Initial Decision of an SEC Administrative Law Judge
In the Matter of
In the Matter of
THE CITY OF MIAMI, FLORIDA,
June 22, 2001
APPEARANCES: Mitchell E. Herr for the Division of Enforcement,
Securities and Exchange Commission
Thomas Tew and Daniel S. Newman for Respondent City of Miami,
Florida, with co-counsel Alex Villarella, City Attorney
Steven E. Chaykin and Glen Widom for Respondent Manohar Surana
BEFORE: Brenda P. Murray, Chief Administrative Law Judge
On September 22, 1999, the Securities and Exchange Commission ("Commission") issued an Order Instituting Proceedings ("OIP") pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"), which authorize the issuance of cease and desist orders where appropriate. The OIP, amended on November 1, 1999,1 charges that in 1995: (1) the City of Miami, Florida ("City") violated Sections 17(a)(1), 17(a)(2), and 17(a)(3) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, in connection with the offer, purchase, and sale of municipal bonds, and (2) Cesar Odio, the City Manager, and Manohar Surana, the City's Director of Finance and Management and Budget, committed or caused the City's violations.
I held hearings for three days in Miami, Florida, on March 6 through 8, 2000. The hearing record consists of testimony from six witnesses, including two experts, sponsored by the Commission's Division of Enforcement ("Division"), 118 exhibits sponsored by the Division, and twenty-three exhibits sponsored by the City.2 Four of the Division's exhibits were transcripts of investigative testimony with additional exhibits. The Division called Respondent Odio to testify. He did not participate in the hearing on his own behalf because the Commission accepted his Offer of Settlement. See Cesar Odio, Order Making Findings and Imposing a Cease-and-Desist Order, 72 SEC Docket 614 (Apr. 14, 2000). Mr. Surnana was represented by counsel at the first day of the hearing. His participation then ended because he too agreed to settle the allegations. See Manohar Surana, Order Making Findings and Imposing a Cease-and-Desist Order, 73 SEC Docket 1110 (Sept. 22, 2000). Messrs. Odio and Surnana, without admitting or denying liability, agreed to cease and desist from committing or causing any violation and any future violation of Sections 17(a)(1), 17(a)(2), and 17(a)(3) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
The Division's Post-Hearing Brief is dated May 15, 2000. The City served its Post-Hearing Brief on July 17, 2000. The Division filed its Post-Hearing Reply Brief on August 8, 2000.3
On September 28, 2000, the Division moved to reopen the record to take official notice of news from the September 28, 2000, issue of The Miami Herald that Donald Warshaw, a former City Manager, had been indicted by a federal grand jury on one count of conspiracy and four counts of mail fraud for allegedly stealing $86,563 from the Miami Police Relief and Pension Fund and the Do The Right Thing charity from 1993 to 1999. Mr. Warshaw was the City Manager at the time of the hearing. (Tr. 732.) The Division wants the record to contain this material to refute testimony in the record of Mr. Warshaw's integrity, and to demonstrate that the City has not shaken its "legacy of public corruption." (Division's Motion To Reopen Record at 3.) The City filed its opposition on October 12, 2000, noting that Mr. Warshaw was dismissed as City Manager in April 2000 and that the charges in the indictment are unconnected to the allegations in the OIP. The City argues that Mr. Warshaw's situation is unrelated to whether or not there is a likelihood that the allegations in the OIP, if proven, will reoccur. (Respondent, The City of Miami, Florida's Opposition to the Division's Motion To Reopen Record at 2.)
Rule 323 of the Commission's Rules of Practice provides that I may take official notice of any material fact if it is a matter which might be judicially noticed by a district court. Rule 323 also provides that if official notice is taken of a material fact not in evidence, the parties shall be afforded an opportunity to establish "the contrary." 17 C.F.R. § 201.323. While district courts do on occasion take judicial notice of newspaper articles, I deny the Division's request that I do so here. The proposed exhibit consists of unresolved allegations against Mr. Warshaw. These allegations are entitled to no probative value. To grant the motion would likely result in further evidentiary submissions and this material does not merit reopening the record that was closed at the conclusion of the evidentiary hearing fourteen months ago. See, e.g., Cities of Campbell v. FERC, 770 F.2d 1180, 1191 (D.C. Cir. 1985).
The Division alleges that the City violated the antifraud provisions by distributing false and misleading information and omitting material information about its financial status in the City's 1994 Comprehensive Annual Financial Report ("CAFR") and in the Official Statements4 for three bond offerings. Specifically, the Division alleges that the City violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, by making materially false and misleading representations and omitting material information in its Official Statements, in the offer and sale of three bond issues. It also alleges that the City violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, by making materially false and misleading representations and omitting material information in its 1994 CAFR in connection with its outstanding bonds. (Div. Br. 1, 6-9, 20-25, 39-40; Div. Reply 1-3, 5-6, 17-19.)
The 1994 CAFR and the Official Statements both contained the City's 1994 audited General Purpose Financial Statements ("Financial Statements"). However, the 1994 CAFR and the Official Statements differ in that: (1) the 1994 CAFR was not used in the offer and sale of securities and, unlike the Official Statements, it disclosed that the City's bonds had been downgraded after fiscal year ("FY") 1994 closed; and (2) the Official Statements contained a summary of the City's 1995 budget, which the 1994 CAFR did not. These differences caused slightly different allegations by the Division.
The Division alleges that:
1. Both the 1994 CAFR and the Official Statements omit that the City experienced a serious cash decline after the City's 1994 Financial Statements closed;
2. Both the 1994 CAFR and the Official Statements misrepresent "Operation Right Size," portraying it as a positive measure that would strengthen the City's financial position; and
3. In the Official Statements, the City falsely represented that it had a balanced budget for FY 1995, and it omitted to report that Standard & Poor's, Inc. ("S&P") had downgraded the City's bonds. Also, in the Official Statement for the pension bonds, the City did not make sufficient disclosure about the pension bond proceeds being used to bail the City out of the cash deficit in the prior fiscal year.
II. FINDINGS OF FACT
I base my findings and conclusions on the record and on the demeanor of the witnesses who testified at the hearing. I applied "preponderance of the evidence" as the applicable standard of proof. Steadman v. SEC, 450 U.S. 91, 97-104 (1981). I have considered and rejected all arguments and proposed findings and conclusions that are inconsistent with this decision.
Miami is the largest of the thirty or thirty-one cities in Miami-Dade County. The county government has a budget of $4.5 billion and 28,000 employees. (Tr. 589.) In contrast, the City has a budget of about $250 million and about 3,300 employees. (Tr. 589.) The City government serves one of the country's poorest urban populations, and as of 1994 and 1995 it had been struggling with a deteriorating financial situation for a number of years. (Tr. 234-36, 254, 736.) The City has a City Commissioner-City Manager form of government. The City Commission, an elected body consisting of a Mayor, a Vice-Mayor and three City Commissioners, was responsible for the conduct of the City government.5 The City Commissioners delegated responsibility of day-to-day management to an appointed official, the City Manager, who was responsible for all City departments and who was the ultimate superior of every City employee. (Tr. 102-03; Div. Ex. 190, Tab 10 at 1.)
Cesar Odio was City Manager from November 1985 until he retired on September 11, 1996. (Tr. 256.) Soon after his retirement, Mr. Odio pled guilty to felony charges of obstruction of justice under a negotiated plea agreement with federal authorities and served a twelve-month sentence in prison. (Tr. 91-93, 256.) Mr. Odio's arrest and plea came about as the result of "Operation Green Palm," an undercover federal law enforcement action, which brought to light many of the facts in this record. (Tr. 99-100.)
Manohar Surana was the City's Director of Management and Budget when Mr. Odio became City Manager. Mr. Odio appointed Mr. Surana to Assistant City Manager in 1991. In February 1995, when Mr. Garcia, the Finance Director, retired, Mr. Odio consolidated the Departments of Finance and Management and Budget ("Department of Finance"), and named Mr. Surana Director.6 (Tr. 250-52, 550.) Mr. Surana was responsible for preparation of the City's financial statements from February 1995 until he left City employment in August 1996. He was also responsible for the Official Statements in the three bond offerings. (Tr. 93, 263-64.)
Howard Gary & Company ("Howard Gary"), a full-service investment banking and underwriting firm, and Raymond James & Associates, Inc. ("Raymond James") (collectively, "Financial Advisor"), acting jointly, became the City's Financial Advisor in 1989, and served in that capacity in 1994 and 1995. (Tr. 91, 235-38, 291-96; Div. Exs. 181B, 181E.) Mr. Howard Gary, the president, CEO, and principal of Howard Gary, was the City Manager before Mr. Odio. (Tr. 90-91, 290.) The City did not renew its contract with Howard Gary in late 1996. (Tr. 302.) The Financial Advisor's contract called for a wide range of duties, but the Financial Advisor played a limited advisory role, and its primary source of payment from the City was from participating in City bond offerings.7 (Tr. 340-41, 348-53, 559; Div. Ex. 181B.) Kishor M. Parekh ("K. Parekh"), the Financial Advisor's key contact with the City, had a strained relationship with Mr. Surana.8 (Tr. 295, 549-550.) K. Parekh found out about financial actions of the City after they occurred. (Tr. 337-38, 343-45.)
To understand these allegations of fraud involving the bond offerings of 1995 and the dissemination of materially misleading financial information, it is necessary to understand the City's compilation of financial data. The City's balance sheet shows assets under various fund headings. The general fund is the largest component of the City's operating budget and funds most of the City's core activities, such as the largest City departments, including the fire and police services. (Tr. 193-94, 209-10; Div. Ex. 178 at 61-62.) Rating agencies and bond insurers give primary attention to the condition of the general fund in assessing the City's financial condition. (Tr. 303; Div. Ex. 103 at 20, Div. Ex. 175 at 20-21.) The general fund "is the general operating fund. It is used to account for all financial resources except those required to be accounted for in another fund." (Div. Ex. 18 at 30.) It is "to account for resources traditionally associated with government which are not required legally or by sound financial management to be accounted for in another fund." (Div. Ex. 18 at 59.)
A significant general fund expense of the City during the period at issue was the Gates Judgment, a designation used for the result of a March 23, 1985, consent decree in a court action that alleged that the City had mishandled pension funds over an extended period. (Tr. 106, 298-99, 311-12; Div. Ex. 103, Div. Ex. 133 at 101-02, Div. Ex. 181F.) The City's liability was $213 million. (Div. Ex. 103 at 19.) Payments totaled about $17 million annually to the Fire Fighters' and Police Officers' Retirement Trust and the General Employees' and Sanitation Employees' Retirement Trust until they were fully funded.9 (Tr. 298-00; Div. Ex. 103 at 27, Div. Ex. 178 at 174-75.) The City's mandatory payment toward the Gates Judgment was reduced in the early 1990s but it remained a "significant drain on the general fund." (Tr. 311-12; Div. Ex. 181F.)
