Speech by SEC Staff:
Securities Laws and the Municipal Market: Points Every Issuer Should Keep in Mind
Paul S. Maco
Director, Office of Municipal Securities
U.S. Securities and Exchange Commission
Before the New York State Government Finance Officers Association,
West Point, New York
October 1, 1999
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 author and do not necessarily reflect the views of the Commission or of the author's colleagues on the Commission staff.
Good morning. Thank you for inviting me to join you today. Today I'd like to discuss some securities law issues of importance to issuers of municipal bonds. Before I go any further, I must remind you that my comments here today reflect my own point of view, which is not necessarily shared by my colleagues on the Securities and Exchange Commission's staff, or by the Commission.
My name is Paul Maco and I am the Director of the Office of Municipal Securities at the Securities and Exchange Commission in Washington. Like most of the folks in my office, however, I am also a bond lawyer. Actually, for most of my career, I was in private practice, helping communities like your communities borrow in the bond market. I began that practice here, in New York State, advising issuers like yourselves.
Local governments have been issuing municipal bonds in the United States for almost two hundred years. The size of today's market may surprise you approximately $1.5 trillion of municipal bonds are currently outstanding in the United States. More than 73% of this amount is held by individual investors either directly or through mutual funds, according to the most recent quarterly data, as published in the Bond Buyer last week. Last year, New York communities led the nation, issuing over $36 billion in the municipal bond market in over 700 offerings.
I understand that most of you issue municipal bonds. Some of you may do so more frequently than others, but when you do, a few things happen that I think are good for anyone involved to keep in mind. I want to talk a bit with you today about those things and, of course, answer your questions as best I can.
The easiest way I can think of to sum these things up is that issuing bonds is like meeting new people and learning about new laws. Like meeting anyone for the first time, or renewing the acquaintance, if you're like me, you hope the meeting goes well and it's one you can look back on with satisfaction. Let me assure you, even though lawyers are involved, this can be the result. The great majority of the time, it is the result. And I hope that for you it will always be the result.
First: how is it like meeting new people? When you issue bonds, as opposed to borrowing from the bank, you meet a new group of people investors those who consider buying and those who actually buy your bonds. Who are they? They may be a young couple in Wisconsin setting aside money for a child's education. They may be a much older couple in Florida saving for retirement and minimizing the taxes they pay. Or they may be a neighbor, simply using a tax-exempt money market fund to manage their own day-to-day funds. Quite often, they are just like you and me.
You may not always know much about them, but there is a lot they want to know about you. What they do come to know about you may be from any number of sources, but the principal way will be through your official statement and the annual information you provide. This information is known as "disclosure." That information is very important to them, for it may affect their decision to invest in your bonds over some other municipality's bonds.
The folks whose money you borrow expect your disclosure to be true, just as they expect you to repay the money you borrow. Not surprisingly, so does the law. This is where we at the Securities and Exchange Commission come in. Federal securities law has protected investors for over sixty five years by requiring the information provided investors be accurate, complete and not misleading. Issuers of municipal bonds such as yourselves are generally exempt from most of the federal securities laws, but not from those sections forbidding misleading statements or omitting material facts from the disclosure you make in official statements and annual financial information. Those provisions known as the antifraud provisions apply to any person. I will come back to the antifraud provisions in a few moments, with a few things you should remember about them, but right now I ask you to remember one very important thing about them you should be sure your lawyer, and anyone else who helps you prepare your official statement, is familiar with them. If they are not, unfortunately, you may be the one to pay the price.
When you issue bonds, you also encounter another set of federal laws the tax code. The interest on most municipal bonds is exempt from federal income taxation and often from state income taxation. From an investor's point of view, tax exemption is a very important feature of municipal bonds. From your point of view, the lower borrowing rate is undoubtedly important. Of course you can imagine how unhappy an investor would be to learn that supposedly tax-exempt bonds were in fact taxable. Misleading facts in disclosure as to the tax status of municipal bonds may be fraud under the securities laws. The SEC has brought several enforcement actions based on misleading disclosure of facts affecting the tax status of municipal bonds. In several cases where bonds have been declared taxable, the Internal Revenue Service has looked first to the issuer to pay the penalty. Once again, I ask you to be sure your lawyer who gives the opinion that your bonds are tax exempt understands the tax law and is competent to advise you in such matters. If they are not, it may hurt you and your investors.
