Remarks at the 45th Annual Rocky Mountain Securities Conference
Commissioner Daniel M. Gallagher
U.S. Securities and Exchange Commission
May 10, 2013
Thanks, Don [Hoerl], for that very kind introduction. I am very glad to be back with you this year.
I must, of course, remind you that my remarks this morning are my own and that they do not necessarily reflect the views of the Commission or my fellow Commissioners.
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When I joined you for this esteemed conference last year, it was the first time I participated as a Commissioner. Another first on that trip was my initial visit to a regional SEC office as a Commissioner, as I was able to meet with the Denver office the day before last year's conference. If you know anyone from our Denver staff — or our Salt Lake City staff, with whom I was privileged to meet yesterday — you know that they are incredibly talented and dedicated. And if you're a member of one of those offices, I want you to know that the agency is very lucky to have you. In fact, I have now had the opportunity to visit with all of the SEC regional offices with the exception of Fort Worth, and I can tell you that our regional staff are exceptional across the board. That's a lot of pressure for Fort Worth, I know, but I assume they will make the grade!
Having a regional presence across the country remains a key to the Commission's effectiveness, particularly where our inspection, examination, and enforcement activities are concerned. If you find yourself thinking, as it would be easy to do, that New York and a couple of other U.S. financial centers are where America's business gets done, think again. America's businesses, and the entrepreneurial energy behind them, have always been national in scope. Unfortunately, fraud and other forms of financial malfeasance also span the country, so if we are to be effective, we need experienced, sophisticated staff in regional offices across the continent. Computers link us together as never before, but they don't inspect regulated firms and they definitely don't go to court.
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Last year at this conference, I commented on the creation of specialty practice groups in the Division of Enforcement. We've gotten used to the idea now, as the specialty groups have had a few years to grow and develop. These groups help the Commission deploy its accumulated knowledge in a more focused manner than would otherwise be possible. It's similar to the specialized structure commonplace in most law firms.
As a Commissioner — that is, as one of the staff's five principal clients — I think that's good. It points to greater effectiveness and efficiency in pursuing investigations and enforcement action. I have always thought that the SEC's annual plea for more appropriated "resources" — which translates to more people and money — is much more persuasive when we can show that we are using our existing staff and technology as effectively as possible — even when that requires us to change our longstanding work habits. A great example of this is OCIE's Risk Analysis Exam Team, which comprises just three staffers, but uses technology to do the work of hundreds.
Each year, the SEC trumpets its enforcement statistics.1 And over the past month or so, news stories have suggested that the Division's pipeline of cases, and in particular "financial crisis" cases, is shrinking.2 But, that does not mean that overall SEC enforcement activity is waning. Numbers alone don't tell the full story of the Enforcement Division's work, let alone put it into its proper context. For example, annual enforcement totals invariably include a large percentage of Exchange Act section 12(j) and follow-on administrative proceedings.3 To be sure, these types of cases are important to the Commission's mission — but they are far less time and resource intensive than a major accounting, insider trading, or regulated entity investigation. Sure, quantity is an easy way to measure, and it's a good place to start. But case quality is more important, though it's harder to measure, and certainly hard to advertise. I hope the SEC can find a way to move past the fascination with quantity and re-focus on the many quality cases brought each year.
As our specialty groups take root, one would expect the number of high quality cases in those specialty areas to increase. And we have tangible evidence of this progress coming from one the specialty groups that I would like to focus on this morning — the Municipal Securities and Public Pensions unit, which is headed very ably by Elaine Greenberg of our Philadelphia Regional Office.
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I have two principal reasons for focusing on the municipal securities specialty group this morning. First, the municipal securities market is huge — there was $3.7 trillion in outstanding municipal debt in 2012.4 Second, municipal securities are extremely important to millions of ordinary Americans. Not only does muni debt finance local public works for taxpayers, but three-quarters of municipal bonds are held by retail investors. And the level of direct retail participation — meaning bonds held directly by individual investors — is an amazing 45 percent. Municipal securities are, moreover, central to many individuals' retirement planning. "Baby boomers" have long been counseled that municipal bonds are low-risk investments that should be at the heart of a stable, income-oriented portfolio. That has been the conventional wisdom: Move from equities to fixed income, including municipal securities, as you age.
