Is the SEC Letting States Get Away With Fraud?
In its complaint against Illinois last week, the Securities and Exchange Commission offered about a dozen instances of how officials ‘misled' or failed to properly ‘disclose' information to potential investors about the worrying condition of the state's employee pension funds. Some of these lapses, like failing to tell investors that the state's basic plan to finance its pension system was inadequate in the first place, might strike the average investor as serious omissions.
The SEC's complaint three years ago against New Jersey, the first state ever charged with fraud by the market regulator, seemed even more incriminating. There the SEC charged that officials committed a particularly big whopper: failing to tell investors that the state had justified a big benefits boost for workers in 2001 by valuing its pension funds as if it were still 1999, before the technology stock meltdown knocked billions of dollars off the pension system's assets.
Although these omissions don't seem like the sort that just happen by accident, the SEC decided in both cases to accept the explanation that the misdeeds were a result of bad training, a lack of communication among agencies, and other such deficiencies. In neither the Illinois nor the New Jersey case did the SEC appear to probe beyond the omissions themselves to determine whether they were accidental or intentional, whether there was any conspiracy to misstate the financial health of the states, and whether any elected officials might have had any hand in helping produce financial documents containing so many questionable assertions.
Unlike its investigations into corporate issues, the SEC's probe of the states seems largely limited to what you could learn by reading newspapers and perusing bond documents. As legal scholar Philip Grommet observed in a 2012 Journal of Legislation article about the New Jersey case, which the SEC initiated after reading about the state's suspect disclosure practices in the New York Times, "This antifraud action was hardly the result of an in-depth investigation."
The 1975 Tower Amendment to the Securities Exchange Act limits the agency's purview over the municipal securities market, giving the SEC much less of a role in requiring disclosure from states than it has in setting the standards for corporate securities issues. But federal securities law also contains antifraud provisions which bar municipal issuers from engaging in deceptive or fraudulent practices when selling securities.
Perhaps because regulators have limited jurisdiction over municipal issuers, some states and cities act as if the basic rules of accounting don't apply to them. Some are keeping two sets of books, one for potential investors and another to govern with.
For instance, back in 2010 New York State's comptroller issued a damning report on the state's fiscal practices, describing what he termed "fiscal manipulations" to present a "distorted view of the State's finances" through a host of accounting gimmicks and maneuvers, some of which seemed to violate the state's own constitution. Yet nothing like this kind of language found its way into New York's bond documents. New York officials can hardly claim ignorance, moreover, since it is the comptroller's office that is responsible for issuing the state's bond materials.
State officials consistently tout their dubious achievements in ways that would get a corporate executive whose firm is in registration for an offering in trouble. In its complaint against Illinois, for instance, the SEC notes that the state stopped misleading investors and took remedial actions to fix its bond documents in 2009. But in a June of 2010 roadshow presentation for potential investors, state officials were ballyhooing recent pension legislation as a significant reform and cost-savings even while the press and independent budget experts were deriding the changes as insignificant. Today, Illinois continues to have one of the worst-funded pension systems in the country, evidence of how little improvement the so-called reforms touted by the state achieved.
These kinds of omissions and misleading statements by municipal issuers are especially pertinent now because of the ways that state and local governments are using debt. As Grommet points out, whereas once states and cities used the bond market principally to raise money to build roads and bridges and other capital projects, increasingly governments are employing borrowing to plug budget shortfalls, sometimes with creative forms of debt that stretch the limits of what states' own laws allow. This makes state and local debt increasingly "intertwined" with the ability of some municipal issuers to pay their basic operating bills. "The integrity of the market has never been more important," Grommet notes.
Even more to the point, governments are racking up a relatively new kind of debt that is outside of the traditional restrictions on borrowing in most state constitutions and city charters, namely retirement promises to workers. States and cities, for instance, have promised workers about three quarters of a trillion dollars in health care benefits when they retire but funded only five percent of that liability.
Of course many states and cities have disclosure requirements of their own which regulate how much material they release to the public about their budgets. That information alone, some argue, should be enough to inform the typical investor about whether a state or municipality is getting into financial trouble.
But as the New York State comptroller's report suggests, our elected leaders are using increasingly complex techniques to budget and spend, making it harder to judge accurately a government's financial condition. Once upon a time, for instance, states paid most of their bills out of one account, a general fund. Today, general funds account for about half of state expenditures and the rest of the money comes from a plethora of special accounts whose purpose sometimes seems to be to hide the actual amount government spends. Similarly, the accounting used to determine the liabilities of defined-benefit pension systems run by many governments is highly obscure and easily subject to manipulations that can hide a debt problem until it becomes very large.
Perhaps the best defense of the SEC's rather easygoing enforcement of municipal issuers is that big muni defaults are relatively rare. Still, if the last few years have taught us anything about financial markets, it is that what's past is not necessarily prologue. In the end, the SEC's job is to protect investors, not taxpayers. It can do its job by demanding more accurate disclosure from issuers so that investors can make more informed decisions.
Whether taxpayers take that information and make more informed decisions themselves is another matter altogether. Long before the SEC cited Illinois, for instance, the state capital had turned into an acknowledged fiscal circus. Nothing seems to have changed.