I mentioned a few moments ago that based on your disclosure, an investor may decide whether or not to buy your bonds. Some consider this decision so important that they refer to bondholders as a second constituency. If your financial operations depend upon borrowing in the bond market as well as your tax base, you may understand how they come to feel this way. Each time you return to the bond market to borrow money, you ask this constituency to vote for you again. If bondholders have a pleasant meeting in your first encounter, they are more likely to pursue additional meetings or vote for you by continuing to buy your bonds in the years ahead.
This idea that an investor may decide whether or not to buy your bonds based on the disclosure you provide that investor is at the heart of federal securities law and the antifraud provisions. That investor expects true and complete information in making an investment decision. In essence, the antifraud provisions say that any person may not make any untrue statement of a material fact or omit to state a material fact necessary to make something said not misleading in connection with the offer, purchase or sale of a security. Now, if you were paying close attention, you probably noticed the word "material" in my description. When courts apply the antifraud provisions, an omitted fact is material if there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by reasonable investors as having significantly altered the "total mix" of information made available. The focus of the law is on the information given to investors to make their investment decision.
Over the years, the Commission has devoted a good portion of its resources to enforcing the antifraud provisions. If you look at our recent Annual Report, you will see that over the last five years, the Commission has brought on average approximately 475 cases each year. In those five years combined, we have brought over 75 cases against participants in municipal securities transactions.
Our cases involving the municipal securities markets include actions against underwriters, financial advisors, accountants, consultants, bond counsel, issuers and issuer officials. The securities law violations involved include misleading disclosure in use of proceeds, risks associated with the borrowing, stale and incomplete accounting information and matters affecting the tax status of the bonds.
We have compiled most of the cases involving municipal bonds the Commission has brought over the last thirty years, together with other Commission guidance, and are providing the compilation to bond lawyers at a variety of different seminars this year. While these materials have always been available to lawyers in law libraries, we want to make it even easier for them to access it. You may want to make sure the lawyers you hire to help you prepare disclosure are familiar with this information. They have little excuse not to be familiar with it. This compendium, as well as new cases may be accessed on our web site at www.sec.gov
You may be particularly interested in a few of the cases involving issuers and issuer officials. Many of the more recent cases involve bond issues involving the investment pools of Orange County, California. You may recall that four years ago, Orange County filed for bankruptcy following difficulties relating to its investment pools. The Commission settled its enforcement proceedings with the County and the County Board of Supervisors, as well as the former County Treasurer and Assistant Treasurer for misleading disclosure, including failure to reveal the risks associated with investing in the pools and certain facts affecting the tax status of the notes. The Commission also issued a report critical of the conduct of the members of the Board of Supervisors.
The Commission has also initiated proceedings against several communities in California that issued notes to invest in the pool, alleging failure to disclose the purpose of the borrowing and risks associated with the investment. Five out of six of these communities settled and one community is currently in litigation with the Commission.
The Commission has also settled proceedings with Maricopa County, Arizona and Syracuse, New York arising from stale and misleading accounting information provided to investors. Just last week, the Commission initiated an administrative proceeding against the City of Miami, Florida, and two of its former officials.
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.
Considerable guidance is available on the operation of the municipal disclosure framework and application of the antifraud provisions, 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. Under the caption, "Areas Where Improvement is Needed," the Commission reviews numerous municipal disclosure practices, organized in six general headings, needing improvement in light of the antifraud provisions.
For example, one area singled out as needing improvement was "Conflicts of Interest and Other Relationships or Practices." Here, the Commission observed, "If, for example, the issuer (or any person acting on its behalf) selects an underwriter, syndicate or selling group member, expert, counsel or other party who has a direct or indirect (for example, through a consultant) financial or business relationship or arrangement with persons connected with the offering process, that relationship or arrangement may be material. Areas of particular concern are undisclosed payments to obtain underwriting assignments and undisclosed agreements or arrangements, including fee splitting, between financial advisers and underwriters."
Under "Financial Information," the Commission observed, "In addition, issuers must assess whether the future impact of currently known facts mandate disclosure….For example, in a hospital financing, a steadily declining population in the surrounding community that, in the future, would not support the size of the facility to be built would be important to investors."
Under "Delivery of Official Statements," the Commission observed that it "anticipated that, in order to allow underwriters to meet their obligation to have a reasonable basis for recommending any municipal securities, issuers would have to begin drafting disclosure documents earlier, and perhaps with greater care than in the past."