When you focus on the scope of the municipal securities market and the scale and nature of its retail component, you quickly understand how critical it is that the SEC be a sophisticated regulator of those markets, as well as the cop on the muni market beat. Municipal market oversight cleanly invokes all three prongs of the SEC's statutory mandate: (1) the muni markets are essential for state and local capital formation; (2) ensuring fair and efficient muni markets benefits both investors and issuers; and (3) with a regime focused on transparency and rigorous enforcement of violations against issuers and their employees, we can protect municipal investors.
In that context, it is counterintuitive that the SEC has historically devoted a very small proportion of its resources and its attention to the municipal securities markets. For example, when I was asked to serve as a Deputy Director of the Division of Trading and Markets, our municipal securities group had a grand total of two staff members. Now, to be fair, these were two stellar staffers, but relative to the size and complexity of the muni markets they were like the Spartans going up against the Persians in Thermopylae. One of the very few provisions of the Dodd-Frank Act that I genuinely welcome is the legislative nudge to create a new Office of Municipal Securities.5 This operational mandate is certainly not responsive to the financial crisis, but it did meet a pressing need. I am hopeful that this new office will be the bedrock upon which the SEC can develop a sophisticated understanding of and oversight program for the municipal markets. The head of the office, John Cross, is already making excellent strides in that direction. And I further hope that we can do the same for the corporate debt markets, as they dwarf even the muni markets in the amount of debt outstanding6 — and I appreciate the leadership of Tom Eady in our Division of Trading and Markets on those issues. This makes good sense as we continue to pursue a Dodd-Frank mandated oversight regime for a narrow slice of the derivatives markets. The derivative, fixed income, and equities markets may seem unrelated, but they are very closely intertwined and the SEC must move toward a more sophisticated understanding of the interplay between and among these markets. Merging the SEC and CFTC so we could add in the futures markets would make good sense, too, but I am not going to hold my breath for that.
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At the SEC's recent Fixed Income Roundtable,7 I pointed out that the combination of rising interest rates and municipality credit risk — essentially, the risk of municipal defaults or even bankruptcies, which is a real issue in California and several other states — could create disastrous conditions in this massive, retail-dominated portion of the securities markets. The risk of defaults on what have long been considered "safe" fixed income investments, positioned at the heart of many seniors' retirement portfolios, are, though hopefully remote, higher than ever. An even greater risk is that rising interest rates will depress municipal bond prices for investors who must sell their bonds before they have matured. And I believe the average retail investor's understanding of these twin risks — the risk to what they probably regard as the safest portion of their investment portfolios — is low.8
And so, it would be prudent, at a minimum, to make a far greater effort to educate investors about the risks inherent in investing in municipal securities under current economic conditions. This is not a matter of regulatory paternalism. It is, however, about improved investor education and awareness — and it goes hand-in-hand with rooting out fraud in those markets. I know this point is not lost on our Office of Investor Education and Assistance, and I look forward to working with OIEA and FINRA to implement investor education initiatives in this area.
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Increased attention to the municipal securities markets is also apparent in our Division of Enforcement. While the SEC has a long history of bringing actions to enforce the antifraud provisions of our securities laws with respect to participants in the municipal securities market, there has been a noticeable uptick in that activity over the last couple of years. This uptick may result from a combination of market conditions and the creation of the municipal securities specialty group. Under current conditions, the municipal issuer's incentive to raise funds through issuing bonds is unusually high, but so is the risk that the expected revenue to repay the bonds will fall short of the assumed cash flows. Under economic conditions this precarious, the motive for engaging in fraudulent conduct in connection with a municipal securities issuance may be especially high.
Now, it is true that the federal securities laws do not permit the SEC to regulate municipal issuers in the way that we regulate corporate issuers. Direct regulation of municipal issuers is reserved to the states.9 But that does not limit the SEC's ability to apply the antifraud provisions of the federal securities laws to the actions of municipal securities issuers and other market participants. And, as I have noted, when economic times are bad and municipalities face significant fiscal challenges, the conditions exist in which fraudulent activity can flourish in connection with municipal securities. Historically, the SEC's enforcement experience suggests a correlation between municipal fraud actions and municipal duress or bankruptcies. Let me cite three examples, two of them very recent.
