Speech by SEC Staff:
Giving the Dirt on
Paul S. Maco
Stephen J. Weinstein
Office of Municipal Securities
U.S. Securities and Exchange Commission
To the Municipal Securities Rulemaking Board
Forum on Land-Secured Disclosure
September 1416, 1999
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement 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 authors' colleagues on the Commission staff.
Good afternoon. I want to extend my thanks and appreciation to both the Municipal Securities Rulemaking Board for organizing this series of seminars on land-based financings, as well as for the invitation to be your speaker, and to the National Federation of Municipal Analysts for their efforts to prepare Recommended Best Practices in Disclosure for Land Secured Debt Transactions
, the draft providing the subject matter for these seminars. I want to remind you at the outset that my comments today represent my own views and not necessarily those of the Commission, or my colleagues on the Commission staff.
Giving the dirt on land based financings is by no means a new topic. "The intimate connection between municipal debt troubles and real estate speculation has not yet been sufficiently stressed. Bonds, whether railroad aid, irrigation, drainage district or special assessment, have all too often been issued in aid of the real estate speculator and promoter, so much so that a large portion of all municipal debt difficulties could be summed up under the caption real estate bond defaults.'" Those words were written over sixty years ago by A.M. Hillhouse, J.D., Director of Research, Municipal Finance Officers' Association in his book Municipal Bonds, A Century of Experience
. In three separate chapters, captioned "Real Estate Boom Bonds," "Other Improvement Bonds," and "Special Assessment and Special District Defaults," Hillhouse examines and catalogues the causes of defaults in land based financings from New Jersey to Washington State and places in between through the nineteenth and early twentieth centuries.
Hillhouse is a good reference point for today's remarks for several reasons. Note at the outset that the study appeared only two years after creation of the Securities and Exchange Commission and enactment of the Securities Exchange Act of 1934, the second of six acts of legislation known as the federal securities laws. In the sixty-plus years since, numerous additional defaults in land based municipal bonds have occurred, as chronicled by Zane Mann's California Municipal Bond Advisor
, and others. Mann observes that of sixteen California bond issues defaulting in 1997, only one was not a land related deal. Some defaults have been the result of unforeseen changes in market conditions, others the product of out and out scams, still others somewhere on the spectrum in between, just as occurred in the century studied by Hillhouse. So, please note as well that the wisdom offered by Hillhouse's study and the many studies that followed did not bring an end to defaults in land based financings; neither did the federal securities laws.
Hillhouse and the federal securities laws pursue different paths. Hillhouse optimistically concludes his work with the chapter "Preventing Municipal Defaults," suggesting "drastic restrictions should be thrown around the issuance of special assessment bonds for improvements in undeveloped areas so as to prevent their becoming subsidies to real estate speculators and subdividers It should be required by statute that before bonds are issued, a certain percentage of the property must have been improved and in actual use," and other qualitative hurdles to issuance. Qualitative and other limits on municipal securities issuance have historically been adopted by state legislatures and I suspect Hillhouse included state legislatures in his intended audience.
The federal securities laws take a different path. Rather than qualitative hurdles, or what academics call "merit regulation," the core philosophy of federal securities regulation is based on disclosure. Justice Brandeis's elegant phrase, "sunlight is said to be the best of disinfectants," captures this philosophy, as does the much less elegant expression of my generation, "tell it like it is."
Investors buying bonds are, at the core, loaning money to the issuer. Understandably, they expect to be repaid, at the times and rate of interests specified. Investors expect true and complete information in making investment decisions. The federal securities laws are built upon the premise that an investor is entitled to full and fair disclosure in making investment decisions, such as choosing whether or not to buy a particular bond.
Municipal securities, including land based financings, are generally exempt from the registration and reporting provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. Transactions in municipal securities are, however, subject to the antifraud provisions found in both acts. These provisions prohibit any person, including municipal issuers and brokers, dealers and municipal securities dealers, from making a false or misleading statement of material fact, or omitting any material facts necessary to make statements made by that person not misleading, in connection with the offer, purchase or sale of any security.