Another balance sheet item was the enterprise funds, which consisted of self-supporting operations where the cost of providing goods or services is financed through the collection of user charges. (Div. Ex. 18 at 39, Div. Ex. 192 at 68.) For example, the marina, the Orange Bowl, and solid waste collection were supposed to be self-sufficient operations. Collected fees were set aside to pay those costs. (Tr. 178.) The City's enterprise funds experienced the following operating deficits:
FY 1992 close to ($4 million)
FY 1993 ($6.5 million)
FY 1994 close to ($5 million)
FY 1995 approximately ($5.6 million)
(Div. Ex. 192 at 89-94.) In FY 1993, FY 1994, and FY 1995, accumulated deficits in the enterprise funds totaled $47 million, approximately $62 million, and $67.5 million, respectively.10 (Div. Ex. 16 at 48, Div. Ex. 18 at 47, Div. Ex. 192 at 101-02, 104.)
In FY 1994, the internal service funds experienced a deficit of $10 million. (Div. Ex. 18 at 47, Div. Ex. 192 at 102.) In FY 1995, the accumulated deficiency in internal service funds totaled $107.5 million (Div. Ex. 16 at 48, Div. Ex. 192 at 104.) The City's Financial Statements in FY 1993, FY 1994, and FY 1995 reported that most of its enterprise funds and internal service funds had accumulated deficiencies. (Div. Ex. 192 at 114-15, 144.) In FY 1995, the City borrowed $43.5 million from the funds it had set aside for capital improvements. (Div. Ex. 16 at 40, Div. Ex. 92 at 114.)
The City put all its cash in one "pooled" account. The alleged documentation that identified amounts belonging to the general fund, to the individual enterprise funds, and to the internal service funds did not exist. (Tr. 393-96, 596, 599-601, 662; Div. Ex. 181S.)
Florida law requires that the City's fiscal year begin on October 1 and end on September 30 of the following year. See Fla. Stat. Ann. § 166.241(2). The City's FY 1995 ran from October 1, 1994, through September 30, 1995. (Tr. 138.) On September 30, 1994, the Financial Advisor delivered a written statement of concerns, similar to what it had expressed on previous occasions, about the City's "deteriorating fiscal condition" to Mr. Garcia, Finance Director. The Financial Advisor referenced the following specifics:
The City's issuance of $18 million Special Non-Ad Valorem Revenue Bonds to finance a self-insurance claims reserve fund for the payment of liability settlements or judgments against the City for the next two (2) fiscal years, in conjunction with the City's Fiscal Year 1994/1995 Budget are particular sources of concern. Other continuing concerns include the low level of unreserved general fund balances; the City's reliance on non-recurring revenue initiatives; asset sales; basic infrastructure maintenance needs; as well as the City's overall revenue inflexibility.
(Div. Ex. 181I.)
In the same correspondence, the Financial Advisor warned that the major rating agencies would downgrade the City's general credit rating in the near future. (Div. Ex. 181I.) Mr. Garcia responded by chastising K. Parekh and informing him not to put anything of that nature in writing in the future.11 (Tr. 376-78.) On October 17, 1994, S&P downgraded $36.1 million of the City's general obligation bonds from A+ to A noting that the:
[D]owngrade reflects continued fiscal stress arising primarily from revenue inflexibility, which has caused the city to utilize nonrecurring sources to support operations . . . . The unreserved general fund balance has remained at a minimum level of less than 2% of expenditures and transfers, with the liquid portion continuing to decrease.
(Tr. 367-68; Div. Ex. 181J.)
Deloitte & Touche, LLP, ("Deloitte") audited the City's financial statements from 1989 through 1995. (Div. Ex. 178 at 12.) The audits were of the City's financial statements for each fiscal year ending September 30; the audit work continued until the end of February of the following year, which was the date that appeared on the audit reports.12 The audit had to consider events occurring between the end of the fiscal year audited and the audit date as part of its subsequent events work. (Tr. 808-09; Resp. Ex. 70 at 2.) Deloitte completed the audit fieldwork for the FY 1994 audit on February 28, 1995, and it signed the audit opinion on the City's 1994 Financial Statements on that date. (Div. Ex. 18 at 15, Div. Ex. 178 at 85.) The persuasive evidence is that the City received the audit of its 1994 Financial Statements in February or March 1995.13 (Tr. 723, 794, 814, 830; Div. Ex. 18 at 5.)
During the FY 1994 audit, Deloitte became aware of a trend that showed a deterioration of the City's cash balances. (Div. Ex. 177 at 10-12, Div. Ex. 178 at 19-23, Div. Ex. 178B.) In December 1994 or early January 1995, Mr. Paredes informed Mr. Garcia and Mr. Odio that the City faced a potential shortfall of $35 to $40 million for FY 1995, and that the City could run out of cash to meet payroll as early as May 1995. (Tr. 158-61; Div. Ex. 177 at 56-57, Div. Ex. 178 at 12, 19-29, 33, 35-37.)
The City was aware that it had serious cash deficiency problems before Deloitte raised the issue. (Div. Ex. 177 at 56-57, Div. Ex. 178 at 26.) The City was the only source of financial information about its operations for Deloitte. The auditor's concern about the City's cash deficits was based on a cash flow study prepared by Mr. Garcia. (Div. Ex. 178 at 54-56.) Deloitte kept the City fully informed of its work on the audit, and only discussed the audit work with City officials and consultants. (Div. Ex. 177 at 126, 134-36, Div. Ex. 178 at 54-58, 201-02.) Deloitte continuously consulted with industry specialists on this engagement. (Div. Ex. 178 at 201-02.)
Mr. Odio convened a series of meetings with department heads, union representatives, a City Commissioner, and persons from Deloitte during the first quarter of calendar year 1995, to address the projected $35 million revenue shortfall that Mr. Padares had informed him about ("Orange Bowl meetings").14 (Tr. 227-28, 247, 737.) The participants at these meetings knew the City Commission had a record of refusing to raise revenues by increasing taxes or service fees because of political considerations.15 (Tr. 123-34, 300-02; Div. Ex. 192 at 130-33.) For example, the City refused to increase its annual solid waste fee of $160 per single-family residence even though the cost of rendering the service was over $380. (Tr. 127.) The City paid annual operating deficits of $12 to $15 million from the general fund because the City Commission refused to raise the solid waste fee. (Tr. 128.)
Without increased revenues, the City had to achieve cost savings in operations and it had few options. Close to eighty percent of the City's budget went to payroll costs that increased $7 million annually. (Tr. 228-29, 234.) As most City workers were union members, reductions in the work force could not be accomplished unilaterally. (Tr. 737-39.) On February 28, 1995, Mr. Odio, Mr. Surana, and Mr. Garcia met with persons from Deloitte to discuss the City's plans to address the projected cash deficit. (Resp. Ex. 50 at Bates 2676.) The City projected that an early retirement program, "Operation Right Size," effective June 1, 1995, would reduce City expenditures by $15 million to $25 million annually by, among other things, reducing the number of City employees by 300 to 400 people, and introducing a two-tiered salary structure to replace long-time employees whose average salary was $50,000 with lower-cost employees.16 (Tr. 228-29, 815; Div. Ex. 177 at 77; Resp. Ex. 50 at Bates 2676, Resp. Exs. 61, 62, 63, 64.)
Issuing debt was a viable revenue alternative because the legal limit was fifteen percent of assessed value and the City in late 1994 had a debt to assessed value ratio of 1.6 percent. (Div. Ex. 176K at 185-86.) S&P characterized the City's overall debt as moderately high. (Div. Ex. 181J.) Some municipal managers believed that it was highly inappropriate to issue debt to pay operating expenses such as pension expenses. (Tr. 610-11, 639-40, 679-80.) On the other hand, other municipalities had been issuing debt to fund their pension costs. (Div. Ex. 183 at 87.)
The City releases and broadly disseminates a CAFR annually. (Tr. 195, 378-79.) The document contains the independent auditor's report of the City's Financial Statements, and a transmittal letter to the Mayor and City Commissioners from the City Manager and Finance Director. (Div. Exs. 16, 17, 18.) Basically the CAFR is the City's Financial Statements, which rating agencies and investors require from a municipality that offers securities. (Tr. 535.) The City mailed the 1994 CAFR to persons in the financial community who were interested in information about the City's financial well-being. (Tr. 195-96, 378-79.)
By letter dated February 28, 1995, Mr. Odio and Mr. Garcia transmitted the City's 1994 CAFR to the Mayor and City Commissioners. The letter transmitting the 1994 CAFR noted that:
Responsibility for both the accuracy of the data, and the completeness and fairness of the presentation, including all disclosures, rests with the City of Miami. To the best of our knowledge and belief, the enclosed data is accurate in all material respects and is reported in a manner designed to present fairly the financial position and results of operations of the various funds and account groups of the City. All disclosures necessary to enable the reader to gain an understanding of the City's financial activities have been included.
. . . .
The City maintained its 1993 bond ratings of A by Moody's Investors Service and A plus by Standard & Poor's ("S&P"). Shortly after year end, S&P lowered its rating on the City's general obligation bonds to A.
(Div. Ex. 18 at 5, 8.)
The 1994 CAFR included Deloitte's independent auditor's report that the City's 1994 Financial Statements for the fiscal year ending September 30, 1994, presented "fairly, in all material respects, the financial position of the City . . . at September 30, 1994 and the results of its operations and the cash flows of its proprietary funds" in conformity with generally accepted accounting principles ("GAAP"). (Div. Ex. 18 at 15.) The only disclosures in the 1994 CAFR and the transmittal letter alluding to Deloitte's projection that the City would run out of cash by May 1995, appeared in Note 5 and Note 9 to the 1994 Financial Statements. (Div. Ex. 161 at 2-3.) Note 5 showed funds "Due From/To Other Funds." Almost $20 million of the $23.8 million "Due from Other Funds" came from five capital improvement funds. (Div. Ex. 18 at 39, Div. Ex. 189, Tab 8 at B-25.) Note 9 is considered below.
Generally, a management letter is sent to a client at the end of an audit engagement and typically addresses internal controls and operating efficiencies. The client usually responds in a written communication. (Div. Ex. 178 at 86-88.) Deloitte sent the City a management letter at the conclusion of each of its audits from 1989 through 1995. (Div. Ex. 178 at 90.) On February 28, 1995, Deloitte sent a management letter to the City in regard to its FY 1994 audit, stating that the "City's cash position needs improvement," and noting that in February 1995, the City implemented several programs to "right-size" its operations that were estimated to reduce the City's operating budget by approximately $30 million. (Tr. 246-47; Div. Ex. 6 at 2, Resp. Ex. 49 at 2.) Because of the City's deteriorating financial cash position, Deloitte warned the City to avoid two consecutive years of budget deficits, as defined by Section 218.503 of the Florida Statutes Annotated, that would trigger emergency financial provisions.17 (Div. Ex. 6 at 2, Div. Ex. 178 at 94-96, Resp. Ex. 49 at 2.)
The City's cash deficiencies continued through the end of calendar year 1995. (Tr. 463-64, 482-83; Div. Ex. 182M.) In this same time period, the City used the proceeds of three bond issues that will be described later to create a positive impact on the balance in its general fund. (Tr. 198, 719-20; Div. Ex. 160 at 8, Div. Ex. 161 at 4, Div. Ex. 186B.) The City's Financial Statements for the fiscal year ended September 30, 1995, showed the general fund with a $26 million balance while a "statement of revenues, expenditures, and changes in fund balances" showed the general fund with a $33.8 million deficit. (Div. Ex. 16 at 20-21, 23.) The positive general fund balance came about because over $71 million was transferred into the general fund from "operating transfers," land sales, and bond proceeds. (Div. Ex. 16 at 23.)
