Earlier this month, Illinois became the second state ever to be the target of a cease and desist order from the US Securities and Exchange Commission for fraud related to its state-backed securities. The order charges Illinois with defrauding investors of more than $2.2 billion in the sale of Illinois municipal bonds from 2005 to 2009. The state is accused of failing to inform investors of widespread problems in its pension funds.
The rare legal action by the SEC could portend similar action against other states and municipal governments based on conduct that has become commonplace in the murky, sometimes polluted waters in which municipal financing swims.
The SEC’s Acting Director of the Division of Enforcement, George S. Canellos, said in a statement about the Illinois action, “Time after time, Illinois failed to inform its bond investors about the risk to its financial condition posed by the structural underfunding of its pension system.”
“Municipal investors are no less entitled to truthful risk disclosures than other investors,” he added.
SEC order says Illinois misled investors on state’s precarious finances
The SEC order said Illinois asserted that it had adequately funded the retirement plans of state workers but that it did not inform investors of the risky nature of the bonds it was offering tied to the pension program. This caused investors to overpay for bonds that were worth less than the presented value in light of the precariousness of the state’s finances. The cease and desist order did not impose fines or penalties, but required the state to provide greater information about its securities. Illinois agreed to comply, but was given the option of not admitting or denying the SEC allegations.
The SEC order is the second of its kind. In 2010, the SEC charged New Jersey with securities fraud for misrepresenting the value of municipal securities to investors. For nearly six years ending in April 2007, New Jersey sold $26 billion of municipal bonds in 79 offerings without adequately disclosing its financial condition, according to the SEC. New Jersey settled the case without admitting or denying the accusations and agreed to take remedial action.
SEC’s Illinois order appears to be part of a larger crackdown on fraud in the offering of municipal securities. One result thus far is that states have been compelled to increase disclosures about their bond offerings.
Municipal securities market is SEC ‘top priority’, official says
Elaine Greenberg, Chief of the SEC’s Municipal Securities and Public Pensions Unit, said, “Regardless of the funding methodology they choose, municipal issuers must provide accurate and complete pension disclosures, including the effects of material changes to their pension plans. Public pension disclosure by municipal issuers continues to be a top priority,” she added.
D. Daxton White, an attorney at the White Law Group, a securities law firm in Boca Raton and Chicago, said the SEC seems to be increasing its focus on state securities.
He said, “I believe the SEC’s investigation of Illinois and its sales of municipal bonds may be a strategic shift by the SEC.”
“Given that the SEC has already launched a similar investigation into the State of New Jersey… it appears the (SEC) will be more closely scrutinizing the sale of municipal bonds by various states,” White continued.
The SEC’s July 2012 “Report on Municipal Securities Market” showed that in the last 30 years, the municipal securities market has “grown significantly and now represents an increasingly important part of the US capital markets.” It is “extremely diverse” and is composed of nearly 44,000 state and local issuers whose municipal securities markets are valued at $3.7 trillion.
“Despite its size and importance, the municipal securities market historically has not been subject to the same… regulation as other sectors of the US capital markets,” the report said. Except for securities fraud, the SEC has limited authority over disclosure practices of municipal issuers because it is “significantly constrained” by the law, the report said.
Underfunding pension program caused Illinois crisis
According to the SEC cease and desist order, in 2011, the Illinois pension systems were underfunded by $83 billion and “system assets covered only 43% of system liabilities.” The gargantuan debt resulted from the chronic underfunding of pension systems by Illinois.
In 1994, as part of its Pension Funding Act, Illinois enacted the Statutory Funding Plan to remedy the securities liabilities pressures within 50 years. But, the report said the long term schedule was “insufficient” because it delayed most of the pension contributions. In 1995, the state’s pension system liabilities were at $20 billion, and only 50% of the liabilities were covered by assets.
The habit of deferring resolution of the issue continued as legislators discovered ways to postpone the Statutory Funding Plan. Under Governor Rod Blagojevich, who is now imprisoned on unrelated charges, the state passed a two-year pension holiday cutting pension payments in 2005 and 2006 by a total of $2.3 billion.
Present Governor Pat Quinn focused the fiscal year 2014 budget on reforming the state’s treatment of pension securities, which he called a “crisis” in his annual budget address. He said, “Inaction on comprehensive pension reform has left our state with less revenue for our most important priorities.”
SEC requires Illinois to expand and continue remediation measures from 2009
The SEC order recognized that Illinois began taking remedial steps in 2009, but said that the steps needed to be continued and broadened to “correct process deficiencies and enhance its pension disclosures.” The state amended the pension section of bond offering documents to include a greater and more accurate description of the bond values. It also commissioned a Pension Modernization Task Force to analyze the state’s pension programs and a Commission on Government Forecasting and Accountability to establish disclosure controls and written policies and procedures.
The settlement of Illinois with the SEC extends the original remedial actions. The state agreed to retain a disclosure legal counsel who will review future offerings, including financial documents.
The move toward greater detail in the municipal bond offerings by Illinois may produce greater transparency at the cost of greater eyestrain. A recent Illinois bond offering contained 33 pages of small print, compared to prior offerings of 10 pages or less of more legible font sizes.