This is the second of a three-part series taking a look at the lasting effects of the Orange County Chapter 9 municipal bankruptcy on Dec. 6, 1994. In this article, securities law experts and market participants debate how the financial debacle compared to Enron Corp. and other scandals in the corporate market and what impact Orange County had on federal regulation and enforcement actions in the municipal market. The series concludes on Friday with a look at the bankruptcys impact on the derivatives market.
WASHINGTON Was the Orange County, Calif., financial disaster the Enron of the municipal market?
Some securities law experts and market participants are drawing that comparison 10 years after the countys Dec. 6, 1994, bankruptcy filing. Others are wary of comparing the two debacles.
Enron Corp. used an overly aggressive undisclosed accounting strategy that led to its demise as well as to a series of new governance and accounting reforms in the corporate market. Orange County used an overly aggressive, undisclosed investment strategy that resulted in its bankruptcy filing and focused federal regulators attention on municipal issuers and their responsibilities in the municipal market.
Orange County was the Enron for the municipal market in terms of making people wake up and realize there were problems, said one former Securities and Exchange Commission official who did not want to be identified.
Like Enron, Orange County was something of a watershed event, securities law experts said.
I think there was a presumption that the municipal market was not perfect, but it probably worked pretty well, said William R. McLucas, a former SEC enforcement director who is now a partner and co-chair of the securities law department at Wilmer Cutler Pickering Hale and Dorr here. Default rates were low, the risk assessment was not that high, and there was this assumption that there were professionals who were probably doing a decent job of policing the market.What you saw in Orange County was one guy having this idea and cooking up a series of high-risk investment strategies that ended up getting the entire county in trouble, McLucas continued. And but for one critic outside the county government, nobody until somebody pulled the plug out of the bottom of the bathtub stopped and said, What is this guy doing?
It scared the hell out of everyone and it made, in a sense, for a very sobering benchmark for law enforcement and for the SEC in terms of trying to set higher standards for conduct, disclosure, transparency, and professionalism in the municipal market, McLucas said.
Like Enron, Orange County led to a series of enforcement actions and litigation. In fact, Orange County was the first major crisis in the municipal market that led the SEC to take enforcement action. After the two previous municipal securities disasters New York Citys fiscal crisis in the mid-1970s and the Washington Public Power Supply Systems $2.25 billion bond default in the 1980s the SEC conducted studies and wrote reports, but it did not take enforcement action. WPPSS spurred the SEC to issue guidance and disclosure rules for the municipal market.
In the aftermath of Orange Countys bankruptcy filing, the SEC brought enforcement action against virtually every major market participant involved in the countys bond financings and investments the county, its treasurer and assistant treasurer, the countys board of supervisors, bond counsel, underwriters, financial advisers, and the firms who sold the county its investments and then helped it leverage them.
The SEC also took action against a handful of other local governments who invested in Orange Countys investment pool and then failed to disclose the risks associated with those investments in their own bond offering documents.
It showed that when something goes wrong, SEC enforcement can cast a very broad net, said Paul Maco, former director of the commissions Office of Municipal Securities who is now a partner at Vinson & Elkins here.But some municipal market participants are wary about comparing Orange County with Enron and point out key differences between the two debacles.
WARY OF COMPARISON
Personally I wouldnt make an Enron comparison, said Mark Zehner, regional municipal securities counsel in the SECs Philadelphia district office.
Enron was fundamentally about greed and was sort of emblematic of problems throughout corporate America. Here were people who were personally profiting enormously from lying about the success of Enron, Zehner said. Orange County was ultimately about a treasurer making unwise investments, but he didnt personally profit. Orange County was more about the vulnerability of a lot of municipal entities with respect to their investment practices and how those practices can bring down a government.
Another key difference is that while both the Enron and Orange County debacles involved violations of existing rules, as former SEC commissioner Richard Roberts pointed out, Enron and the corporate scandals that followed it led to the Sarbanes-Oxley Act of 2002, which established a series of governance and accounting reforms for the corporate market. The Orange County debacle came after the SEC had just put in place guidance and disclosure rules in the municipal market.