Mr. Paredes believed the "City's finances at the end of [FY] 1995 were in a difficult situation." (Div. Ex. 178 at 84.) Deloitte's original draft of its management letter following the audit of the City's 1995 Financial Statements included the following paragraph:
As a result of the challenges, the City was temporarily not in compliance with Florida Statutes, Section 166.241(3), as a result of deficiencies of revenues and other sources of approximately $26 million under appropriations. The deficiency resulted from receiving approximately $12.5 million less in planned revenues and incurring unplanned expenditures for police and fire overtime, claim payments and other. The deficiency became apparent in February 1995 and the City immediately began the process of correcting the deficiency through several actions including workforce reductions, cost reductions and operating efficiencies. The benefits of these measures principally affected the 1996 Budget, whereby the City was able to reduce expenditures by $36 million. In addition, in July 1995, the City Commission approved a bond program to address the immediate cash flow requirements. On December 1, 1995, the City issued the first series of pension bonds in the amount of $62 million to cover current and future pension contributions.
(Div. Ex. 176AA.) Mr. Paredes eliminated this language from Deloitte's management letter after City officials objected to it and a technical person at Deloitte informed him that Florida law required the City to have balanced budgets not balanced results.18 (Tr. 216-17; Div. Ex. 178 at 205-07.)
Deloitte issued "clean" or unqualified audit opinions to the City in 1994 and 1995. (Tr. 668-69; Div. Exs. 16, 18.) The clean audit opinions indicated, among other things, that the auditors believed that the City would be able to continue as a going concern and pay its bills for a year from the date of the Financial Statements.19 (Tr. 663, 786-87; Div. Ex. 4, Resp. Ex. 70 at 2.) A Deloitte going concern work paper noted that FY 1995 presented a difficult cash flow situation, but that FY 1996 would be much stronger due to the cost savings program instituted. A best-case scenario for FY 1995 projected a cash balance of approximately $2.3 million and a worst-case scenario projected a cash deficiency of $18.2 million. (Div. Ex. 178 at 44-45, 50-51, 54, Resp. Ex. 50 at Bates 02676.) The work paper noted Mr. Odio's representation that the City would prepare another $20 million bond offering to fund self-insurance expenses "only if cash flow is necessitated." (Div. Ex. 178 at 52, Resp. Ex. 50 at Bates 02675.)
Deloitte decided to give a clean audit opinion for the 1994 Financial Statements:
Because the City had plans and was instituting processes . . . they were managing the process and that's what this analysis shows. They had the capacity to issue debt and sell assets which all generate resources to make their ends meet.
I think we need to understand that this analysis was done to see if there was a going-concern need in the opinion. We concluded clearly that there was no need for that.
We further concluded that, based now on the facts as we have determined, that it might be a good idea for them to put some disclosures on the financial statements showing that they are experiencing cash deficits that were being funded by other funds and that they probably needed to do some belt tightening.
(Div. Ex. 177 at 91-92.) As the result of consultations between Deloitte and the City, the City added Note 9 to its 1994 Financial Statements. (Div. Ex. 177 at 87, 89.)
On September 13, 1996, seventeen days before the end of FY 1996, Merrett R. Stierheim, a government professional, became interim City Manager.20 (Tr. 591.) Mr. Stierheim quickly learned that the City was in "very serious financial difficulty," "the budget was a mess, the capital side was beyond description." (Tr. 596.) From 1989 through 1995, the City's general fund had consistently incurred deficiencies and operating losses.21 (Div. Ex. 192 at 71.) Funds intended for capital expenditures had been "cannibalized" to meet operating expenses; the City had regularly used money from trust accounts to meet operating costs; responsible City personnel did not know what capital funds were available; the records needed to determine what funds should have been in the capital accounts did not exist; and the capital accounts held no reserves. (Tr. 599-600, 610.) For example, $8 million was taken from the storm water trust fund account and put in the general fund to contribute to the appearance of a positive balance on September 30, 1995, when the FY 1995 operating budget had a shortfall of about $45 million, and an audit revealed a $73 million shortfall in the self-insurance reserves. (Tr. 609-10.)
On September 26, 1996, after thirteen days as interim City Manager, Mr. Stierheim informed the Mayor and City Commissioners that the City would close out FY 1996 with a $19.4 million revenue shortfall, and that an incomplete analysis of the capital improvement budget showed serious problems. (Tr. 596; Div. Ex. 186A.) Mr. Stierheim's memorandum expressed frustration "as to how this situation could have progressed so far without disclosure," and he included the following conditions in a list of eighteen causes of the City's financial crisis:
Inadequate and insufficient financial reporting,
Inadequate and questionable auditing practices, both internal and external,
The manipulation and commingling of funds that should be segregated,
The depletion of necessary or required reserve accounts,
The issuance of bonds to meet operating requirements, and
The withholding of critical financial information that sheltered this crisis.
(Div. Ex. 186A.)
Dipak M. Parekh ("D. Parekh"), K. Parekh's brother, understood how the City financed its operations in 1994 and 1995. (Tr. 398-99.) D. Parekh worked in the City's Finance Department from 1984 through 1999. (Tr. 710.) From 1993 through 1995, D. Parekh was the City's Revenue Management Administrator, from 1995 through 1997 he was Deputy Director of the Finance Department, and from 1997 through 1999 he was Budget Director. 22 (Tr. 398-99, 710-11.) D. Parekh "walked [Mr. Stierheim] through" how the City disguised the projected $40.8 million deficit in its general fund balance at the end of FY 1995, by the following transfers into the general fund so that the fund showed a positive fiscal year-end balance of $26 million:23 (Tr. 620-28, 679, 714-23; Div. Ex. 186B.)
$2.3 million a state grant
$8.8 million storm water capital reserve
$25.0 million pension bond proceeds
$9.7 million sale of City land
$21.0 million Florida Power & Light ("FP&L") bond proceeds
(Tr. 593-94, 624-28; Div. Ex. 178G at 2, Div. Ex. 186B.)
Mr. Stierheim organized thirteen task forces with executives from government and the private sector to analyze almost every facet of the City's government and to prepare a recovery plan for the City. (Tr. 598.) Mr. Stierheim found the performance of the City's internal auditor deficient so he accepted the auditor's resignation. (Tr. 602-03.) Mr. Stierheim recommended that the City fire Deloitte and sue the external auditor for damages. (Tr. 607, 678-79.) The City Commission voted to institute the lawsuit at an emergency meeting two days before a primary election. (Div. Ex. 192 at 153-155.) On November 4, 1997, the City initiated a civil action against Deloitte seeking over $86 million in damages alleging negligence, breach of contract, and breach of fiduciary duty in connection with audits of the City's Financial Statements for the fiscal years ended September 30, 1989, through September 30, 1995. See City of Miami, Florida, vs. Deloitte & Touche, L.L.P., and Frank Paredes, Case No. 97-25179-CA-10, Dade County Florida, 11th Judicial Circuit Court (Nov. 4, 1997). (Div. Exs. 10, 11.) As of June 2001, the civil suit was pending.
After two months of exhaustive efforts, Mr. Stierheim determined that the City's FY 1996 budget had a shortfall of $50 million in the general operating fund and a shortfall of $18 million in the capital budget. (Tr. 595-96.) In response to questions from the City's unions on the status of pension funds, Mr. Stierheim discovered that the City had only $2 or $3 million of the $72 million proceeds from the pension bond offering in December 1995, because it had: (1) used $25 million to fund the Gates Judgment in the City budget for FY 1995; (2) used $35 million to fund the Gates Judgment in the City budget for FY 1996; and (3) put $9.7 or $10 million into something else. (Tr. 593-94, 626; Div. Ex. 178 at 175.)
On December 3, 1996, the Governor of the State of Florida declared that the City was in a financial emergency. Eight days later he appointed a Financial Emergency Oversight Board ("Oversight Board") to oversee the City's finances. (Tr. 739-40; Div. Ex. 17 at 2.) The Oversight Board approved a five-year plan designed to achieve financial stability for the City by 2001. The Oversight Board has "continuous existence until three years after the City has produced two successive years of balanced operations and none of the statutory conditions for determining a local government financial emergency exist." (Div. Ex. 17 at 20.)
The City's Three Bond Offerings in Calendar Year 1995
The City made disclosure for each bond offering through an Official Statement that included:24
1. The City's 1994 Financial Statements.25 (Tr. 379; Div. Ex. 189, Tab 8, Div. Ex. 190, Tab 10, Div. Ex. 191, Tab 29.)
2. A summary of the City's budget for FY 1995. (Div. Ex. 189, Tab 8 at 23, 25, Div. Ex. 190, Tab 10 at 16, 19, Div. Ex. 191, Tab 29 at 17, 20.)
3. A letter from Deloitte consenting to inclusion of the 1994 Financial Statements in the bond offering. On each occasion, the City entered an engagement letter and paid Deloitte a fee to use the City's 1994 Financial Statements in the Official Statement, and Deloitte prepared a consent letter that was required for the closing to occur.26 (Tr. 665; Div. Ex. 66, Div. Ex. 177 at 108-12, 146.) The consent letter followed a "consent due diligence memorandum" that Deloitte prepared outlining actions it took to assure itself that no subsequent events occurred that had a material effect on the City's 1994 Financial Statements and therefore required no adjustment to the 1994 Financial Statements or disclosure in the Official Statements. (Div. Ex. 161 at 5-6, Div. Ex. 177 at 114-15.) As part of this process, Mr. Paredes inquired of City officials whether anything had changed that would have a bearing on the 1994 Financial Statements.27 (Div. Ex. 177 at 117-18.)
The three bond issues were insured so that bondholders had an unconditional guaranty to full payment of principal and interest. (Div. Ex. 175 at 36.) The investors involved in the offerings had a high comfort level because the bonds were insured and assumed that the City's finances had received careful scrutiny. (Div. Ex. 183 at 81-83.) It appears that the City limited its disclosure for the same reasons.28 (Tr. 244, 283-85.) According to Mr. Odio,
[M]ost people don't read [the Official Statement], nobody reads this. They go by what the raters, that is Moody's, Standard & Poor's, saying that these bonds are safe to buy. By rating them AAA, they're a very good buy. Therefore, they wouldn't go reading this. Nobody does.
1. Sewer Bond Offering
On June 27, 1995, the City closed an offering in which it sold $22.5 million in general obligation, twenty-year bonds to finance sewer system improvements ("Sewer Bond Offering") pursuant to authorization passed on May 25, 1995.29 (Tr. 460; Div. Ex. 189 at 1 and Tab 2.) The closing memorandum for the offering reported that the bonds were general obligations of the City payable from unlimited ad valorem taxes levied on all taxable property located in the City. The Sewer Bond Offering was a competitive or bid type offering and Merrill Lynch & Company, Inc. and Prudential Securities, Inc. were the underwriters.30 (Tr. 655.) The City used many "highly paid" people to represent them. (Tr. 241-42.) A Miami law firm was bond counsel. The City attorney was shown as handling certain issues. Howard Gary and Raymond James participated as Financial Advisor to the City. (Div. Ex. 189, Tab 8.)