First, just this week the Commission announced a settled cease-and-desist action against the City of Harrisburg, Pennsylvania, alleging fraudulent misstatements and material omissions by the City.10 The Commission's concern in the Harrisburg case had to do with material misstatements and omissions by public officials that, over time, had the cumulative effect of misinforming the secondary market about the City's actual financial condition and, therefore, about its ability to repay bonds that financed a resource recovery facility.11 The City posted a variety of relevant information on its public website, but, for example, failed to disclose a downgrade in the credit rating on its general obligation debt. The City also did not disclose how much of the debt on the resource recovery facility would have to be repaid directly from the City's general fund — certainly an indication that the bonds were not likely to be repaid as intended at the time of issuance.
As too often happens in these types of cases, the Commission did not pursue actions against individuals. However, the Commission's section 21(a) report in the Harrisburg case points out that statements by City officials were, under the circumstances, an important element of the total mix of information available to the market, and that a reasonable investor would likely have wanted to evaluate the City's financial condition when considering an investment in its resource recovery project bonds.12 The Report points out that, "[g]iven this potential for liability, public officials who make public statements concerning the municipal issuer should consider taking steps to reduce the risk of misleading investors," including "adopting policies and procedures that are reasonably designed to result in accurate, timely, and complete public disclosures" — something the City of Harrisburg has since done.
As Mark Twain once said, history may not repeat itself — but it often rhymes. The Commission's Harrisburg 21(a) report had precedent in a similar report issued in 1996 with respect to the bankruptcy of Orange County, California.13 There, the Commission cautioned those participating in the primary market for municipal securities, especially with respect to securities offering documents. Orange County officials had failed to disclose all material information they knew concerning the County's financial condition. If they had disclosed that information — which the County's Board of Supervisors unquestionably had in its possession — then potential investors would have had reason to question the county's ability to repay its municipal securities in accordance with their offering terms. The Commission noted that it was issuing its 21(a) report "to emphasize the responsibilities under the federal securities laws of local government officials who authorize the issuance of municipal securities and related disclosure documents ."14 The Commission's report explained that "a public official may not authorize disclosure that the official knows to be false; nor may a public official authorize disclosure while recklessly disregarding facts that indicate that there is a risk that the disclosure may be misleading."15
In another recent case, the Commission two weeks ago built directly on this admonition in the Orange County report in an action against the city of Victorville in southern California.16 As alleged in the complaint, the Victorville case stems from two fundamental factual components. First were the actions taken by Victorville officials. The responsible city official signed off on a property valuation over fifty percent higher than what the county assessor had told him was appropriate. This was critical, because the bonds were to be repaid from the tax increase attributable to the higher property valuation.17 Second were the issuer's statements: The City's Director of Economic Development passed the county assessor's disappointingly low valuation on to the underwriter, who used the higher valuation in the Official Statement.
The combined effect was to justify a bond size in excess of what the project in question could reasonably support. Lowering the property valuation would have reduced the increase in tax revenue that would support the bonds' repayment. Both the City's Director of Economic Development and the underwriter knew that the misrepresentation as to the property valuation made the bonds look like a safer investment than they were. The risk of default was, in fact, higher than had been disclosed in the Official Statement.18 Importantly, in this matter the Commission is pursuing an action against individuals — not only the underwriter's two key officers, but also the City's former Director of Economic Development — charging that they aided and abetted the City's fraud violations by causing inflated property valuations to be provided in connection with the bonds' issuance.
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The Orange County and Harrisburg matters are settled, and the Victorville case is now in court.19 The important point to be made here is that these cases did not just fall from the sky. The Commission has on several occasions — most notably in its 21(a) reports, promulgation of Rule 15c2-12, the 2012 Report on the Municipal Securities Market, the 1994 Interpretive Guidance,20 and in enforcement cases — made very clear how those active in the primary and secondary municipal markets should understand their obligations under the antifraud provisions of the federal securities laws.
I hope that both the Victorville action and the Harrisburg section 21(a) report have enhanced and updated market participants' awareness of these issues. Taken together, I think they make an additional point worth stressing. Although cities and municipal issuers are distinct legal entities, in fact they act through individuals. And they meet their primary and continuing disclosure obligations under state and federal law through the conduct of public officials. So when we find material misstatements or omissions by public officials in connection with municipal securities, we can, should, and will take action to hold the appropriate public officials accountable.
