Local governments that are less than forthcoming in their bond offering documents open themselves to prosecution by the Securities and Exchange Commission (SEC). But guess what? These governments may also be subject to prosecution for failure to update their disclosures. They may also be prosecuted for the statements of public officials that are outside of documents relating to the financial condition of the bond issuer. In one recent case, that included prosecution based in part on a mayor’s annual State of the City address.

In 2010, the SEC created a specialized unit of the Division of Enforcement focused on municipal securities markets. In July 2012, it followed that with a comprehensive report on the municipal securities market that incorporates feedback from market participants including investors, issuers, underwriters and regulators. The goal of the report is to provide recommendations intended to “help improve the structure of the…municipal securities market and enhance the disclosures provided to investors.” The effect is the SEC’s prioritizing fraud and disclosure cases against municipal securities issuers, as well as those who make statements that can be attributed to those issuers—such as city finance directors, mayors and those responsible for ensuring bondrelated disclosure documents are kept current. In 2012, the SEC initiated more than twice the number of cases related to misconduct in the municipal securities market as compared to 2011.

So, why the increasing focus on the municipal securities market? Just look at the data: in 1945, total outstanding municipal securities were $20 billion. By 1981, that amount had risen to $861 billion. Today, the total market has ballooned to $3.7 trillion. There are roughly 51,000 state and local bond issuers and 1.3 million separate municipal securities in existence. Most importantly, the typical municipal bond investor is not an institutional investor. Seventy-five percent of municipal securities are owned by “retail investors.” These are mom-and-pop investors seeking safety and a reliable return on investment. With that in mind, the SEC has initiated high profile cases against one state and three cities in the first half of 2013.

The crux of the SEC’s enforcement conduct is summarized neatly by Rosalind Tyson, Director of SEC’s Los Angeles Regional Office: “Municipal officials have a personal obligation to ensure that investors are provided with complete and accurate information about the issuer’s financial condition.” As the SEC expands its reach and exerts its authority, several themes have emerged in their prosecution. First, failure to fully and accurately disclose pension fund obligations can be grounds for allegations of securities law violations. Second, statements made in bond disclosure documents can be the basis for liability. Third, and most recently, statements made by public officials outside of the disclosure documents can be the basis for alleging securities law violations.

Misstating or Omitting Pension Obligations in Offering Documents Can Be the Basis for Prosecution

The SEC’s prosecution of bond issuers for failure to disclose or omitting disclosure of pension obligations is well documented. Cases against New Jersey and Illinois alleged that those states misled investors about the financial health of their pension funds in bond offering documents. Those cases both centered around failure to accurately represent the underfunded status of the pensions and, in the case of Illinois, to accurately disclose the impact of pension fund reforms. In both cases, the states settled with the SEC with a cease-and-desist order and agreements to improve disclosures.

Statements Outside the Documents Can Be the Basis for Prosecution

Concluding its case against Harrisburg, Pa., the SEC issued a report warning public officials that they must “be mindful that their public statements, whether written or oral, may affect the total mix of information available to investors, and should understand that these public statements, if they are materially misleading or omit material information, can lead to potential liability” under federal securities laws. The proceeding against Harrisburg relates to the failures of the city to adequately disclose its deteriorating financial condition and credit ratings during the period 2009 to 2011.

According to the SEC, the case against Harrisburg is unique because it marks the first prosecution of a public official for statements made outside of disclosure documents. The SEC alleged that Harrisburg ran afoul of the securities laws by making misleading statements in annual financial reports, mid-year reports and the mayor’s State of the City address, all of which failed to provide investors with the information necessary to evaluate the financial health of the city. The import of these statements was augmented because the city failed to comply with its ongoing reporting obligations to file Comprehensive Annual Financial Reports, and failed to file material event notifications related to debt downgrades. The SEC emphasized that fraud liability is based upon the particular facts and circumstances and that written or oral statements of public officials—even if not intended to be the basis of investment decisions, but which nevertheless may be reasonably expected to reach investors and the securities markets—can affect the total mix of information available to investors and be the basis for antifraud liability.

Failure to Submit Statements in a Timely Manner Can Be Grounds for Prosecution

Most recently, the SEC opened a case against West Clark Community Schools, an Indiana school district. “This is the first time the SEC has charged a municipal issuer with falsely claiming in a bond offering’s official statement that it was fully compliant with the annual disclosure obligations it agreed to in prior offerings, and an underwriter and its principal for not doing the necessary research to attest to the truthfulness of the claim,” commented Andrew Ceresney, codirector of the SEC’s Division of Enforcement, in a statement. “This case demonstrates that we will be vigilant in making sure municipal issuers and underwriters comply with their obligations.” West Clark Community Schools issued a $31 million bond in December 2007 but failed to inform investors that it had not properly submitted annual reports and other information related to a $51 million bond offering in 2005. The SEC and the school district agreed to settle the case with West Clark being obligated to update its filings. In a separate related settlement, the bond agency that assisted the school district was forced to pay $580,000 in disgorgement and penalties. This case demonstrates the SEC’s emphasis on scrutinizing public finance disclosures and the necessity of post-issuance compliance.

Now What?

While it is clear the SEC is cracking down on municipal securities issuers suspected of hiding or misrepresenting information from investors when they sell bonds, the SEC is also providing guidance on how to avoid being a target. Public officials should seek to comply with continuing disclosure and material event notification requirements. If they are unable to provide those disclosures, they should notify the markets and provide the required information as quickly as they can, while being especially sensitive to the accuracy of the other information that may be available to investors. Compliance with these obligations can best be assured if there are specific disclosure policies, procedures and controls in place that are tailored for and proportionate to the needs of the particular issuer.