The City transferred $8.8 million or thirty-nine percent of the sewer bond proceeds into the general fund to address the revenue deficiency it faced in operating funds. (Tr. 719-20; Div. Ex. 186B.) The Official Statement for the Sewer Bond Offering did not state that the proceeds would be used for operating costs. According to the Official Statement, "The City Commission has approved the expenditure of funds for improvements and extensions to the sanitary sewer system of the City," and the total amount for the eleven sanitary sewer projects described was $22.5 million. (Div. Ex. 189, Tab 8 at 12.)
I conclude that a major purpose of the Sewer Bond Offering was to solve the deficits in the general fund. This is conformed by Mr. Paredes's remarks to Mr. Odio in June 1995, congratulating him on getting the City "off the hook," "turning the corner," and "saving the situation," in dealing with the City's cash crisis. (Tr. 226.) This conclusion is buttressed by the testimony of K. Parekh that Mr. Surana and other City officials appeared to calm down about the City's cash deficit crisis around May or June 1995, at about the time the City Commissioners approved the Sewer Bond Offering. (Tr. 459-62.)
2. Florida Power & Light Bond Offering
In August 1995, the City offered and sold $22 million in special obligation non-ad valorem revenue bonds in a negotiated offering pursuant to the July 13, 1995, authorization of the City Commission. (Tr. 655; Div. Ex. 190, Tab 2.) According to the Official Statement, the funds were to be used to purchase an FP&L property for $15.6 million; capital improvements at a specific site for $1 million; and acquisition of another FP&L building for $2 million. (Div. Ex. 190, Tab 10 at 3-4.) The City temporarily transferred $21 million of the bond proceeds into the general fund so that on September 30, 1995, the general fund had a $26 million balance.31 (Tr. 198, 211-14, 627-28, 721-22; Div. 161 at 4, Div. Ex. 178 at 151-52, Div. Ex. 186B.)
William R. Hough & Co. and First Southwest Company were senior managing underwriters and WR Lazard, Laidlaw & Mead Inc. and Muriel Siebert & Co., Inc. were underwriters. A Miami law firm was bond counsel. The underwriters had two law firms located in Miami as co-counsel. The City attorney was shown as handling certain issues. Howard Gary and Raymond James participated as Financial Advisor to the City. (Div. Ex. 190, Tab 8.)
3. Pension Bond Offering/Gates Judgment
On July 13, 1995, the City adopted Resolution No. 95-564 that authorized the City Manager to issue bonds totaling $309 million.32 (Tr. 499-503, 517.) The City's first offering pursuant to Resolution No. 95-564, was a negotiated offering of $72 million of revenue bonds: $62,135,000, taxable pension series 1995, and $9,865,000, taxable compensated absence series 1995. (Div. Ex. 191, Tab 14.) The Official Statement dated December 1, 1995, bears the designation $72 million Non-Ad Valorem Revenue Bonds and states that the purpose is to pay "all or part of the City's unfounded actuarial accrued and future liabilities to certain City pension plans and providing for the payment of all or part of the City's accumulated and future compensated absence liabilities, including reimbursing the City for payments made for Fiscal Year 1995." (Div. Ex. 178 at 68-70, Div. Ex. 191, Tab 29 at 2.) The offering closed on December 19, 1995. (Div. Ex. 191, Tab 8.)
Rauscher Pierce Refsnes, Inc. ("Rauscher") and Smith Barney Inc. were co-senior managing underwriters and three other firms were participating underwriters. (Div. Ex. 183 at 80, Div. Ex. 191, Tab 29.) A Miami law firm was bond counsel. Three firms were co-counsel to the underwriters.33 The City attorney was shown as handling certain issues. Howard Gary and Raymond James participated as Financial Advisor to the City. (Div. Ex. 191, Tab 29.)
III. POSITIONS OF THE PARTIES
The Division alleges that the Official Statements for the three bond offerings and the City's 1994 CAFR made material misrepresentations as to why the City adopted "Operation Right Size," gave the false impression the City would finish FY 1995 in "better financial shape," and did not acknowledge that it was experiencing a severe cash flow crisis. (Div. Br. 41-42.)
The Division alleges that the City had a responsibility to disclose fully and accurately material changes to "Operation Right Size," which occurred after FY 1994 closed, because the City raised the subject in its 1994 CAFR. (Div. Br. at 1, n.1.)
The Division alleges that that the Official Statements materially misrepresented the City's 1995 budget. (Div. Br. 22, 42.) The Division also alleges antifraud violations in the bond offerings because the City falsely certified that its finances had not adversely changed and then used the 1994 Financial Statements in the bond offerings; and the City failed to disclose that the pension bond offering was a bailout of its cash flow crisis. (Div. Br. 20-22.)
The Division does not challenge the accuracy of the numeric figures in the City's 1994 Financial Statements and does not charge the City with misusing the bond proceeds.34 (Tr. 185; Div. Br. at 7, n.11, Div. Reply 13.)
The City argues that the Division has fixated improperly on its cash flow position during FY 1995 rather than its year-end results. It reasons that the gist of the Division's allegations is that the City did not disclose "adequately" its cash position during the fiscal year since the Division does not allege that the figures that the City presented in its 1994 Financial Statements were wrong. (Resp. Br. 2-3.)
The City contends that due to the constant flux between incoming revenue and outgoing expenses, the Division's focus on cash flows at any particular point in the fiscal year is inapposite. The City cites to three positive "going concern" inquiries that Deloitte made on September 21, 1994, March 13, 1995, and June 30, 1995, where it concluded that the City would continue as a going concern for the next fiscal year to support its position that it made adequate disclosure in the Official Statements. (Div. Ex. 4, Resp. Exs. 50, 69; Resp. Br. 2-3.) Furthermore, the City contends that it properly relied on its outside auditors, the underwriters, underwriters' counsel and bond counsel. (Resp. Br. 4.) Specifically, the City asserts that the underwriters were responsible for preparation of the Official Statements and due diligence of the City's 1994 Financial Statements. (Resp. Br. 4-5, 16-18.)
The City relies heavily on Deloitte's representations, expressed by Mr. Paredes, that the City made appropriate disclosure about its financial situation and "Operation Right Size" in its 1994 Financial Statements because City officials were making plans and instituting processes to remedy the financial crisis. There was no reason to state that the City was expected to be unable to meet its operating expenses because the City had the capacity to issue debt and sell assets to generate resources. (Resp. Br. 7-15.)
The City also denies that it failed to inform investors that pension bond proceeds would be used to pay a prior year's pension obligation and cites language on page one of the pension bond Official Statement that the purpose of the offering included "reimbursement to the City for payments made for fiscal year 1995." (Resp. Br. 15.)
IV. CONCLUSIONS OF LAW
Congress exempted offerings of municipal securities from the registration requirements and civil liability provisions of the Securities Act and the periodic reporting requirements of the Exchange Act. It did not, however, exempt municipal securities from Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act or Rule 10b-5, the antifraud provisions of those statutes. See Statement of the Commission Regarding Disclosure Obligations of Municipal Securities Issuers and Others, 56 SEC Docket 596, 597 (March 9, 1994). The antifraud provisions are used to determine whether in the offer or sale, or in connection with the purchase or sale, of municipal bonds, using the means of interstate commerce or the mail, a person employed any device, scheme or artifice to defraud, obtained money by means of an untrue statement or omission of a material fact needed to be stated so as not to mislead, or engaged in a transaction, practice, or course of business which operated or would operate as a fraud and deceit.
Considerable evidence in the record does not elucidate the issues. For example, Mr. Stierheim had a problem with the use of funds set aside as storm sewer reserves for operating expenses. (Tr. 626.) D. Parekh believed that money intended for capital sewer improvements should not be used to balance the operating budget. (Tr. 720.) Mr. Stierheim had a "serious problem" with the use of bond proceeds to pay pension costs because it created a continuing obligation to pay an annual operating obligation, and he found it "highly unusual" to put $25 million in an account after the books closed to show a positive closing balance. (Tr. 610-11.) Evidence about the responsibilities of accountants and auditors, and whether municipalities should pay operating expenses by issuing bonds and transferring funds from capital accounts do not address the single issue that is the basis for this proceeding.
Furthermore, the adequacy or inadequacy of Deloitte's audit of the City's 1994 Financial Statements is not the focus of this proceeding. In determining whether the City misled investors through the use of the CAFR and Official Statements, I need not and do not make any determination as to the adequacy of the 1994 Financial Statements in relation to GAAP or GAAS standards. The issue is not whether the material within the 1994 Financial Statements complies with these standards; the issue is whether the City made full and fair disclosure of material information through the 1994 CAFR and the three Official Statements to investors when it issued bonds. See SEC v. Caserta, 75 F.Supp.2d 79, 92 & n.2 (E.D.N.Y. 1999) (recognizing that an audit's compliance with GAAP and GAAS does not foreclose a finding that the same documents could be misleading to investors.)
The jurisdictional requirements for application of the antifraud provisions are present. The three bond offerings involved the offer and sale of securities. The City's 1994 CAFR was used in connection with the purchase or sale of securities as it was distributed to inform and influence the investing public. The City conducted both activities using the mails and instruments of interstate commerce. See SEC v. Softpoint, Inc., 958 F.Supp 846, 865 (S.D.N.Y. 1997), aff'd, 159 F.3d 1348 (2d Cir. 1998) (stating that these requirements "are broadly construed, so as to be satisfied by any activity connected with a national securities exchange, by intrastate telephone calls, and by even the most ancillary mailings"). Courts have also interpreted the phrase "in connection with," that appears in Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, broadly.35 See Superintendent of Ins. of N.Y. v. Bankers Life and Cas. Co., 404 U.S. 6, 12 (1971); In re Ames Dep't Stores Inc. Stock Litig., 991 F.2d 953, 964-67 (2d Cir. 1993). In general, "fraud can be committed by any means of disseminating false information into the market on which a reasonable investor would rely." Ames Dep't Stores, 991 F.2d at 967; SEC v. Hasho, 784 F. Supp. 1059, 1106 (S.D.N.Y. 1992).
To violate Section 17(a)(1) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, the misrepresentation or omission must be material. The standard for materiality is whether or not there is a substantial likelihood that a reasonable investor or prospective investor would consider the information important in deciding whether or not to invest. See SEC v. Steadman, 967 F.2d 636, 643 (D.C. Cir. 1992); see also Basic, Inc. v. Levinson, 485 U.S. 224, 231-32, 240 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). In determining whether an official statement released in connection with a bond issue was misleading, one court has articulated this standard as, "whether an investor who had been reasonably diligent in reviewing the Official Statement would have been misled." Durning v. First Boston Corp., 815 F.2d 1265, 1268 (9th Cir. 1987).
Also, a person must act with scienter. Scienter is defined as "a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). A showing of recklessness or actual knowledge can satisfy the scienter requirement.36 See SEC v. Steadman, 967 F.2d at 641-42; David Disner, 52 S.E.C. 1217, 1222 & n.20 (1997). Recklessness is defined as "an extreme departure from the standards of ordinary care . . . which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it." Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 (9th Cir. 1990) (quoting Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)); see also Meyer Blinder, 50 S.E.C. 1215, 1229-30 (1992).