WPPSS massive bond default led the SEC in 1989 to adopt disclosure rules for new municipal bond issues in the primary market. Arthur Levitt, who became chairman of the SEC in mid-1993with strong support from Roberts and Maco, made regulation and enforcement of the muni market a priority after comparing it in an interview at that time to an Oriental bazaar. Levitt, who is now with Washington-based investment firm the Carlyle Group, declined to comment.
Under Levitt, the SEC in March 1994 issued an interpretative release describing the staffs views of municipal market participants obligations and responsibilities under the federal securities laws. The commission then proposed in March and adopted in November of that year, amendments to its Rule 15(c)(2)-(12) setting forth a framework for continuing disclosure in the secondary market. Those rules stipulated that, in order for dealers to be able to underwrite their bonds, municipal issuers would have to disclose financial and operating information on an annual basis and notices of material events whenever any events from a list of at least 11 or 12 occurred.
The SEC also stepped up its enforcement activity in the municipal market. But most of the initial enforcement cases dealt primarily with kickbacks and other alleged corruption not with the issuers and other transaction participants failure to disclose complete and accurate information about the issuers financial condition to investors.
SEC DRAWS FIRE
The SEC was lambasted by many dealers, issuers and other market participants for going too far in both the regulatory and enforcement arenas. Some market participants felt Levitts focus on the municipal market was unwarranted.
Less than a month before the final amendments to 15(c)(2)-(12) had been put into place and then through that whole period from March to November, the constant refrain was, There are never any problems in the municipal market, and then less than a month later you have the biggest meltdown ever to occur in the municipal market, Maco said.
There was a fair amount of criticism that the SEC was overreaching, McLucas said. Orange County caused people to be less vocal in their criticisms.
The Orange County debacle silenced the critics, at least temporarily, and provided the SEC with its first opportunity to show how the guidance and rules should be applied in the municipal market.
That was the first time the commission said, Here is how we apply the interpretative release and the continuing disclosure amendments to Rule 15(c)(2)-(12) to actual facts and circumstances, said Drew Kintzinger, a partner at Preston Gates & Ellis LLP in Seattle.It was the first time that the SEC brought actions against issuers and issuer officials, Maco said, adding, That certainly was a milestone. The previous cases involving issuers mostly involved conduit borrowers, not governments.
It basically gave the SEC a forum for trying to illustrate the responsibilities of issuers and issuer officials, said Robert Doty, president of the financial advisory firm American Governmental Financial Services Co. in Sacramento. Orange County really gave the SEC an opportunity to lay an enforcement foundation for the regulations and guidance they had issued.
To some extent, it was a watershed after which the SEC showed increased willingness to take action against issuers, said Fredric Weber, a partner at Fulbright & Jaworski LLP in Houston. In effect, it gave the SEC the muscle and political cover and strength to elevate enforcement in municipal securities.
The SEC, in settlements, sought and obtained permanent court injunctions against former Orange County treasurer Robert Citron and his assistant Matthew Raabe, prohibiting them against future securities law violations. The commission also settled securities law violations with the county, its flood control district and its board of supervisors, ordering them to cease and desist from further securities law violations.
In addition, the commission filed and settled securities law charges against several other localities in California that had invested in Orange Countys investment pool and then failed to disclose the risks of those investments in their municipal bond offering documents. Those cases all resulted in settlements.
Since the Orange County bankruptcy, the SEC has filed securities fraud charges for alleged disclosure failures against a number of issuers and borrowers, including more than 44 small towns in Mississippi, Maricopa County, Ariz., Nevada County, Calif., Syracuse, N.Y., Miami, the Massachusetts Turnpike and its former chairman, James K. Kerasiotes, the Neshannock Township School District in Lawrence County, Pa., and the Dauphin County, Pa., General Authority. The Neshannock school district was the first issuer to pay the SEC to settle securities fraud charges, paying $28,904 to settle charges over misrepresentations made about an arbitrage-driven note deal.
The SEC is naming issuers with regularity and some of them are even making payments to the SEC, said Zehner.
Maco added that the SEC jumped with both enforcement feet into the municipal market in Orange County and the ripples from that have been spreading throughout the market every since. SEC enforcement is a fact of life in the municipal market.
