MUNICIPAL SECURITIES LAW ENFORCEMENT: A CURRENT ASSESSMENT REMARKS BEFORE THE GOVERNMENT FINANCE OFFICERS ASSOCIATION BY WILLIAM R. MCLUCAS DIRECTOR, DIVISION OF ENFORCEMENT U.S. SECURITIES AND EXCHANGE COMMISSION* JANUARY 30, 1996 * The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the authors and do not necessarily reflect the views of the Commission or of the author's colleagues on the staff of the Commission. Over the course of the last several months I've read much about what the SEC is supposedly doing with respect to its initiatives in the municipal securities markets. My primary focus, not surprisingly, is with respect to the Commission's enforcement efforts. What are some of the things we are supposedly doing, according to our critics and other observers? Let me summarize a few of our activities, according to press accounts: * The SEC's program involves nothing but the application of new standards, after the fact, to business practices that have been viewed as entirely appropriate until now. As the cases I'll refer to in a moment make clear -- the conduct being challenged is very often plain vanilla securities fraud. * This effort with regard to the municipal finance market is an SEC power grab for jurisdiction, or worse yet, for headlines. We've testified before Congress that we do not want, nor are we seeking, repeal of the Tower Amendment. * Where is the problem -- there was little difficulty in this market until the SEC arrived to invent it. * This is an "experiment" in which it is simply unclear how the SEC will handle enforcement issues. As to these latter two points -- the cases brought to date have answered these criticisms. Even beyond Commission cases, if you look at the Bond Buyer today there is a Headline "Oklahoma County Officials, Advisers, Indicted in Alleged Pay-to-Play Scheme." These are some of things -- and there is much more -- that have been said about what we are doing and why we are doing it. Now -- let me preface my remarks by making clear what my purpose is today. I wanted to clear the air a little about what the Commission is doing and what it is not doing in the area of municipal securities law enforcement. I will confess, in advance, to some frustration over the past several months. Since some of the critics are associated with specific investigations or represent those actually under investigation -- the rules have not permitted me to respond in kind, without compromising the non-public nature of our process. Nor have I wanted to overreact. Having been in this business for a few years, my skin has gotten pretty thick. Indeed, contrary points of view are generally healthy for the process of regulation and law enforcement generally. None of us has a monopoly on what is right on all occasions. As for the enforcement process, which I will describe in some detail in a moment, the SEC traditionally has defined the word "independent" in the phrase "independent regulatory agency". This is not done out of arrogance -- nor is it done out of obliviousness to market and political realities. It is simply a discipline in the Commission's management of its law enforcement role which has, over the years, lent integrity to the agency's law enforcement process.. In short, public statements or lobbying efforts designed to sway the agency or bring pressure to bear on law enforcement matters, generally have little, if any, influence on the agency's deliberations. At the staff level, we'll make the recommendation we think appropriate in any given case. Chairmen and Commissioners at the SEC have guarded their prosecutorial independence quite vigorously over the years. The same holds true today. This organization -- the Government Finance Officers Association -- in particular, represents those people who have focussed on and worried about disclosure in this market long before it became a primary part of my concern as a prosecutor. Your interest -- full disclosure of material information by municipal issuers -- is consistent with the SEC's objective. How we get there and whether we use the enforcement process in any specific case, is obviously a matter of concern to this group and to the markets as a whole. Why the Municipal Securities Markets and Why Now? The general exemption of municipal securities issuers from the panoply of SEC registration and disclosure requirements, make this market somewhat unique. It has grown, however, and has taken on far greater significance to individual investors and to our overall capital market system. Today there are more than 150,000 different issues of municipal securities outstanding, with a market capitalization well in excess of one trillion dollars. The investors in these securities, both through direct holdings and mutual funds, tend to be individuals, as compared with a decade ago, when institutional holders like banks and insurance companies were the predominant investors. This market is also both more liquid and more national in scope today, with investors in Maine buying securities issued by municipal governments in Southern California. But growth, in and of itself, does not account for the SEC's interest. As Chairman Levitt has testified, -- the SEC is not seeking the same jurisdiction or disclosure regime for this market as for public companies. We already have plenty to do at the SEC under the self-regulatory framework as it now exists. Our statutory mandate -- investor protection -- coupled with the broader concern for integrity of our capital markets, -- is at the heart of the current Commission initiative. The Investigatory Process Let me say a few words about the Commission's investigatory process, which is somewhat alien territory to most of you. We conduct two types of inquiries, -- informal -- those with no subpoena power where we rely on voluntary cooperation -- and formal inquiries -- those where we issue subpoenas to compel testimony and production. Both are confidential under SEC rules. Because we have often been dealing with governmental entities and political leaders, however, some of the issues or concerns about specific investigations seem to be communicated to the SEC by way of the press. This, I will confess, is a learning experience for me. Sometimes I learn about what certain government officials or their lawyers think of what we might be doing not from my mail or my phone logs but from the newspapers. How and why would we open an inquiry of a particular matter? The sources for our investigations might be the newspapers, a broker dealer inspection, an investor complaint, an anonymous informant -- sometimes including disappointed or disgruntled employees or even paramours -- or a variety of other sources of intelligence. We evaluate the situation -- including the motives of any informant. Once we commence an inquiry, we do not have the concept of targets as that term is used in grand jury proceedings -- and counsel may always accompany a client/witness during the process. If the staff thinks there is a problem, that is, a violation of the law -- we usually solicit a written submission -- a so- called Wells submission -- from someone about whom we have concerns before we go to the Commission with a recommendation. Here, counsel can address the factual, legal and policy issues which argue against Commission enforcement. We also make every effort to be straight forward on what we think the problem is and why. We will, within reason, try to meet with the counsel to have a dialogue about the facts, the issues and the law. If an enforcement recommendation is made to the Commission, the staff submits the written recommendation and the Wells submission, and trys to answer the Commission's questions before the Commissioners vote on any recommendation. If the Commission authorizes a proceeding, it will determine whether to proceed (i) administratively before an Administrative Law Judge, or (ii) in Federal District Court. A number of people have literally taken off after SEC Chairman Arthur Levitt, criticizing him for being biased and alleging "prejudgment" of issues which have arisen in certain of these cases. In short, these individuals have said that the Commission cannot be objective because the Chairman may have certain views about the municipal securities markets or about specific cases. While I cannot, for reasons that are obvious, talk about specific cases, this attitude of "shoot the messenger" simply misses the mark. The Chairman must, if the SEC is to do its job, speak out from a policy perspective about current problems in the markets, about investor protection, and about abuses which he perceives we must guard against. Every SEC Chairman under whom I've served - - and there have been more than I care to admit -- from Harold Williams and his crusade to improve corporate governance, to Richard Breeden and his insistence that banks and thrifts comply with the federal securities laws -- has done the same, and properly so. This responsibility -- to address publicly the policy priorities and current market issues confronting each Commission -- is in contrast to the judicial role each Chairman and Commissioner face, sitting as judges. In that role, as adjudicator of administrative charges, they pass on the facts, the law and, where appropriate, the remedies in a specific case. They undertake this responsibility seriously and with absolute and total isolation from the enforcement staff prosecuting the case. The complaints about prejudgment in the municipal finance area have, in my view, missed the point. They have confused the Chairman's public policy responsibilities with the agency's law enforcement mission. Its a variation of the old addage, if you don't have the law, argue the facts; if not the facts, argue the law, -- and, if neither, pound the table. Except here, its shoot the messenger. SEC Enforcement Cases To Date The Commission, in the past year and one-half or so, has filed approximately 19 cases in connection with our look at the municipal securities industry. These cases have involved market participants in virtually every aspect of municipal finance -- national and regional underwriting firms, national and local financial advisory firms, employees of those firms, bond counsel, underwriters counsel, consultants -- even elected officials. When the SEC commenced this initiative our critics charged that we were over reacting to a non-existent problem. What have we found? -- Contrary to what these individuals have said we've certainly found some problems -- - the solicitation and payment of kickbacks to obtain underwriting business; - the providing of financial incentives to a public official in connection with an underwriting contract; - serious, undisclosed financial arrangements affecting the independence of the financial advisers to municipal governments; - fundamental and serious disclosure deficiencies in offering circulars involving the sale of Billions of dollars of securities. No one, I would hope, would argue that the allegations in these cases reflect a radical departure from time tested, well- established principles -- graft associated with the underwriting of securities, and certainly fundamental disclosure omissions -- violate the anti-fraud provisions. In some of these cases, the issuers, the taxpayers and the ratepayers behind them, as well as investors, were defrauded. The process of bringing securities to market, the role of professionals and public officials, as well as the quality of disclosure -- must not be untainted by practices which, if subjected to public scrutiny, would do irreparable damage to public confidence in this market. Orange County Last