In a separate section of the Release captioned "Disclosure in the Secondary Market for Municipal Securities," the Commission stated "A municipal issuer may not be subject to the mandated continuous reporting requirements of the Exchange Act, but when it releases information to the public that is reasonably expected to reach investors and the trading markets, those disclosures are subject to the antifraud provisions."
Still later in the Release, the Commission stated: "In light of the underwriter's obligation, as discussed in the prior releases, to review the official statement and to have a reasonable basis for its belief in the accuracy and completeness of the official statement's key representations, disclaimers by underwriters of responsibility for the information provided by the issuer or other parties, without further clarification regarding the underwriter's belief as to accuracy, and the basis therefor, are misleading and should not be included in official statements."
The release contains many more instances of disclosure practices that, in the Commission's view, need improvement. Many recent municipal enforcement actions brought by the Commission involve one or more of these shortcomings. Yet, although the Commission offered this "heads up" to the municipal market over five years ago, some bond counsel, as well as other market participants, appear to be unaware of it. You may want to review it with your professionals before your next offering and see if the problem areas identified still exist in your disclosure.
One message for issuers that rings clear through many of the cases the Commission has brought involving municipal bonds is know the professionals you hire. More than a few of the proceedings involve breach of fiduciary duty by financial advisors to issuer clients.
In recent years, we have brought actions against underwriters and financial advisors for failure to disclose payments from third parties that sold or brokered investments to municipal issuers. Last year, the Commission found O'Brien Partners in violation of investment advisory laws by failing to adequately disclose to issuers that while providing advisory services to these issuers, O'Brien Partners also was receiving payments from guaranteed investment contract brokers used by these issuers to invest their bond proceeds. Find out if somebody is getting a kickback in exchange for your business.
If somebody is trying to sell you something, find out what is in it for them. Our recent yield-burning actions are a case in point. In a recently settled yield-burning case, the Commission charged Lazard Frères with violating its fiduciary obligations to issuers by failing to disclose to them the excessive markups and profits it took from selling them securities for refunding escrows.
In their textbook, Securities Regulation, Professors Soderquist and Gabaldon instruct lawyers to recognize two dramatically different perspectives lawyers may take on securities law: that of the planner and that of the litigator. The planner counsels the client away from the precipice, recognizing the danger of liability. The litigator is often faced with the challenge of arguing back from over the edge of the precipice of liability.
Where liability finally depends upon the facts and circumstances reviewed by a court, there may be situations in which some information, in a particular setting of facts and circumstances, ultimately would not be found material by a court. Lawyers should keep this planner/litigator distinction in mind when advising clients about the antifraud provisions and disclosure. Issuers, developers and underwriters should be conscious of it too.
If you are being advised by an aggressive litigator, recognize that you are being taken for a walk along the edge of the precipice. Your lawyer may think you are close to, but not over, the edge. A court may see it otherwise and if you've gone over the edge, you are the one falling.
If safety is your concern, whether in the primary or secondary market, when in doubt, disclose.
Don't be afraid to ask your professionals questions and demand answers you understand. When investment bankers present you with complicated financial proposals, perhaps involving advance refundings, or interest rate swaps or derivative products, if you are not sure what they are talking about, ask questions. Don't be embarrassed because you're afraid they'll think you're asking about things you should already know. That's their job. Don't assume that just because they use a lot of financial jargon and talk fast that they are very sophisticated. If they can't explain it to your satisfaction, that may be a warning sign. Maybe the reason they can't explain it to you is that it doesn't make any sense.
Several years ago, the Commission worked with the National League of Cities, the Government Finance Officers Association and other groups representing issuers to prepare a booklet called "Questions to Ask Before You Approve a Municipal Bond Issue." It contains ten questions officials should ask themselves and their staff and five questions officials should ask outside professionals. I encourage you to get it and read it before each of your offerings, and share it with your colleagues.
In closing, I want to thank you and the members of the New York State Government Finance Officers Association for this opportunity. I also ask for your advice. This is the one of the first sessions of a series specifically designed for small issuers that my colleagues and I plan to participate in around the country. We want your suggestions as to how we could improve it. Please call or e-mail us. Our phone is 202-942-7300 and our e-mail is email@example.com. Also, please do not hesitate to call us anytime we may be of assistance to you. Thank you.