In a landmark case, the Securities and Exchange Commission yesterday sanctioned San Diego for committing securities fraud by failing to disclose in bond offering documents, financial statements, and discussions with rating agencies soaring unfunded pension liabilities and retiree health care liabilities that placed it in serious financial straits.
After an investigation of almost three years, the SEC did not impose any monetary penalties on the city in a settlement of the charges. Instead, it ordered the city to cease and desist from further securities fraud violations and directed it to hire an independent consultant to conduct three years of annual reviews and make recommendations for improvements in the city’s policies, procedures, and internal controls relating to its bond disclosures.
The SEC sanctions help pave the way for San Diego, which has been shut out of the muni bond market since 2003 except for private placements, to obtain auditor approval of its fiscal 2003, 2004, and 2005 financial statements so that it can issue them and begin publicly offering bonds in the spring.
The case, which may be followed by SEC enforcement action against former San Diego officials and employees, has been closely watched in the municipal market and comes as many state and local governments across the county are grappling with growing unfunded pension liabilities and the extent to which they should disclose information about those liabilities.
“I think at a minimum this case is saying, ‘You better fully and fairly disclose information about your pension liabilities and your ability to pay them in the future,’” said Kelly Bowers, the SEC’s senior assistant regional director in Los Angeles.
Some market participants complained yesterday that the SEC merely slapped the city on the wrist for its disclosure failures.
But SEC officials disputed that notion. They said this case marks the first time the SEC has ever ordered a municipality to hire an independent consultant to conduct such reviews and that the city has agreed to adopt and implement all of the consultant’s recommendations or alternatives designed to achieve the same objectives.
“San Diego’s misconduct jeopardized the interests of its citizens, its current and future retirees, and those who placed their trust in the city’s bonds as an investment,” said Randall R. Lee, director of the SEC’s Pacific regional office in Los Angeles. “The C&D order, combined with the imposition of an independent consultant represents a serious and substantial sanction against the city. If we learn that the city is not following the recommendations after any given annual review, we’ll have something to say about that.”
Lee said the sanctions reflect the fact that the city had already taken some remedial measures to detect and prevent such problems from occurring in the future, as well as that the SEC is reluctant to impose monetary penalties on municipalities for fear the taxpayers will ultimately bear the cost.
The case also “signifies [the SEC’s] resolve to hold state and local governments accountable when they commit fraud while seeking to borrow the public’s money,” said Linda Chatman Thomsen, director of the SEC’s enforcement division.
Martha Mahan Haines, chief of the commission’s office of municipal securities, said the case contains “lessons learned” for other muni bond issuers. “As a result of the commission’s order, San Diego must educate its officials about their responsibilities under the federal securities laws and establish effective policies, procedures, and internal controls regarding its disclosures for offerings, including disclosures made in financial statements. Other issuers and conduit borrowers would be wise to consider taking similar steps as preventative measures to ensure that their own disclosures meet the standards for accuracy and completeness of the securities laws,” she said.
“Today’s announcement that we have reached a settlement with the SEC marks a major milestone in San Diego’s emergence from the financial wilderness,” Mayor Jerry Sanders said yesterday at a press conference he had previously scheduled to outline the financial challenges faced by the city.
“As an entity, the city has recognized the error of its ways and willingly cooperated throughout the SEC’s investigation and has agreed to establish remedial measures to ensure that this kind of activity can never and will never happen again,” he said. “That will be the hallmark of our unfortunate experience.”
Sanders will unveil his plan tomorrow to address budget shortfalls. According to the mayor, without any changes in policy, San Diego faces an $87 million structural budget shortfall in fiscal 2008 that will grow to $174 million in fiscal 2009.
In enforcement documents, the SEC said San Diego’s disclosure failures involved five municipal bond issues totaling $260 million that were sold in 2002 and 2003 as well as secondary market disclosure documents that the city filed with nationally recognized repositories in 2003 in connection with $2.29 billion of its outstanding bonds and notes.
While the city disclosed some information about its pension and retiree health care obligations in these documents and talks with rating agencies, it did not reveal the gravity of its financial problems, the SEC said.
The city failed to disclose that its unfunded pension liabilities were expected to dramatically soar from $284 million at the beginning of fiscal 2002 to $720 million in early fiscal 2003 and to $2 billion by the beginning of fiscal 2009. In addition, its liability for retiree health care was $1.1 billion, the SEC said.
At the same time, the city also failed to disclose that it had been intentionally under-funding its pension obligations so that it could increase pension benefits but defer the costs, and that it would face severe difficulties in funding its future pension and retiree health care obligations unless new revenues were obtained, health care benefits were reduced, or city services were cut, the SEC said.
The total under-funding of the city’s pension plan was expected to increase dramatically, growing tenfold from $39.2 million in fiscal 2002 to an estimated $320 million to $446 million in fiscal 2009, but the city did not disclose this to the market either, the SEC said.
When the city eventually disclosed some of these issues in 2004, rating agencies lowered San Diego’s rating and the city could no longer obtain audited financial statements for 2003 and subsequent fiscal years.
The commission concluded that the city “knew or was reckless in not knowing that its disclosures were materially misleading.”
The controversy over San Diego’s pension and retiree health care obligations and liabilities led to the resignation of then-Mayor Dick Murphy, the departure of many high-ranking city officials and employees, state and federal criminal charges against some officials, and city litigation against several parties, It also has cost the city of tens of millions of dollars in fees paid to law firms, accountants, and consultants that were hired to help address the situation.
Both the law firm of Vinson & Elkins, which initially represented the city in this matter but later resigned and is now being sued by the city attorney, and a three-member independent audit committee that included former SEC chairman Arthur Levitt and former SEC chief accountant Lynn Turner, each sent the city massive reports concluding that some of its former officials could be charged with securities fraud violations.
The SEC said in its order yesterday that “the city, through its officials, acted with scienter” and noted the case law definition of scienter is “a mental state embracing intent to deceive, manipulate, or defraud.”
SEC officials stated yesterday that their investigation “is ongoing as to individuals and other entities that may have violated the federal securities laws” but would not comment further.
Meanwhile, San Diego has put in place some of the recommendations made by Vinson & Elkins and the audit committee. The city has hired a full time municipal securities attorney, chief deputy city attorney Mark Blake, who is responsible for coordinating the city’s public disclosure and who has conducted continuing education for the city’s deputy attorneys on disclosure requirements. It also hired new disclosure counsel John McNally, a partner at Hawkins Delafield & Wood, for all future muni offerings, who will have better and continuous knowledge of the city’s financial affairs.
The city also created a new Disclosure Practices Working Group, comprised of senior officials across city government, that will review the form and content of all disclosure materials. The mayor and city attorney must now personally certify to the City Council as to the accuracy of the city’s financial statements and the city auditor must annually evaluate the city’s internal financial controls and report the results to the City Council.
