The Securities and Exchange Commission’s enforcement division has set its sights on the municipal securities industry, emboldened by its expanded powers under the Dodd-Frank Wall Street Reform and Consumer Protection Act and a new specialization unit devoted to policing muni securities and public pensions.

Although the municipal securities industry has been largely unregulated in the past, the SEC, in conjunction with the Municipal Securities Rulemaking Board, is now charged with overseeing the $3.7 trillion dollar market. The result has been a flurry of recent enforcement activity marking the beginning of the SEC’s crackdown on the muni industry.

The SEC plans to be smarter about its investigation methods. Its municipal securities and public pensions specialization unit now has around 30 members, with attorneys in every SEC region except Salt Lake City and Denver.

Specialization unit members receive additional training about their sector. Moreover, the commission is fulfilling its promise to hire staff experienced in the industry and has recently retained two senior enforcement lawyers with extensive experience in the municipal securities market.

The SEC will also have the resources for its endeavor. Under Dodd Frank, the agency’s enforcement budget is poised to increase 100% over the next five years.

While the SEC saw only a modest increase in its budget this year, the enforcement division is determined to do more with its current resources.

For example, the division has streamlined its staff and obtained a new toolkit of enforcement techniques, including many tried-and-true tactics historically utilized by the Justice Department.

The SEC has also instituted a new whistleblower bounty program offering certain whistleblowers lottery-size rewards to entice tips from municipal insiders, securities professionals and the public at large.

Elaine Greenberg, chief of the commission’s municipal securities and public pensions specialization unit, announced a focus on five specific areas. Although some matters fall into multiple categories, examples of the five targeted areas are provided below.

1. Offering and disclosure fraud: San Diego officials failed to disclose underfunded pension funds in connection with the sale of $260 million of municipal bonds. As part of the settlement, the city retained a consultant to assess its internal controls and adopt his recommendations.

2. Tax or arbitrage-driven fraud: In California, the state controller’s office has alleged that the city of Bell illegally raised its property taxes to make municipal bond payments.

3. Pay-to-play practices and public corruption: Recently, the former Jefferson County, Ala, Commission president received a 15-year prison sentence and paid significant restitution after a criminal conviction for accepting kickbacks of over $150,000 in cash, loans and other benefits in exchange for steering county bond and swap business to his long-time friend and broker-dealer.

4. Valuation and pricing fraud: In 2011, an investment bank paid $47.2 million to settle charges that it fraudulently rigged at least 100 municipal bond reinvestment transactions and generating millions of dollars in ill-gotten gains.

5. Public pension and accounting and disclosure violations: In the first SEC enforcement action brought against a state, New Jersey consented to a cease and desist order after it gave the false impression that its pension funds were adequately funded.

As of August 2011, the SEC has charged 72 entities and individuals with municipal securities violations. Financial institutions have paid more than $743 million in SEC settlements of muni bond investigations.

As policing municipal bond offerings is now a “top priority” for the SEC, immediate proactive measures are advisable for city officials and industry professionals alike. Indeed, municipalities can make some straightforward internal changes to better prepare for heightened scrutiny.

For example, just as public companies assign duties and responsibilities to their chief executive officer, chief financial officer, general counsel and board of directors to maintain checks and balances on power, municipal officers and city counsels should review their governance structure and delegate duties to accomplish a similar system of checks and balances.

Municipalities should likewise adopt compliance policies similar to corporations, such as a document-retention policy and an ethics policy that emphasizes proper “tone at the top.” For city officials, statutory indemnification and immunity protections cover many official activities, but understanding the limits of these protections is critical.

Finally, just like corporations purchase liability insurance policies for directors and officers, municipalities should consider insurance for public officials.

When bringing the case against an investment bank for fraud in connection with a municipal bond offering, Robert Khuzami, director of the SEC’s enforcment divisions said, “Let this be a teaching moment.”

The SEC is clearly taking aim at the municipal securities industries through its new tools and an aggressive approach to enforcement. Prudent municipalities will make the necessary adjustments to protocol and be prepared for a watchful SEC.

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