Once again, thank you for your attention this morning. I wish you an interesting, productive, and enjoyable conference.
1 For example, referring to 2011 activity and the reorganization of the Division of Enforcement, then-Chairman Schapiro, noted "record results
[L]ast year the SEC brought a record 735 enforcement actions, obtained orders for $2.8 billion in penalties and disgorgements," and "returned more than $2 billion to wronged investors. In the area of financial crisis-related cases, we filed charges against nearly 100 individuals and entities." Remarks at the Practising Law Institute's SEC Speaks, Chairman M.L. Schapiro (Feb. 24, 2012).
2 See, e.g., B. Protess, Senior S.E.C. Officials Depart, The New York Times (May 2, 2013) (SEC "on pace to file the lowest number of enforcement cases in a decade"); J. Gallu, "SEC's Canellos Says Enforcers Shifting to Dodd-Frank," Bloomberg (April 26, 2013) (SEC to focus on enforcing Dodd-Frank regulations as "the agency wraps up cases linked to the credit market turmoil of 2008"); J. Eaglesham, "Number of Cases Filed by SEC Slows," The Wall Street Journal (March 18, 2013) (SEC "filing significantly fewer civil fraud cases this year, as its efforts to punish misconduct related to the financial crisis start to ebb").
3 Others have noticed this tendency. See, e.g., J. Gallu, "SEC Boosts Tally of Enforcement Successes with Routine Actions," Bloomberg (Feb. 22, 2013). "[T]he agency has touted record numbers of enforcement actions . Those gains, however, came mainly from a jump in routine administrative proceedings . Excluding those cases, the number of new actions in 2011 and 2012 trailed output in 2009 ." J. Gallu, "SEC to Move Past Financial Crisis Cases under New Chairman White," Bloomberg (April 18, 2013).
4 See, e.g., SEC Report on the Municipal Securities Market (July 31, 2012), at 1.
5 Dodd-Frank Act, sec. 979. By statute, the Director of the new Office reports directly to the Chairman (sec. 979(b)).
6 The SEC staff estimates that, in 2012, the corporate bond market was comprised of $10.8 trillion in outstanding debt, of which $1.7 trillion was asset-backed securities. The retail participation rate was approximately 48 percent.
7 April 16, 2013.
8 See, e.g., summary of Roundtable remarks in J. Benjamin, "SEC member Gallagher defiant on comment," Investment News (April 28, 2013).
9 Securities Act sec. 3(a)(2) and 12(a)(2); Exchange Act sec. 3(a)(12) and 3(a)(29); Exchange Act sec. 15B(d)(1) (the "Tower Amendment").
10 SEC Rel. No. 2013-82 (May 6, 2013).
11 SEC Rule 15c2-12 requires underwriters of municipal securities to ensure that issuers agree to provide certain information about their finances and other events on an ongoing basis, through the Municipal Securities Rulemaking Board's "EMMA" website.
12 Report of Investigation in the Matter of the City of Harrisburg, Pennsylvania Concerning the Potential Liability of Public Officials with regard to Disclosure Obligations in the Secondary Market, Exchange Act Release No. 69516 (May 6, 2013).
13 Report of Investigation in the Matter of County of Orange, California, as it Relates to the Conduct of the Members of the Board of Supervisors, Exchange Act Release No. 36761 (January 24, 1996).
14 Id. at text accompanying note 5.
15 Id. at text following note 6.
16 See Rel. No. 2013-75 (April 29, 2013); SEC Lit. Rel. No. 22690 (April 29, 2013).
17 The land in question, a redevelopment site that became available when an Air Force base closed, required a loan that was to be repaid, in part, by proceeds from a new bond issue.
18 The Commission's action also charges the underwriter with unauthorized draws on an agreed construction management fee, as well as with invention of an undisclosed property management fee by which it is alleged to have siphoned off $2.3 million in misappropriated bond proceeds.
19 Case No. EDCV13-0776 (CD Cal.), filed April 29, 2013.
20 SEC Rel. No. 33-7049; 34-33741 (March 9, 1994) (1994 Interpretive Guidance).