In years past, the Securities and Exchange Commission used a light touch on its enforcement efforts in municipal securities and pension funds. Not any more.
This year the agency dedicated itself, in a very public way, to identifying fraud in the nearly $3 trillion municipal bond market and to cracking down on pay-to-play schemes that continue to permeate the pension fund arena. As developments in October demonstrate, the SEC is beginning to see the fruits of its labor, and much more enforcement activity may be on the way.
The increased scrutiny shouldn’t come as a surprise to anyone. In a 2009 speech, SEC Commissioner Elisse Walter signaled the need to step up regulation in the municipal securities market, when she warned that the marketing of municipal securities lacked transparency. With increasing participation by retail investors, she said, quoting former SEC Chairman Arthur Levitt, “Our nation’s leaders … risk committing a major error if they don’t carefully consider the workings of the municipal bond market. The opacity of this market is unrivaled and thus presents a significant threat to our economy.” Walter said that the status quo meant that investors in municipal securities were in many ways “second-class citizens” who did not receive the protections customary in many other sectors of the U.S. capital markets.
Along with other reforms, Walter proposed that Congress repeal the Tower Amendment. The Tower Amendment, a provision of the Securities Exchange Act of 1934, prohibits the SEC from requiring issuers of municipal securities to file their plans with the SEC prior to sale; in essence, the amendment puts “muni” issuers beyond the reach of federal regulatory oversight. This exemption largely limits the SEC’s regulation to the municipal market’s broker-dealers and underwriters, as well as to enforcement of the general antifraud provisions of securities laws under Rule 10b-5.
Congress declined to implement Walter’s suggestion in the Dodd-Frank Act, however, instead choosing only to direct a study on “the advisability of the repeal or retention of” the Tower Amendment. Some people, such as former Chairman Levitt, believe that the move to repeal the Tower Amendment may now be dead. “In Washington,” he wrote in a column for Bloomberg, “further study is tantamount to burial.”
Either way, the SEC has decided not to wait around for Congress to boost its authority in the municipal area. Instead, the SEC is now aggressively using the antifraud authority it already has to take some unprecedented actions.
The SEC further declared its intentions to become more active in the municipal securities area in January 2010, when it announced that one of the five new specialized units in the Division of Enforcement would be dedicated to municipal securities and public pensions. In August 2010, this unit brought its first significant case, charging the State of New Jersey with securities fraud for failing to disclose to purchasers of billions of dollars’ worth of municipal bond offerings that it was underfunding the state’s two largest pension plans.
Specifically, the SEC alleged that New Jersey offered and sold more than $26 billion worth of municipal bonds from 2001 to 2007 using offering documents that created the false impression that the state’s teachers’ and public employees’ retirement plans were adequately funded. In fact, the SEC alleged, New Jersey was unable to make contributions to these plans without raising taxes or cutting other services, meaning that investors weren’t receiving adequate information to evaluate the state’s financial condition. New Jersey settled the case without admitting or denying the SEC’s findings.
As developments in October demonstrate, the SEC is beginning to see the fruits of its labor, and much more enforcement activity may be on the way.
The SEC’s case against New Jersey marked the first time the agency had ever charged a state with violations of the federal securities laws, and only the second such charge against any government. (In 2006, the SEC settled charges with the city of San Diego that the city sold municipal securities while failing to disclose projections of massive unfunded liabilities to its pension plan.) Just this October, SEC Enforcement Director Robert Khuzami and Elaine Greenberg, chief of the Municipal Securities and Public Pensions unit, emphasized in public remarks that the SEC would be stepping up enforcement in the municipal area. The agency took another step in that direction on Oct. 27, when it announced settlements against four former San Diego officials. Each one allegedly played a key role in San Diego’s disclosure failures, and each agreed to pay fines from $5,000 to $25,000.
The SEC’s ambitions in the municipal securities area may get another boost from the new whistleblower provisions in Dodd-Frank, which provide as much as a 30 percent bounty to whistleblowers whose tips lead to fines in successful cases. In late October, Mark Zehner, deputy director of the Municipal Securities and Public Pensions unit, revealed that numerous municipal market participants have already approached the SEC under the whistleblower program to report municipal bond abuses.
Pension Officials Beware
Another priority for the Municipal Securities and Public Pensions Unit now making headlines is “pay-to-play.” Traditionally, pay-to-play has involved securities firms providing campaign contributions or other benefits to government officials to obtain underwriting business. A new wave of pay-to-play has now been uncovered in numerous states, including New York, California, Illinois, New Mexico, and Kentucky, where firms provide kickbacks to individuals at public pension funds in exchange for an agreement to invest capital with the securities firm.
In October, New York Attorney General (now governor-elect) Andrew Cuomo’s lengthy investigation into pay-to-play allegations of this type against several individuals in the New York State Comptroller’s office—including former Comptroller Alan Hevesi—was capped off when Hevesi pleaded guilty to accepting almost $1 million in kickbacks. In exchange for the kickbacks, Hevesi admitted, he approved $250 million in pension funds investments with a California private equity firm.
Last May, California Attorney General (now governor-elect) Jerry Brown filed similar charges in a civil fraud lawsuit against Alfred Villalobos, a former California Public Employees Retirement System (CalPERS) board member. Brown alleged that Villalobos spent tens of thousands of dollars to “lavishly entertain” senior executives at CalPERS, who in turn influenced the board to authorize investments that generated more than $40 million in commissions for Villalobos. Among other things, Villalobos allegedly took two executives on an around-the-world trip and gave the former CalPERS chief executive a $300,000 job and a condo when he left the pension fund.
The SEC has filed its own pay-to-play case alleging kickbacks against Hevesi’s former deputy comptroller and a top Hevesi political adviser, which is still pending, and is also reportedly investigating the pay-to-play practices at CalPERS. In June, the Commission also approved a new rule under the Investment Advisers Act of 1940 designed to limit the influence of “placement agents,” who work as middlemen with pension funds and facilitate pay-to-play practices by investment advisers. Indeed, the SEC has already reportedly opened an informal inquiry in September into the Kentucky Retirement Systems’ use of placement agents.
The SEC’s recent emphasis on the municipal securities area appears to be just the beginning. As October ended, Commissioner Walter was leading a series of “field hearings” with municipal market participants across the country. In one speech, Walter stated that Dodd-Frank had not gone nearly far enough to protect investors from fraud in municipal securities and that the hearings would result in a report recommending ways to strengthen investor protection in this area. She also emphasized that the Enforcement Division would be actively seeking to develop case law in the municipal area through high-impact cases.
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