Far from a "one size fits all" approach to regulation, the antifraud formula is both remarkably tailored and diverse. It is extraordinarily flexible in its capacity to address the unique, as well as the commonplace, generating disclosures that resemble each other in their completeness and accuracy, but differing in their individual details. Perhaps most relevant of all to the municipal marketplace, it mandates the truth without the tyranny of forms. Land based financings are a particularly diverse lot.
The economic muscle of the buy side, together with other manifestations of market demand such as voluntary guidelines, can be an important force shaping disclosure as well. As the Commission observed in March 1994, "in the absence of a statutory scheme for municipal securities registration and reporting, disclosure by municipal issuers has been governed by the demands of market participants and antifraud strictures." Legal liability under the antifraud provisions and market demands, in other words, drive municipal disclosure.
We are here today to talk about market demand, or more precisely, the shaping of market demand through adoption of best practices in disclosure. If accepted and employed by the municipal market, these best practices will take place within the framework of federal securities laws, particularly the antifraud provisions. They will supplement, not override this framework. So it is only sensible that you have that framework in mind today. Let me take a few minutes to review it, and then bring to your attention a few lessons you might gather from Commission enforcement actions of the antifraud provisions involving land based financings.
The antifraud provisions apply to a municipal issuer, as the Commission observed in March 1994, "when it releases information to the public that is reasonably expected to reach investors and the trading markets." So, when an issuer releases an official statement, files information with a NRMSIR, SID or the MSRB pursuant to a 15c2-12 contract, or otherwise speaks to investors, the antifraud provisions come into play. Let's focus for a moment on the 15c2-12 contract. The 1994 amendments to SEC Rule 15c2-12 require underwriters to make sure a contract is in place between issuers and bondholders under which issuers and obligated persons provide information to central repositories at least once a year, or more often if one or more of certain events occur. On these occasions, when issuers and obligated persons comply with the contract and speak to the market, the antifraud provisions apply.
While the disclosure commitments of the 15c2-12 contract must comply with the baseline of the Rule, they clearly may be expanded to include whatever market forces demand. Stated another way, under the existing regulatory framework, investors are invited to use their economic muscle to negotiate and add to the disclosure requirements contained in the contract. So, for example, participants in an offering are free to incorporate best practices in primary and continuing disclosure, investors are free to use their purchasing power to insist upon it, and financial advisers and underwriters, recognizing the demands of the markets, are free to advise such incorporation.
Considerable guidance is available on the operation of the municipal disclosure framework and application of the antifraud provisions. I have made reference several times today to one such source -- Commission releases, such as the interpretive release Statement of the Commission Regarding Disclosure Obligations of Municipal Securities Issuers and Others of March 1994. This release is a "must read" for all involved in the municipal offering process. In it the Commission reviews numerous municipal disclosure practices needing improvement in light of the antifraud provisions. One such example is the use of disclaimers.
Other releases are equally important. For example, the November 1994 release accompanying the adoption of amendments to Rule 15c2-12 includes a footnote discussing developers as obligated persons in land based financings.
Finally, instances of application of the antifraud provisions in Commission enforcement actions offer guidance within the context of actual transactions. These sources of guidance, including over one hundred forty enforcement proceedings, are listed in Municipal Securities Cases and Materials,
a compilation prepared by the Office of Municipal Securities that is scheduled to be available next week on the Commission's website. It may be found at www.sec.gov, under the Special Studies section of SEC Digests and Statements.
Eight of the over one hundred forty enforcement proceedings I mentioned a few moments ago involved land based financings. They include: SEC v. First California Capital Markets Group, Inc., H. Michael Richardson and Derrick Dumont; In re County of Nevada, City of Ione, Wasco Public Financing Authority, Virginia Horler and William McKay; SEC v. San Antonio Municipal Utility District No. 1, et al.; SEC v. Washington County Utility District, et al.; SEC v. Whatcom County Water District No. 13, et al.; SEC v. Reclamation District No. 2090, et al.; In Re Carl Hanauer & Co.; and In re Walston & Co., Inc. and Harrington.