The City is responsible for the acts of its City Manager and Finance Department officials, and the knowledge of these individuals is imputed to the City. See Will v. Mich. Dep't of State Police, 491 U.S. 58, 79 (1989) (Brennan, J., dissenting) (quoting Poindexter v Greenhow, 114 U.S. 270, 288 (1885)) ("The state is a political corporate body, can act only through agents, and can command only by laws."); Albiero v. City of Kankakee, 122 F.3d 417, 420 (7th Cir. 1977) ("A municipality acts only through agents.").
1. Did the City make material misrepresentations and omit material information in its 1994 CAFR and in three Official Statements?
Material change since 1994 Financial Statements closed
The latest financial information in the three offerings was the City's 1994 Financial Statements that showed a general fund balance of $3.167 million on September 30, 1994. (Div. Ex. 18 at 20-21, Div. Ex. 189, Tab 8 at C-5, Div. Ex. 190, Tab 10 at C-5, Div. Ex. 191, Tab 29 at C-5.) An integral part of each offering was a closing certification by the City Manager that "[s]ince September 30, 1994, no material adverse change has occurred in the financial position of the City," and that the information in the Official Statement is true and correct and does not as of the date the bonds issued-June 1995, August 1995, or December 1995-omit any material information. (Div. Ex. 189, Tab 5, Div. Ex. 190, Tab 4, Div. Ex. 191, Tab 8.)
As an issuer of securities the City was obliged to make full and fair disclosure of material information. See Herzfeld v. Laventhol, Krekstein, Horwath & Horwath, 378 F. Supp. 112, 122 (S.D.N.Y. 1974), aff'd in part, rev'd in part on other grounds, 540 F.2d 27 (2d Cir. 1976) ("Fair presentation is the touchstone for determining the adequacy of disclosure in financial statements. While adherence to [GAAP] is a tool to help achieve that end, it is not necessarily a guarantee of fairness.") Based on the facts in this record, the City Manager's certification that "[s]ince September 30, 1994, no material adverse change has occurred in the financial position of the City" was a blatant misrepresentation. (Div. Ex. 189, Tab 5, Div. Ex. 190, Tab 4, Div. Ex. 191, Tab 8.) The undisputed facts are that after September 30, 1994, City officials became aware that the City's finances were deteriorating significantly.
The City was in a crisis situation beginning in January 1995, when the City Manager, people in the Finance Department, the Financial Advisor, and Mr. Paredes at Deloitte concluded that the City could run out of cash and not meet payroll by May 1995. (Tr. 150, 161, 268.) This was the worst threat to City finances that Mr. Odio had faced in his fifteen years with the City, and from January 1995, his concern was "surviving through May" with the City under a "constant barrage" of financial problems. (Tr. 154, 242-43, 268-69.)
The City's position that it achieved a positive general fund balance in FY 1995 was true in the technical sense that it met payroll and paid its bills, but in reality, the general fund was in a deficit, in that, operating expenses were much greater than budgeted operating funds. (Resp. Br. 20 n.4.) D. Parekh knew in June 1995, that the City's general fund was not "on budget" and that it had a deficit of at least $12 million. (Tr. 760-64.) Mr. Paredes, who warned Mr. Odio in early 1995 that the City would run out of cash by May 1995, considered the City's finances to be in a difficult situation at the end of FY 1995. (Div. Ex. 178 at 84.) Mr. Stierheim concluded after careful analysis, that the City's financial situation in the summer of 1995:
had to be shaky, certainly because of the cannibalization, if you will, of storm water trust money, of unfunded liabilities, utilizing pension bond issue proceeds to meet annual budget requirements for the pension funds.
. . . .
So you've got clear indications of fiscal shortfalls and questionable accounting, official policy.
The expert opinions of Arthur R. Wyatt, CPA,37 and Antonio L. Argiz, CPA,38 are persuasive evidence that the City acted to mislead investors by withholding material information.39 Mr. Wyatt opined that the City's representation that no material adverse changes had occurred subsequent to issuance of the 1994 Financial Statements was misleading if "events subsequent to September 30, 1994, led to any significant deterioration in the City's financial position or in its ability to balance its operating budget from its ongoing operating activities." (Div. Ex. 160 at 7-8.) As previously discussed, the evidence is that subsequent events did lead to significant deterioration. The City's cash flow situation worsened significantly after FY 1994 closed, and in FY 1995 the City had insufficient appropriated revenues in the general fund for operations. The City's general fund avoided a deficit at the end of FY 1995 only because it received $50 million in transfers from capital accounts and $21 million from bond proceeds. (Tr. 629, 719-21, 754-56; Div. Ex. 161 at 4, Div. Ex. 178G at 2, Div. Ex. 186B.) Mr. Argiz independently concluded that the Official Statements for the bond offerings did not represent the facts that existed when they were issued since the City knew at the time of the issues that it had severe cash flow problems that were not fully disclosed in the 1994 Financial Statements.40 (Tr. 820-21, 837; Div. Ex. 161.)
I accept Mr. Wyatt's opinion rejecting the City's defense that Deloitte's clean audit opinion on its 1994 Financial Statements made disclosure of its cash flow crisis unnecessary. According to Mr. Wyatt, "[T]here can be a marked difference between having cash flow problems and having an ability to survive. Those two are not equal." (Tr. 864-870.) Mr. Argiz independently agreed that the fact that Deloitte issued a clean audit on the City's 1994 Financial Statements is not inconsistent with the allegations that the City acted illegally in the three bond offerings. (Tr. 849.)
The fact that the three Official Statements did not inform investors or potential investors of S&P's downgrade of the City's general obligation bonds on October 17, 1994, from A+ to A was a material omission. Mr. Odio and Mr. Surana recognized that this information was important because they included it in the letter to the Mayor and City Commissioners dated February 28, 1995, transmitting the City's 1994 Financial Statements. (Div. Ex. 18 at 8.) Inexplicably, the City did not make the same disclosure in the Official Statements for the bond offerings in June, August, and December 1995. The City should have given notice to investors and potential investors in its general obligation sewer bonds and non-ad valorem FP&L and pension bonds as there was a substantial likelihood that a person considering investing in these debt instruments would consider the information important in making an investment decision. Investors consider the evaluations that rating agencies give municipal securities important in making an investment decision. The fact that S&P downgraded the City's overall credit worthiness is significant to a reasonable investor considering any City debt offering. Mr. Wyatt's credentials justify significant reliance on his expert opinion that the City violated the accounting standard of full disclosure by failing to disclose that S&P lowered its general credit rating on October 17, 1994, after the close of the 1994 Financial Statements.41 (Tr. 860-62; Div. Ex. 160 at 7.)
City's 1994 Financial Statements in the 1994 CAFR and the Official Statements
The Division alleges that the 1994 CAFR and the Official Statements for each of the offerings, which incorporated the City's 1994 Financial Statements, were materially misleading in that they: (1) misrepresented why "Operation Right Size" was initiated, (2) failed to disclose the City's cash flow crisis, and (3) gave the false impression that the City expected its financial condition to improve in FY 1995. (Div. Br. 6-9, 21, Div. Reply 3.) The Division alleges that the 1994 Financial Statements made the 1994 CAFR and the Official Statements materially misleading because Note 9:
failed to reveal that [Operation Right Size] was undertaken to address the City's grave cash crisis. Instead, it gave the misimpression that Operation Right Size was just an exercise in good government that would strengthen the City's financial position over and above FY 1994.
. . . .
The clear, but entirely erroneous, impression that Miami conveyed was that Operation Right Size would put the City in a stronger financial position than it was at the end of FY 1994. In truth, Miami knew that it would finish FY 1995 in far worse condition than the prior year. (Div. Br. at 6-7.)
Note 9 to the 1994 Financial Statements, titled Fund Equity, shows a substantial deficit of about $80 million in the City's enterprise funds and internal service funds. (Tr. 872; Div. Ex. 189, Tab 8 at B-33, Div. Ex. 190, Tab 10 at C-33, Div. Ex. 191, Tab 29 at C-33)
Note 9 states:
The following schedule lists fund deficits for Governmental and Trust and Agency type funds as of September 30, 1994 (in thousands):
Rescue Services Special Revenue ($285)
Self-Insurance Trust Fund ($6,472)
Pension Administration Trust Fund ($34)
In addition to the above fund deficits, the City also experienced cash deficits in several of its operating funds that were temporarily remedied by loans from other funds. See Note 5. It is management's intention to replenish these deficits and, accordingly, in February 1995, the City initiated a review process to "right size" its operations with the goal of reducing its fiscal year 95-96 budget by $30 million. As part of this initiative, significant concessions obtained from the sanitation union are expected to reduce the Solid Waste Department's fiscal year 95-96 budget by $10 million. In addition, several departments are being consolidated and certain operations not directly related to the City's basic services are expected to be discontinued by September 30, 1995. Early retirement plans have been agreed to in principle by the City's administration and union leadership with the purpose of reducing the City's work force by approximately 400 employees by September 30, 1995. The implementation of the proposals discussed above are expected to strengthen the City's financial condition.
(Div. Ex. 18 at 47, Div. Ex. 189, Tab 8 at B-33, Div. Ex. 190, Tab 10 at C-33, Div. Ex. 191, Tab 29 at C-33.)
The inclusion of Note 9 in the 1994 CAFR and the Offering Statements went beyond putting a favorable "spin" on unfavorable information. Note 9 is a misleading and fraudulent description of the condition of the City's "operating funds." A reasonable person reading Note 9 would conclude that cash deficits in the City's main operating fund were temporary and that "Operation Right Size" initiated in February 1995, would help "replenish these deficits," and "strengthen the City's financial condition." None of these statements were true. When the City released its 1994 Financial Statements in March 1995, it had suffered deficits in the general fund for several years and had been continually borrowing from other funds to cover those deficits. A Deloitte "going concern" work paper prepared on or before March 1995, reports the following:42 (Div. Ex. 178 at 45.)
1. Because of significant decreases in available cash balances in its operating funds over the last several years, the City has "borrowed" money from capital project funds including unspent bond proceeds to finance operations during the last few months of each fiscal year. For the last 6 years, the City has issued Tax Anticipation Notes ("TAN") each October for the last six to finance operations until subsequent year tax revenues are collected in December. (Div. Ex. 178 at 41-42, Resp. Ex. 50 at Bates 02672.)
2. The City is $20 to $40 million behind in cash flow, and it appears that the City had overdrawn all its cash in November 1994, but Director of Finance said it received $11 million that was not reflected in the general ledger. Mr. Garcia indicated that cash had been as low as $8 million when monthly payroll cost was $6 million. (Div. Ex. 178 at 39-42, Resp. Ex. 50 at Bates 02673.)
3. The best-case scenario is that the City will have sufficient funds to get through September 1995. Worst-case scenario is that the City will have insufficient funds to operate and meet debt service expenditures for FY 1995. The City cannot issue a TAN until October 1, 1995, so this would not be available. (Div. Ex. 178 at 45, Resp. Ex. 50 at Bates 02673-74.)
