have a professional understanding of the disclosure requirements under the federal securities laws.

SEC Rel. No. 34-26985, 54 F.R. 28799, 28811 n. 84 (July 10, 1989).

Or, to put it in a more practical way, No one knows better than the issuer where the closets are, or what skeletons may be in the closets.

Comments of Paul Maco, Director of SEC Office of Municipal Securities, reprinted in The Bond Lawyer: The Journal of the National Association of Bond Lawyers at 5A (August 7, 1995).

Specifically, with respect to Orange County, the SEC found that:

[T]he Supervisors approved Official Statements that, among other things, failed to disclose certain material information about Orange County’s financial condition that brought into question the County’s ability to repay its securities absent significant interest income from the County Pools. The Supervisors were aware of material information concerning Orange County’s financial condition; this information called into question the County’s ability to repay its securities. Nevertheless, the Supervisors failed to take appropriate steps to assure disclosure of these facts. In light of the circumstances, the Board members did not fulfill their obligations under the antifraud provisions of the federal securities laws . . . .

Report of Investigation in the Matter of County of Orange, California as it Relates to the Conduct of the Members of the Board of Supervisors, SEC Rel. No. 34-36761 at Section I (Jan. 24, 1996).

Recent Cases

As pointed out in Mr. Doty’s article, the SEC has prosecuted several significant enforcement actions recently in this area, including against the Neshannock Township School District (PA), Dauphin County General Authority (PA), Massachusetts Turnpike Authority, the City of Philadelphia and various issuers of conduit bonds in Texas, Florida, Illinois and California. These cases and actions range from outright fraud to examples of disagreements by experts over the best way to make materially correct disclosure. Mr. Doty estimates that the total now stands at 75 enforcement actions against issuers and obligated persons and 54 actions against officials. A thorough reading of Mr. Doty’s article is one way to familiarize yourself with these recent cases.

Renewed Warnings

Bond counsel are also being continually reminded of the disclosure responsibilities of their municipal clients. In his column in the December, 2004 issue of The Bond Lawyer, Paul S. Maco reminds all of the members of the National Association of Bond Lawyers (NABL) that the SEC disclosure and review standard has been around for a long time.

A public official who approves the issuance of securities and related disclosure documents may not authorize disclosure that the public official knows to be materially false or misleading; nor may the public official authorize disclosure while recklessly disregarding facts that indicate that there is a risk that the disclosure may be misleading.

Maco, Federal Securities Law column, The Bond Buyer, December 1, 2004, Vol. 26, No. 4, at 35,36.

The City of San Diego Example

An instructive example of disclosure gone wrong, and the attempts of municipal officials to fix it, is described by Mr. Maco in the Report on Investigation with respect to the City of San Diego, California (City) dated September 16, 2004, prepared by Mr. Maco’s law firm, Vinson & Elkins, L.L.P. That report was commissioned by the City itself, and in fact resulted in extensive changes to its City codes. A copy of the full report is available on the NABL website at www.nabl.org.

The City had for many years operated a municipal pension system that was actuarially severely under funded. Questionable actuarial decisions obscured the growing crisis to all but the most careful observers. The system, San Diego City Employees’ Retirement System (SDCERS), and the City generated separate comprehensive annual financial reports (CAFRs) each year, but each was operated out of the same offices and reviewed by the same outside auditor. In spite of that, the two sets of CAFRs did not match, and the significant liability of the City to fund the SDCERS’ shortfall was not accurately disclosed to investors who bought bonds issued by the City.

The following excerpts from the Report on Investigation highlight the weaknesses in the City’s disclosure process:

When disclosure review does not extend far beyond the rote updating of numbers on a page and inclusion of current events without consideration of what it all means, the picture is likely to remain obscure, even to those who are involved in creating it.

Rather than actively promoting a full and complete disclosure of the City’s finances, staff involved in the City’s disclosure process operated primarily in a ‘check the box’ mentality, emphasizing updating data without pausing to consider its implications.

The City’s disclosure . . . did not receive critical review by senior City management.

The City Manager . . . delegated . . . responsibility to subordinate deputies and directors without preserving the accountability necessary to make the City’s representations as to the accuracy of disclosure reliable.

City staff responsible for the preparation of disclosure, including those in the City Attorney’s Office, received no formal training in disclosure practices or the securities law of municipal finance.

Members of the City Council received no formal training in the securities law responsibilities associated with their approval of City disclosure in connection with City securities offerings.

Maco, Report on Investigation: City of San Diego’s Disclosure of Obligations to Fund San Diego City Employees’ Retirement System and Related Disclosure Practices, 1994-1996, September 16, 2004, at 165-167.

Recommended changes included the creation of a Disclosure Practice Working Group that includes all City officials involved in financial and bond disclosure, and chaired by the City Attorney. That group is charged with the responsibility of doing an annual evaluation of the City’s disclosure procedures and controls, and reviewing the form and content of all of the City’s disclosure materials, including each offering document, CAFR and annual report.

Also created was an independent Financial Reporting Oversight Board to act as an independent audit committee providing input to City officials.

Conclusion

While few municipalities may find it necessary to create similar boards, they should work with their directors of finance, city attorneys, outside auditors and bond counsel to implement procedures that make sure that responsible public officials review all disclosure documents and have available all relevant data. In the event of an allegation of a violation of securities laws, the review of the municipal disclosure document will undoubtedly be made in hindsight. This creates a real and significant risk for each municipality and its officials. Issuers should pay increased attention to documentation of the review process, in order to establish that officials have not “recklessly disregarded” material facts. Only through the use of appropriate review and disclosure procedures, and active participation in the disclosure process by appropriate officials, can issuer officials hope to both (i) comply with applicable securities laws and (ii) discharge their duties as public officials.

Reprinted from Finley’s Ohio Municipal Service, with the permission of the publisher and copyright owner, West Group.