Issuers, developers, financial advisers, appraisers, lawyers, underwriters and dealers in land based financings will find all these cases interesting, if uncomfortable reading.
Let me read a few excerpts from these proceedings as an example:
"The Order alleges that the Official Statement for the Nevada County offering contained misrepresentations and omissions concerning: (1) the value of the property to be developed; (2) the developer's ownership interest in the property; (3) the developer's experience and financial condition; (4) cost estimates to complete the project; and (5) how the project would be financed by the developer and Nevada County .The misrepresentations in the Nevada County Official Statements were material to investors because they directly addressed the security of the bonds. These misrepresentations significantly altered the total mix of information available to the investors . Despite its retention of professional advisers and appraisers, Nevada County remained legally responsible for any misrepresentations and/or omissions in the Nevada County Official Statement."
[In re County of Nevada, City of Ione, Wasco Public Financing Authority, Virginia Horler and William McKay; In re County of Nevada]
The respondents consented to entry of the Order without admitting or denying the allegations.
"The fact that bond issues under the California Improvement Bond Act of 1915 and other similar acts had been widely used by cities, counties and special districts in California made it all the more necessary to inform purchasers of the Rio Ramza bonds that in this case the assessment district was merely the newly-formed instrument of an inexperienced developer and consisted of one tract of undeveloped land not a part of any established community, and that service of the bonds depended entirely on the sale of lots in the district." [In re Walston & Co., Inc., and Harrington, 1967] The respondents consented to entry of the Order without admitting or denying the allegations.
Complaint "allegations state that the sales of Series A of the approved bond issue were made through the use of material misrepresentations and omissions in that investors were led to believe: that real estate lots in Peaceful Valley Subdivision were available for sale or had been sold when, in fact, no lots had been sold; that the defendants would be responsible for repayment of the bond principal and interest in event of defaults on the assessments or if the real estate lots are not sold when, in fact, such assurances were not part of the bond issue and the defendants did not disclose any capability of fulfilling such financial responsibility; that the defendants owned the real property free and clear when, in fact, there were substantial underlying real estate contracts, mortgages, deeds of trust and security interests; that the District's Commissioners were independent from the developers when, in fact, the commissioners of the District had an interest, directly or indirectly, in the development of the Peaceful Valley Subdivision and are related to each other through birth or marriage; and, investors received no financial information for either the District, or the individual defendants." [SEC v. Whatcom County Water District No. 13, et al., 1977] The defendants consented to entry of an injunction without admitting or denying the allegations.
"The Complaint alleges that the disclosure documents used in connection with the offering and sale to the public of the District's Bonds omitted to disclose a multifaceted financing agreement and financial information about the Developer." [SEC v. San Antonio Municipal Utility District No. 1, et al., 1977] The defendants consented to entry of an injunction without admitting or denying the allegations.
"The complaint alleges that the defendants have made numerous untrue statements of material facts with respect to the use of proceeds obtained from the sale of the securities; the purposes for which the bonds were issued; the priority of liens on property owned by [Washington County Utility District] or its divisions; the sufficiency of revenues from WCUD projects to meet operating expenses and to pay interest and principal on the bonds as due; and other matters. Furthermore, the complaint alleges that the defendants have omitted to state numerous material facts, specifically including the fact that WCUD bonds were sold at very substantial discounts to the fiscal agent, Alcock,; that proceeds from the sale of the bonds were being utilized for unauthorized purposes such as loans to Patrick, the manager of WCUD, and to companies controlled by him or his relatives, and to pay interest on prior bond issues; and that Patrick was receiving from Alcock portions of the fiscal agents fees." [SEC v. Washington County Utility District, et al., 1977] The defendants consented to entry of an injunction without admitting or denying the allegations.