When the fieldwork for the 1994 audit closed, the City was searching for additional revenue sources to have enough cash to meet payroll in May 1995. "Operation Right Size" was just getting off the ground. There is nothing in this voluminous record that supports the representation in Note 9 that "Operation Right Size" would replenish the deficits in the operating funds and in other funds created by transfers to the general fund. In March 1995, Mr. Surana requested that the Financial Advisor devise a strategy for the City to raise funds quickly because the City expected to be unable to pay its employees "fairly soon." (Tr. 382-84; Div. Exs. 181O, 181P, 181Q.) On May 9, 1995, the Financial Advisor met with Mr. Surana and persons from the City's Finance Department including D. Parekh, Mr. Luney, and Mr. Chircut seeking remedies for the City's cash deficiencies.43 (Tr. 387-88, 395-96, 399-401; Div. Ex. 181R, Div. Ex.181S.) Notes from the meeting show that "actual cash deficits have to be solved by mid-June." (Tr. 401; Div. Ex. 181R.) On June 9, 1995, City officials, met with union representatives, persons from Rauscher, an underwriter on the pension bond offering, and its Financial Advisor to deal with the City's well-known cash flow problem. (Tr. 406-09; Div. Ex. 181V.)
Note 9 in the 1994 CAFR and the Official Statements was also fraudulent in that it conveyed the impression that "Operation Right Size" was some new, extremely beneficial program. In fact, the City had implemented a similar early retirement program in 1993 that did not solve its financial problems. (Tr. 231, 736.) No one expected "Operation Right Size" to solve the anticipated deficit in FY 1995 of $35 to $40 million that Mr. Paredes warned Mr. Odio about in December 1994 or January 1995. The emergency meetings and union cooperation had positive results but savings in FY 1995 were expected to be only $5 million. Note 9 does not disclose that the City was expected to save $5 million from "Operation Right Size" in FY 1995. (Tr. 158-59, 737, 740-42, 753; Div. Ex. 1 ¶ 20, Resp. Ex. 50 at Bates 2675.) Inexplicably, Note 9 in the 1994 Financial Statements did not contain the sentence, "Management estimates that these programs will result in savings of approximately $5 million and $30 million in fiscal year's 1995 and 1996 respectively" that appeared in the City's February 28, 1995, letter to Deloitte. (Div. Ex. 1 ¶ 20.)
The expert opinions of Messrs. Argiz and Wyatt provide persuasive support that the City failed to disclose fully and fairly material information about "Operation Right Size" in the Official Statements of the three bond offerings. Mr. Argiz opined that the disclosure in each bond offering was inadequate because the Official Statements did not disclose the severity of the City's cash flow difficulties and the possible consequences. Mr. Argiz supports his conclusions with the following:
1. Use of the 1994 Financial Statements in the 1995 bond offerings provided insufficient information about the City's financial situation at the time of the offerings. (Div. Ex. 161 at 4.) The only disclosure of the City's cash deficits appeared in the transmittal letter to the 1994 CAFR and in Notes 5 and 9 to the City's 1994 Financial Statements. (Tr. 799.) The City made inadequate disclosure because it did not indicate "the severity of the City's cash flow difficulties." (Div. Ex. 161 at 3.) Investors and possible investors were "not informed of the pertinent conditions and events giving rise to the cash flow difficulties, the possible effects of those conditions and management's evaluation of those conditions." (Tr. 820-22; Div. Ex. 161 at 4.)
2. The City's disclosure did not reveal how the City would deal with its cash flow deficiencies as of September 30, 1995, inasmuch as the benefits of "Operation Right Size" occurred in FY 1996. (Tr. 821-22, 826-27; Div. Ex. 161 at 4.)
Mr. Wyatt considered it misleading for the City not to disclose that curing a cash deficiency was a major motivation for "Operation Right Size." (Tr. 861, 863.) He faulted the City for presenting "Operation Right Size" as a program to improve operating efficiencies and cash flow without any mention of the fact that one of the program's objectives was to achieve a balanced operating budget. (Div. Ex. 160 at 6-7.) Investors consider it important that an issuer of municipal securities have adequate fund balances in its general operating fund. (Div. Ex. 175 at 20-21.)
It is telling that after the City made the three bond offerings, it disclosed that it initiated "Operation Right Size" because it faced a budget deficiency of $26 million. (Div. Ex. 16 at 33; Div. Br. 7-8.) The Notes to the City's 1995 Financial Statements report that:
In fiscal 1995, the City had a net deficiency of revenues and other sources of approximately $26 million under appropriations. The deficiency resulted from receiving approximately $12.5 million less in planned revenues and incurring unplanned expenditures for police and fire overtime, claim payments, and other. The deficiency became apparent in February 1995 and the City immediately began the process of correcting the deficiency through several actions including workforce reductions, cost reductions[,] and operating efficiencies. The benefits of these measures are expected to reduce operating costs of the City by more than $36 million in 1996. In addition, the City Commission approved a bond program in July 1995 to finance the City's current and future pension contribution. On December 1, 1995[,] the City issued $62 million of Pension Bonds to fund approximately $25 million of fiscal 1995 pension contributions and approximately $37 million for future contributions.
(Div. Ex. 16 at 33.) The City acknowledges that the information was material by including it in its 1995 Financial Statements made public in March 1996. It should have disclosed the true reason it initiated "Operation Right Size" to investors and potential investors in the calendar year 1995 bond offerings.
For all the reasons stated, the City violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, in three bond offerings in calendar 1995. City officials knowingly and with the intention to mislead, manipulate, or defraud, falsely represented that no material changes had occurred in the financial condition of the City since issuance of the City's 1994 Financial Statements, which were the most recent financial information provided in the offering, and it provided false and misleading material information in the 1994 CAFR and Official Statements and omitted material information that should have been conveyed.44 These misrepresentations were material because there is a substantial likelihood that a reasonable investor would consider the changes that occurred in the City's financial status important in making an investment decision and disclosure of accurate information would have significantly altered the total mix of available information. Basic, Inc., 485 U.S. at 231-32, 240; TSC Indus., Inc., 426 U.S. at 449.
2. Did the City falsely represent that it had a balanced budget for FY 1995 in the Official Statements? Did the City make sufficient disclosure in the Official Statement for the pension bonds that the pension bond proceeds would be transferred to the prior fiscal year?
Balanced budget representation
Florida law requires that the City have a balanced budget. (Tr. 146, 160, 192; Fla. Stat. Ann. § 166.241.) The City adopted an annual budget before the start of each fiscal year in a process that involved a submission to the City Commission by the Finance Department, public hearings, and subsequent monitoring. (Div. Ex. 18 at 32.) On September 8, 1994, when the City adopted the FY 1995 budget that was ostensibly balanced, Mr. Odio, Mr. Surana, and others in the Finance Department, knew it had a $12 million revenue deficit because it included $9 million in revenue from a federal crime bill grant that the City would not receive. (Tr. 148-49, 154-56, 270-71, 274, 725-32, 735, 749-50, 768; Div. Exs. 21, 176G, 176I, 176J.) The $9 million in revenue was necessary to achieve a balanced budget. (Div. Ex. 176K at 186-87.) The same reasoning caused the City to include $3 million in revenue from the sale of fine sand or fill. (Tr. 736-37.) In FY 1995, the City received $132,152 of the anticipated $9 million from the crime bill grant and no revenue from the anticipated $3 million from the sale of fill. (Div. Ex. 176M.)
Each of the Official Statements contained a summary of the City's 1995 budget. Each summary showed the general fund with balanced revenues and expenditures. (Div. Ex. 189, Tab 8 at 22-24, Div. Ex. 190, Tab 10 at 16-19, Div. Ex. 191, Tab 29 at 17-20.) The City did not disclose during the three bond offerings that it was not "on budget" or that revenues were inflated by $9 million it was not going to receive from a crime bill grant and $3 million it would not recover from the projected sale of fill. (Tr. 760-61.)
I find that the City, acting knowingly and with the intention to mislead, manipulate, or defraud, violated the antifraud provisions by representing in the Official Statements that it was operating under a balanced budget for FY 1995 when it knew the $222 million in projected general fund revenues was deficient by at least $12 million. The omitted information was material because reasonable investors consider it significant that a municipality issuing securities has a balanced budget. (Tr. 146, 723.) The blatantly false revenue projection contained in the City's 1995 budget was, by itself, material to investors, and its significance was increased by the City's long-standing inability to finance operations from general fund revenues. This conclusion is supported by the expert opinion of Mr. Wyatt that the financial information included with the bond offering circular was incomplete because the City failed to disclose that it would not receive $12 million it needed to balance its FY 1995 budget. (Div. Ex. 160 at 8.)
Use of pension bond proceeds
In FY 1995, the City experienced an appropriated revenue deficiency of approximately $26 million. (Resp. Ex. 60 at 2.) Pension expenses are operating costs payable from the City's general fund. (Tr. 573, 610-11.) Because it lacked funds to pay its FY 1995 pension cost, the City transferred $25 million, or 34.7 percent, of the $72 million proceeds from the pension bond offering in December 1995, to the general fund for the pension obligation due in FY 1995. The FY 1995 general fund balance would have been negative without the use of $25 million from the pension bond proceeds. (Tr. 204-05, 755-56; Div. Ex. 161 at 4, Div. Ex. 178 at 119, Div. Ex. 178G at 2, Div. Ex. 183 at 90-91.)
The Division alleges the Official Statement in the pension bond offering provided only "cryptic" information and charges that the City violated the antifraud provisions by not disclosing "the extent of the bailout, thereby hiding the magnitude of its continuing cash flow crisis." (Div. Br. 22, Div. Reply 5 n.4, 11 n.8.)
The pension bond Official Statement stated in the Introduction that the bonds were being issued for the purposes of:
providing for the payment of all or part of the City's unfunded actuarial accrued and future liabilities to certain City pension plans and providing for the payment of all or part of the City's accumulated and future compensated absence liabilities, including reimbursing the City for payments made in Fiscal Year 1995.
(Div. Ex. 191, Tab 29 at 2.) In the purpose section of the Official Statement, the City notes that:
Since 1985 the City has made its contributions to the Pension Plans, pursuant to litigation settlements with various unions, from funds derived from operating millage which has imposed and continues to impose an increasing strain on the City's operating budget. . . .
Accordingly, the City has determined to issue the 1995 Bonds and to apply a portion of the proceeds thereof to the discharge of all or part of the Unfunded Actuarial Accrued Liabilities and the future liabilities of the City to the Pension Plan with respect to the fiscal years ending September 1995 through 2008.
(Div. Ex. 191, Tab 29 at 5.)
In my judgment, the Division's position would impose too stringent a standard on an issuer. I find that the City did not violate the antifraud provisions because a reasonable investor would know from the City's disclosure in the pension bond Official Statement that a portion of the proceeds would be used to pay a pension liability for the fiscal year ended September 30, 1995.
3. City's Defenses
I find the City's position that the Division's "snapshot" methodology caused it to focus inappropriately on the City's financial status at a single point in the year rather than at year-end results off-base because the issue here is whether the City committed fraud in failing to disclose material information about its financial status when it offered and sold bonds in June 1995, in August 1995, and in December 1995. (Resp. Br. 2, 13, 20, 22, 34.)