Wednesday the Commission named, in an Administrative Proceeding, Orange County, the Board of Supervisors of Orange County, and the Flood Control District of the County. Simultaneously, the Commission brought an injunctive action against the former Treasurer and his Assistant, and published a Report of Investigation involving the individual members of the Board of Supervisors. The reaction to date has been everything from: Where's the Beef? to Terror by other public officials over the Report as to the Board of Supervisors. Let me say a few words about the Report of Investigation. The centerpiece of the Commission's Report is the failure, in the SEC's assessment, of the members of the Board of Supervisors to fulfill their obligations under the federal securities laws in connection with the offer and sale of over one billion dollars in County securities. In essence, these Board members, knowing facts and circumstances which called into question the County's ability to repay various issues of securities, approved the use of disclosure documents without asking any questions or becoming familiar with the information in these documents. Missing from the documents was disclosure that would have highlighted the risks associated with these securities because of, among other things, the County's dependence on the Orange County Pools for income, the leverage in the Pools themselves, and the assumptions being made by Mr. Citron about low interest rates. Obviously, as happened in Orange County, if those assumptions proved wrong, the extent of the leverage in the Pools resulted in the loss of considerable value and the inability of the Pools to meet obligations to third parties -- including County noteholders. What did the Supervisors know and why did the SEC take them to task? Let me read from the Report. The Supervisors were aware of the financial condition of the County and that interest income from the County Pools had become a major component of the County's budget in an environment of increasing budgetary pressure. The Supervisors also knew that the increase in such interest income was [connected to offerings] . . . conducted solely to raise funds for reinvestment. The Commission Report addresses a basic requirement central to the liquidity, integrity and viability of the municipal securities markets -- that is, fundamentally, a municipal government seeking access to capital from investors cannot misrepresent, misstate, or omit facts central and critical to an investor's assessment of risk. This basic proposition -- that in dealing with investors, you must tell the truth, the whole truth and nothing but the truth -- is at the heart of federal securities law and of our capital market system, including the municipal securities market. As to the public officials, whose responsibilities include authorizing the issuance of securities by a municipal government, they are not guarantors of such investments. Their responsibilities, however, do include some reasonable attention to providing accurate disclosure to the investors who buy their bonds and notes. May public officials reasonably rely on lawyers, financial advisors, underwriters and governmental employees? Absolutely - - just as officials of public companies do. That reliance however -- must be reasonable. What is the standard? The Report says the following: A public official who approves the issuance of securities and related disclosure documents may not authorize disclosure that the public official knows to be materially false or misleading; nor may the public official authorize disclosure while recklessly disregarding facts that indicate that there is a risk that the disclosure may be misleading. When a public official has knowledge of facts bringing into question the issuer's ability to repay the securities, it is reckless for that official to approve disclosure to investors without becoming familiar with the disclosure documents and taking steps to prevent the dissemination of materially false or misleading information. Some observers, particularly those in Orange County, have said that the SEC has done too little, too late. Just as prior to Orange County's problems, the SEC had neither the jurisdiction nor the ability to save the County from bankruptcy, today, after the fact, our role is not to speak to poor political judgments, ill-advised investment strategies or plain old mismanagement. The investment decisions and the risks undertaken by those charged by the voters with managing the County's money are not within the province of federal regulators to second guess. The failure to disclose those decisions and the risk associated with that fiscal policy are, indeed, very much within the province of the Commission to speak to, particularly where they are material to investors in the County's securities. Now, if I worried too much about what the critics say, my hair would be grayer than it already is. Our Enforcement policy is not driven by headlines. The only headline I'm interested in seeing, is the one that reads "Investors get a fair shake, issuers get it right." Conclusion Where does all this leave us? I'd like to close by saying, "Trust me I'm the Director of Enforcement and I'm here to help you", but I'm afraid I'd never make it to the door. All of us have the same objective with respect to this market -- to have the most liquid, efficient and safest vehicle for municipal finance possible. We may disagree about how we get there, but our goal is the same. I can promise you -- we will do our part. We will be tough where need be, and without apology. We will also be fair. If we succeed in raising the standard of behavior, the quality of disclosure and the efficiency of the market, then this effort will have been well worth it for investors, for taxpayers and for municipal governments.