"The Complaint alleges that the offering circular contained false and misleading statements and omitted to state material facts of investors concerning, among other things: (1) the use of proceeds derived from the note sales; (2) the underwriting discounts and commissions received by the sellers of the promissory notes; (3) the financial condition of the District; (4) the operating history of the District; (5) the debt structure of the District; and (6) the risk factors involved in a purchase of the District's promissory notes." [SEC v. Reclamation District No. 2090, et al., 1976] The defendants consented to entry of an injunction without admitting or denying the allegations.
Some market participants have expressed concerns that the "facts and circumstances" approach of the antifraud provisions is complex and does not provide them the certainty offered by a checklist approach. On the contrary, I would suggest it is rather simple and based upon common sense. I suspect that the disclosure items in the proceedings I reviewed are things that you would want to know before you made an investment of your own. That's not a bad place to start. Most disclosure for financing projects has a three-part "can they build it, will they come, and how will they pay me back?" character to it. Ask and answer these questions when preparing disclosure and look to the guidance offered by the Commission.
The Commission has continually provided the municipal market with ample notice of its point of view on proper disclosure in land based and other municipal financings. It has been doing so for some time -- one proceeding I just quoted dates from 1967. Obviously, issuers, underwriters, lawyers, appraisers, financial advisors and others participating in disclosure preparation for land based financings would be wise to heed the warnings of these and other past enforcement actions. Issuers, in particular, should be sure the lawyers they hire are familiar with Commission guidance.
It is wise as well to follow best practices. When it approved the amendments to Rule 15c2-12 five years ago, the Commission observed existing sound practices such as following voluntary guidelines issued by the Government Finance Officers' Association and NFMA. "Although those guidelines are not mandatory," it said, "the Commission encourages market participants to continue to refer to those voluntary guidelines and the Commission's Interpretive Release," as well as the antifraud provisions, in preparing disclosure documents.
Sixty years ago, Hillhouse observed that "a hundred years of borrowing have produced many a blot on the municipal escutcheon." In the intervening sixty years, many a blot has been added, and doubtless many more are to come. We have the potential to reduce the blots accruing from fraud. You can be sure that the Commission will continue to do its part through vigorous enforcement of the securities laws. Market participants however, can do much more, however, through conscientious adherence to the law and the development and implementation of best practices.
The NFMA deserves appropriate credit for this undertaking to develop best practices. I offer the observation that the initiation of practices is at a minimum a two step process: first, development and second, adoption for routine use by the issuers, lawyers, advisers and underwriters involved in the day to day work of disclosure preparation. History and human nature both suggest that when those parties are so involved in the first, or development step that they have a sense of ownership of the best practices, the second, or implementation, step may be much more readily accomplished. It is my strong hope that the NFMA succeeds in developing best practices that are quickly embraced by the marketplace and that truly are the best -- for investors and for all participants in the municipal market.
SEC v. First California Capital Markets Group, Inc., H. Michael Richardson and Derrick Dumont Civ. No. 97-2761-SI (N.D. Cal.), Litigation Release No. 15423 (July 28, 1997) and 16107 (April 7, 1999); In re County of Nevada, City of Ione, Wasco Public Financing Authority, Virginia Horler and William McKay, Securities Act Release No. 7503, Exchange Act Release No. 39612, A.P. File No. 3-9542 (February 2, 1998); SEC v. San Antonio Municipal Utility District No. 1, et al. Civ. Action No. H-77-1868 (S.D. Tex.), Litigation Release No. 8195 (November 18, 1977); SEC v. Washington County Utility District, et al. Civ. Action No. 2-77-15 (E.D. Tenn.), Litigation Release No. 7782 (February 15, 1977); SEC v. Whatcom County Water District No. 13, et al. , Civ. Action No. C77-103, (W.D. Wash.), Litigation Release No. 7810 (March 7, 1977); SEC v. Reclamation District No. 2090, et al. Civ. Action No. 76-1231-SAW (N.D. Cal.), Litigation Release No. 7460 (June 22, 1976); In Re Carl Hanauer & Co. Exchange Act Release No. 9099, A.P. File No. 3-723 (March 12, 1971); and In re Walston & Co., Inc. and Harrington, Exchange Act Release No. 8165 (September 22, 1967).