I reject the City's argument that it is not liable because it acted in good faith and followed the advice of many well-respected and well-paid firms in accomplishing each of the bond offerings and in incorporating the 1994 Financial Statements into the Official Statements. (Tr. 244; Div. Ex. 183 at 73, Div. Ex. 192 at 34; Resp. Br. 20, 32-33.) As a matter of law, the City as the issuer, not the auditors, had ultimate responsibility for making full and fair disclosure of material matters in the three Official Statements and its 1994 Financial Statements. (Tr. 581; 840-41, 875; Div. Ex. 160 at 4-5, Div. Ex. 161 at 4-5.) The City was responsible for the contents of notes to its 1994 Financial Statements and it made no difference who drafted the language. (Tr. 875.) The expert testimony is that with respect to auditors, "For at least forty years (and undoubtedly longer) the authoritative auditing literature has clearly specified that the primary responsibility for the fairness of presentation of financial statements and the related financial information lies with the management of the reporting entity." (Div. Ex. 160 at 4.) The rationale for this black letter rule is that the reporting entity has the best information. (Div. Ex. 160 at 4.) The City acknowledged that it carried this responsibility on three separate occasions in connection with the FY 1994 audit: (1) in the letter from Deloitte that Mr. Odio signed on November 22, 1994, (2) in the representation letter the City sent to the auditors dated February 28, 1995, and (3) in the letter from Mr. Odio and Mr. Surana transmitting the 1994 CAFR to the Mayor and City Commissioners dated February 28, 1995. (Div. Exs. 1, 18, 42.)
I reject the City's claim that it cannot be found to have acted with scienter because the federal courts have recognized good faith reliance on the advice of an accountant as a defense to scienter in a securities fraud action, and it followed Deloitte's advice.45 See Caserta, 75 F. Supp. 2d at 94; SEC v. Goldfield Deep Mines Co., 758 F.2d 459, 467 (9th Cir. 1985).
To establish a good faith reliance defense based on the advice of an accountant or an attorney, one must show that she (1) made complete disclosure, (2) sought the advice as to the appropriateness of the challenged conduct, (3) received advice that the conduct was appropriate, and (4) relied on the advice in good faith. See Caserta, 75 F. Supp. 2d at 94; John Thomas Gabriel, 51 S.E.C. 1285, 1292 (1994), aff'd, 60 F.3d 812 (2d Cir. 1995) (Table). The City has not satisfied those elements. First, when it made the three bond offerings and when it distributed its 1994 CAFR, the City did not ask for, receive, or rely on advice from Deloitte as to whether its financial status had changed materially from what was shown in its 1994 Financial Statements dated February 28, 1995. To the contrary, Deloitte asked for, received, and relied on information from the City in preparing its consent letter for the three offerings. Mr. Paredes called the Finance Department and in response to his inquiry was told that nothing had happened that would have a material bearing on the City's 1994 Financial Statements. (Div. Ex. 177 at 117-18.)
Most important, when it took these actions in late March, June, August, and December 1995, the City knew that the information it was providing investors and potential investors did not fully and accurately describe its financial situation at those particular times. It is well-settled case law that a person cannot claim reliance on another when the person knowingly makes fraudulent statements and intentionally omits information about material subjects. The holding of the 7th Circuit sitting en banc in United States v. Erickson, 601 F.2d 296, 305 (7th Cir. 1979) (citations omitted) is applicable to these facts:
Although certified by accountants as prepared in accordance with [GAAP], the financial statements are nevertheless the representations of management. If a company officer knows that the financial statements are false or misleading and yet proceeds to file them, the willingness of an accountant to give an unqualified opinion with respect to them does not negative the existence of the requisite intent or establish good faith reliance.
See also Goldfield Deep Mines Co., 758 F.2d at 467; United States v. Colasurdo, 453 F.2d 585, 594 (2d Cir. 1971).
IV. CEASE AND DESIST
The Division urges the imposition of a cease and desist order inasmuch as the City's actions were deliberate, egregious, premeditated, and recurrent. It argues that a cease and desist order is needed because the Oversight Board will cease to oversee the City's finances in another year, and that the City has not recognized its wrongful actions or given any assurances against future violations. The Division concludes that the evidence satisfies the "reasonable likelihood" of future violations standard. (Div. Reply 23-25.)
The City maintains that a cease and desist order is inappropriate because: (1) it did not commit the alleged violations since it followed Deloitte's advice, and (2) the Division failed to make the required showing that it will likely violate the securities laws in the future. (Resp. Br. 30-36.)
Section 8A of the Securities Act and Section 21C of the Exchange Act authorize the Commission to order a person to cease and desist from committing any present or future violations where the Commission, after notice and hearing, finds that a violation of the statutes occurred.46 The Commission's latest guidance on when such an order is appropriate is found in KPMG Peat Marwick LLP, 74 S.E.C. Docket 384, 436 (Jan. 19, 2001), appeal filed, D.C. Cir., No. 01-1131 (footnote omitted).
Along with the risk of future violations, we will continue to consider our traditional factors in determining whether a cease-and-desist order is an appropriate sanction based on the entire record. Many of these factors are akin to those used by courts in determining whether injunctions are appropriate, including the seriousness of the violation, the isolated or recurrent nature of the violation, the respondent's state of mind, the sincerity of the respondent's assurances against future violations, the respondent's recognition of the wrongful nature of his or her conduct, and the respondent's opportunity to commit future violations. In addition, we consider whether the violation is recent, the degree of harm to investors or the marketplace resulting from the violation, and the remedial function to be served by the cease-and-desist order in the context of any other sanctions being sought in the same proceedings. This inquiry is a flexible one and no one factor is dispositive. This inquiry is undertaken not to determine whether there is a "reasonable likelihood" of future violations but to guide our discretion.
See also Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff,d on other grounds, 450 U.S. 91 (1981).
An objective consideration of the evidence indicates that a cease and desist order is necessary to protect investors. The violations involved conduct by top City officials intended to mislead the public about material information concerning the status of the City's finances in the offer and sale of bonds totaling approximately $116.5 million. The illegal actions were repeated on three occasions over a six-month period. The City's attitude that disclosure was not important because no one reads the Official Statement when the bonds are insured, and that regardless of what the 1994 Financial Statements showed, "people in the business" understood what was going on does not engender confidence in the City's future conduct. (Tr. 202, 243.) Even though the key people involved in these events are no longer with the City, the problems appear to be systemic since there is no evidence that the City is willing to acknowledge, or is even willing to consider, that that the City broke the law. Unfortunately, this evidentiary record does not support Mr. Stierheim's belief that the City is "on the road to recovery." (Tr. 661.)
V. RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), I certify that the record includes the items described in the record index issued by the Secretary of the Commission on April 5, 2001.
Based on the findings and conclusions set forth above:
I ORDER, pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, that the City of Miami, Florida shall cease and desist from committing any violations or any future violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360. Pursuant to that rule, a petition for review of this initial decision may be filed within twenty-one days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision upon such party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the initial decision shall not become final as to that party.
Brenda P. Murray
Chief Administrative Law Judge
1 I accepted the unopposed amendment at the prehearing conference on November 1, 1999, pursuant to Rule 200(d)(2) of the Commission's Rules of Practice, 17 C.F.R. § 201.200(d)(2). (Prehearing Transcript 15-16.)
2 "(Tr. __.)" refers to the transcript of the hearing. I will refer to Division and Respondent exhibits as "(Div. Ex. __.)," and "(Resp. Ex. __.)," respectively. "(Ans. at ¶__.)" refers to Respondent City of Miami's Answer, Defenses and Affirmative Defenses.
3 I will refer to the Division's initial posthearing filing as "(Div. Br.__.)"; the Respondent's initial posthearing filing as "(Resp. Br.__.)"; and the Division's second posthearing filing as "(Div. Reply __.)."
4 An official statement is the "financial disclosure by a state or local government planning a municipal securities offering that states the purpose for the issue and how investors will be repaid. The official statement also discloses pertinent information on the issuer's financial condition." Barron's Dictionary of Banking Terms, 325 (3rd ed. 1997). It is also described as "the municipal equivalent of a [corporate] prospectus" which is a "formal written offer to sell securities that sets forth . . . the facts concerning an existing [business enterprise] that an investor needs to make an informed decision." Barron's Dictionary of Finance and Investment Terms, 294, 382, 445 (4th ed. 1995).
5 In September 1994, Stephen P. Clark was Mayor, Miller J. Dawkins was Vice-Mayor and Wifredo Gort, Victor De Yurre, and J.L. Plummer, Jr., were City Commissioners. (Div. Ex. 176K at 172.)
6 Mr. Surana was not an accountant. (Tr. 252.) In 1997, the consolidation was reversed. (Tr. 712.)
7 The duties included reviewing and evaluating the City's financial condition, policies and plans; developing a financial plan; dealing with rating agencies; and preparing for bond sales. (Div. Ex. 181E.)
8 In 1998, K. Parekh paid a sanction of $2,500 and agreed not to associate with any National Association of Securities Dealers ("NASD") member firm for ninety days to settle an NASD complaint. (Tr. 290-91.)
9 The 1994 CAFR shows a $27,490 contribution to pension funds. (Div. Ex. 18 at 23.)
10 The record does not explain why the sum of the accumulated deficit in FY 1993 and the deficit for FY 1994 and FY 1995 does not equal the accumulated deficits in FY 1994 and FY 1995 as shown in the Financial Statements for those years. (Div. Ex. 16 at 48, Div. Ex. 18 at 47.)
11 However, the Financial Advisor raised "continuing concerns" in letters to Mr. Surana in November 1995, and January 1996. (Div. Exs. 182M, 182T.)
12 I accept the representation by the Division's expert witness that the Statements on Auditing Standards set the date of the last day of fieldwork as the date of the audit report. (Tr. 807-08.) See Statements on Auditing Standards, No.1, § 530.
13 The record does not explain the discrepancy between the considerable persuasive evidence that the City received the audit results in March 1995, and the belief of Francisco J. Paredes, the Deloitte partner who supervised the City's audits for several years, that the audit report was issued to the City in late May 1995. (Div. Ex. 178 at 85-86.)
14 Only City Commissioner Gort was present because the "Sunshine" law would have applied if more than one City Commissioner attended the meeting. (Tr. 162.) Despite attending the meetings, City Commissioner Gort testified he did not know that the City's effort to cut $30 million in costs was because Deloitte had warned of imminent cash shortages. (Div. Ex. 192 at 121-22, 127-29.)
15 The Florida Constitution permitted the City to levy ad valorem taxes up to $10 per one thousand dollars of assessed valuation for general governmental services. For the fiscal year ending September 30, 1995, the rate was $9.5995 per one thousand dollars. (Div. Ex. 190, Tab 10 at 14.) The City had a tax rate at this level since 1988. (Div. Ex. 181J.)
16 The City had implemented a similar retirement program in 1993 that did not solve its financial problems. (Tr. 231, 736.)
17 Section 218.503 of the Florida Statutes Annotated, titled "Determination of financial emergency," describes a number of conditions that indicate a local government entity is in a state of financial emergency. These include when it fails to pay employees for one pay period due to lack of funds, and when it has a total fund balance deficit for which it does not have sufficient resources for two consecutive years. (Div. Ex. 178 at 110-12.)
18 The governing body of each municipality "shall make appropriations for each fiscal year which, in any one year, shall not exceed the amount to be received from taxation or other revenue sources." Fla. Stat. Ann. § 166.241(3) (as written prior to 1996 amendment).