In other big Orange County cases, the SEC filed securities fraud charges against the former Rauscher Pierce Refnes Inc. and its investment bankers Kenneth Ough and Virginia Horler for failing to ensure that the official statements for several note issues sold by municipalities in Orange County disclosed that the proceeds would be invested in Orange Countys risky investment pool. Rauscher had underwritten nine of the issues and was financial advisor for another. The two bankers helped draft the official statements for the issues.
Ough took the lead litigating the charges with the SEC. The commission won the case with a favorable Ninth Circuit court of Appeals decision, and then settled the charges with Ough, who is now a managing director for San Francisco-based Sutter Securities Inc. Rauscher, now RBC Dain Rauscher Inc., settled with the SEC soon afterward and the commission dropped charges against Horler after she retired. The cases highlighted the disclosure responsibilities of underwriters in the municipal market.
The SEC also settled securities fraud charges against Jean Costanza, who was then a lawyer with LeBoeuf, Lamb, Greene & McRae and served as bond counsel for $1.425 billion of notes sold by localities in Orange County. Costanza helped draft the official statements for the notes. The SEC charged she failed to ensure the official statements were not false or misleading. The case highlighted the disclosure responsibilities of bond counsel in the municipal market. Constanza is now a lawyer in the alternate public defenders office in Los Angeles.
TAX ISSUES
The enforcement documents in the Orange County cases gave the SEC the opportunity to emphasize its view that investors need to know about any risks that jeopardize the tax-exempt status of municipal bonds.
Thats really the essential view of the SEC today that investors are concerned and do view as material the tax analysis behind the tax-exempt status of the bonds, Kintzinger said. There are varying interpretations of that, but [the language in the documents] is important today for evaluating what kinds of tax analysis or tax risk should be disclosed in a primary offering and what kinds of tax events need to be disclosed to the secondary market.
It remains a troubling and unresolved area and a source of concern for issuers, lawyers, underwriters and investors, said Dean Pope, a partner at Hunton & Williams in Richmond, Va. It suggests the frightening possibility of allegations of securities fraud against all the parties if the IRS or anyone else raises questions about the tax opinion, even if the bonds are not ultimately ruled to be taxable.But Zehner, Kintzinger and several other lawyers agreed with Macos assessment that, the most important enforcement step to come out of Orange County was at the time the least onerous in terms of sanctions and that was the so-called 21(a) report on the countys board of supervisors.
The document, the result of an SEC investigation under section 21(a) of the Securities Exchange Act of 1934, stated for the first time that state and local government officials who authorize the issuance of municipal securities and related disclosure documents, and not just the governments themselves, have responsibilities under the federal securities laws.
It still is the seminal statement from the commission on the responsibilities under the federal securities laws of local officials with respect to disclosure on municipal bond offerings, said Kintzinger. In the aftermath of the report, many bond counsel met with their issuer clients to discuss the roles and responsibilities of board members and commissioners and authority members with respect to their responsibilities under the federal securities laws.
Most local officials now understand that while there can be reasonable reliance on professionals, local officials must bring to the disclosure process their own knowledge of the issuers financial condition, said Pope.
San Diego even went so far as to adopt Sarbanes-Oxley reforms in its municipal code after pension and accounting issues raised financial questions and led the city to temporarily halt its bond offerings. The city voluntarily disclosed the problems to the market and then commissioned an independent investigation, which resulted in the recommendations for the reforms.
ISSUES REMAIN
Another key difference from Enron is that while the Sarbanes-Oxley Act attempted to comprehensively deal with the governance and other issues that arose from the Enron and other corporate scandals, the Orange County debacle left some open issues, according to some securities law experts.
Orange County was a wake-up call, a painful and necessary wake-up call, said Zehner. But my personal fear is that after 10 years people are becoming a little complacent again and that the lessons of Orange County havent really been learned.
To me the scary part is the extent to which investments and derivatives are still not as understood as they could be and that there are still issues and problems and concerns with respect to the sale of derivatives and other sophisticated products to unsophisticated clients, Zehner continued.
Many state and local governments have the size, but not the sophistication to handle derivatives and other complex financial products, he said.
Like Orange County, which was using its investment strategy to raise revenues in the wake of a state proposition that prohibited tax increases, many governments today are being squeezed by taxpayers unwilling to raise taxes to pay for increased services and are seeking out creative ways of finding revenue, including through their investments and financings, Zehner, Maco, and several other lawyers said.