19 According to City's expert, Paul Munter, Accounting Department Chairman and KPMG Professor of Accounting, School of Business Administration, University of Miami:
[P]reparation of financial statements in accordance with generally accepted accounting principles (GAAP) is based on the assumption of continued existence. Because the going concern concept is fundamental to financial reporting in accordance with GAAP, the auditor has a responsibility to evaluate the appropriateness of that assumption when conducting the audit engagement in accordance with generally accepted auditing standards (GAAS).
. . . .
Because going concern is embedded in the financial reporting process, the auditor has a responsibility, in accordance with [Statement on Auditing Standards] SAS No. 59, to make an evaluation of the entity's ability to continue as a going concern. . . . SAS No. 59 requires that the auditor evaluate the entity's ability to continue for a reasonable time - which is not to exceed one year from the financial statement date. However, the auditor has a responsibility to consider all matters which are presented up to the conclusion of the audit field work.
(Resp. Ex. 70 at 2.)
20 Mr. Stierheim earned an undergraduate degree in commerce and finance and a master in government administration from the Wharton School of the University of Pennsylvania. Mr. Steirheim worked for the City early in his career. He was the City Manager of Clearwater, Florida, from 1967 to 1973, Administrator of Pinellas County from 1973 to 1976 and Manager of Miami-Dade County from 1976 to 1986. From 1986 to 1990, he headed Women's Professional Tennis Worldwide, and from 1990 to 1998 he was Director of the Greater Miami Convention and Visitors Bureau. When he testified in March 2000, Mr. Stierheim had been Manager of Miami-Dade County since 1998. (Tr. 588-91, 594.)
21 City Commissioner Gort could not recall, or was unaware of, these deficiencies when they occurred in 1993 and 1994. (Div. Ex. 192 at 71-72, 80-96.) Mr. Gort's lack of knowledge is difficult to reconcile with his professional accomplishments, and the fact that he was the City Commissioner who was interested in finance. (Tr. 162.) In 1994, Mr. Gort was a majority owner and principal of AIBC Investment Services, a registered broker-dealer that dealt in municipal bonds. (Div. Ex. 192 at 6-9.) Mr. Gort earned several securities licenses, including municipal securities principal. (Div. Ex. 192 at 10-11, 20.) Prior to his election as a City Commissioner, Mr. Gort's firm participated as an underwriter in two or three security offerings by the City. (Div. Ex. 192 at 20.)
22 D. Parekh has two bachelor's degrees from Middlesex University in London, and a master of science degree from the London School of Economics. (Tr. 710.)
23 D. Parekh had worked closely with Mr. Surana, but Mr. Stierheim concluded that D. Parekh recognized the change in leadership and found D. Parekh honest and knowledgeable. (Tr. 624.) In his final report to the Mayor and City Commissioners, Mr. Stierheim extended appreciation to D. Parekh, Phil Luney, and Pete Chircut of the City's Finance Department "who consistently went above and beyond to research and assist in documenting what went wrong and helping me determine how we might proceed." (Div. Ex. 107 at 23.) Mr. Stierheim's notes written in 1996 indicate, "This is how the City Auditor told Surana and Dipak to close out the 1994/95 books so as to have a positive fund balance." (Tr. 609; Div. Ex. 186B.) However, D. Parekh denied meeting with the auditors in order to close out the City's year-end figures for FY 1995. (Tr. 715, 767-68.) D. Parekh was a credible witness. There is no explanation for the discrepancy in the evidence.
24 The closing documentation also included a statement by the City that it had no knowledge that the Official Statement was incomplete or omitted any material facts. (Div. Ex. 189, Tab 18, Div. Ex. 190, Tab 24, Div. Ex. 191, Tab 29 at 41.)
25 Since all municipalities end their fiscal year on September 30, it was not unusual for the offerings to use audited financial statements for a period that ended up to fourteen months before. (Div. Ex. 183 at 84.) The City did not issue interim financial statements. (Tr. 274, 276, 379.)
26 The three Official Statements contain wording very similar to the following:
We agree to the inclusion in the Official Statement for the City of Miami, Florida . . . of our report dated February 28, 1995, appearing in [the] Appendix of such Official Statement. We also agree to the reference to us under the heading "Financial Statements" in such Official Statement.
(Div. Ex. 189, Tab 25, Div. Ex. 190, Tab 40, Div. Ex. 191, Tab 23.)
27 Mr. Paredes spoke with Mr. Surana, Mr. Chircut, or Mr. Luney. (Div. Ex. 177 at 117.)
28 Mr. Odio stated, "I had no idea you have to disclose everything." (Tr. 244.)
29 A general obligation bond is supported by the general full faith and credit of the issuer, while a non-ad valorem bond is supported by a specified revenue stream. (Div. Ex. 175 at 14, 40, Div. Ex. 178 at 64-65.) For example, the legally available non-ad valorem revenues for the FP&L bond offering were from the General Fund, Public Service Taxes, Orange Bowl Stadium, Convention Center and Exhibition Center, Marinas, Golf Courses, Parking Garage, Building & Zoning, and Solid Waste. (Div. Ex. 190, Tab 40.) The courts can compel the issuer of general obligation bonds to raise taxes to pay debt service on the bonds. (Div. Ex. 175 at 14.)
30 Under a bid process, the winning bid becomes the purchaser and underwriter for the bonds. (Tr. 654-55.)
31 Mr. Odio admitted that the $26 million general fund entry could mislead someone who was not familiar with the Financial Statements, but he insisted that anyone in the business would know the source of the $21 million transfer. For example, Moody's knew that the money originated from the proceeds of the FP&L bonds. (Tr. 201-02.)
32 Resolution No. 95-564 specified that every year for a period of fifteen years, the City Manager could issue $15 million and $7 million, respectively, in revenue bonds to pay certain pension obligations and compensated absence (sick leave) costs. However, the annual amounts could be increased by the authorized amount times the number of years remaining. It was unusual for elected officials to delegate this significant responsibility to staff and to capitalize pension and sick leave costs. (Tr. 505.) Both of these expenses had been paid from the City's general fund. (Tr. 505-06.)
33 According to one bond counsel involved in the pension bond offering, only one bond counsel and one underwriter's counsel were needed. When there is more than one, the reason is usually political. (Div. Ex. 183 at 72.) One explanation for three underwriters counsel is that "like everything else in South Florida, they were spreading the work around for political reasons." (Div. Ex. 183 at 71-72.)
34 KPMG, LLP, the auditors who replaced Deloitte, did not have the City restate its prior- year Financial Statements, and issued an unqualified report of the City's 1996 Financial Statements. (Div. Ex. 160 at 6.) Based on these facts, the Division's expert, Arthur Wyatt, opined that "it is fair to conclude that the 1995 and 1994 (as well as prior years in question) Financial Statements as reported on by Deloitte had, in fact, contained accurate dollar amounts, used an appropriate reporting format and were not, as alleged by City of Miami management, misleading." (Div. Ex. 160 at 6.)
35 The City does not dispute the applicability of these statutory provisions to these facts.
36 Scienter is not required to establish a violation of Section 17(a)(2) or (3); a finding of negligence is adequate. See Jay Houston Meadows, 52 S.E.C. 778, 785 n.16 (1996); see also Steadman, 967 F.2d at 643 n.5 (citing Aaron v. SEC, 446 U.S. 680, 701-02 (1980)); Newcome v. Esrey, 862 F.2d 1099, 1102 n.7 (4th Cir. 1988).
37 Mr. Wyatt earned a bachelor's degree, a master of science, and a doctorate in accountancy from the University of Illinois where he taught from 1949 to 1966, the year he joined Arthur Andersen & Co. ("Andersen"). In the course of his career with Andersen, Mr. Wyatt became a partner and chaired the accounting principles group. From 1975 to 1979, Mr. Wyatt was a member of the executive committee of the American Institute of Certified Public Accountants ("AICPA"), and he chaired the AICPA's executive committee in 1977 through 1979. Mr. Wyatt left Andersen to become a member of the Financial Accounting Standards Board from January 1, 1984, until October 31, 1987. From 1988 until 1992, Mr. Wyatt was the AICPA representative on the International Accounting Standards Committee in London. Following his retirement from Andersen in 1992, Mr. Wyatt became an adjunct professor at the University of Illinois. Mr. Wyatt has authored, co-authored, and edited five books and some fifty-seven articles on accounting. (Div. Ex. 160.)
38 Mr. Argiz, a graduate of Florida International University, is a managing shareholder at Morrison, Brown, Argiz & Co., CPA, a public accounting firm and a member of the AICPA. Mr. Argiz, an audit and litigation support partner, heads the firm's dealership division. (Div. Ex. 161 at 1, 7.) Mr. Argiz has served on the governing body of the AICPA and has chaired the Florida Board of Accountancy and its Probable Cause Panel. Mr. Argiz has also served on the Board of Governors and as chairman of the Audit and Legislative Committee for the Florida Institute of Certified Public Accountants. (Div. Ex. 161 at 1, 7.) Mr. Argiz has conducted seminars and lectures and has published articles on accounting, auditing, and fraud prevention, and has testified as an expert in over thirty cases. (Div. Ex. 161.)
39 I reject the City's dismissal of the experts' opinions. The City contends that both experts have not done municipal accounting, have not participated in a municipal offering, and are not current in the continuing education requirements needed to audit a municipality. (Tr. 771-73, 852-53; Resp. Br. 27-28.) The experts demonstrated familiarity with Government Accounting Standards Board ("GASB"). I accept Mr. Wyatt's position that GASB could not require less than GAAS and GAAP. (Tr. 855.) I accept Mr. Argiz's position that he has reviewed the accounting literature and nothing in GASB would change his position. (Tr. 775-77.)
40 Mr. Argiz's opinion is based on the following assumptions which the evidence shows to be true: (1) after December 1994, the City was experiencing cash flow deficiencies and it expected these deficiencies to last through FY 1995 unless it reduced expenditures significantly or increased revenues; (2) when the City released its 1994 CAFR, the City had no assurance that the actions it planned would cure its cash flow deficiencies; and (3) if the City continued on course, it may have been in a position where it would not have sufficient funds to pay its obligations. (Tr. 819-22; Div. Ex. 161 at 2.)
41 K. Parekh, a non-expert, believed that disclosure, if required, would only be for the general obligation bonds (sewer bonds). (Tr. 373-75.)
42 An auditor must make a "going concern" determination in every audit. (Tr. 784.) See Statements on Auditing Standards, No. 59.
43 The idea for the pension bond issue arose at this meeting. (Tr. 405.)
44 Mr. Odio did not read what he signed, but there is nothing that indicates he did not realize the significance of the documentation and the importance of his actions as City Manager in issuing the bonds. (Tr. 168, 189-90.)
45 The City is wrong that it should prevail because the Division did not produce evidence to refute the City's defense. The Division's witnesses addressed this issue.
46 Under Section 2(a)(2) of the Securities Act, a "person" is defined to include a "government or political subdivision thereof," and under Section 3(a)(9) of the Exchange Act, a "person" is defined to include a "government, or political subdivision, agency, or instrumentality of a government."http://www.sec.gov/litigation/aljdec/id185bpm.htm
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