In difficult economic times for local governments, oversight by elected officials and staff generalists is especially important. Some of the most significant enforcement cases prosecuted by the Securities and Exchange Commission (SEC) against local governments that issued bonds originated in decisions made during economic downturns or other periods when the affected local governments experienced fiscal difficulties. As states and local governments again wrestle with such difficulties, they may well be tempted by a short-term solution that will ultimately cost them and their governmental unit much more in the long haul.

On March 21, 2003, the SEC issued a cease-and-desist order against the City of Miami, Florida, in which the city was ordered to cease and desist "committing or causing any violation or future violation of the antifraud provisions of the federal securities laws." City of Miami, Florida, Securities Act of 1933 Rel. No. 33-8213, Mar. 21, 2003. On the one hand, this decision flowed logically from the SEC’s emphasis on enforcing the antifraud provisions of federal securities laws against local governments throughout the 1990s; on the other hand, this decision starkly rejected the city’s defense that it relied on its staff and its financial professionals in preparing its disclosures. Members of governing bodies of local governments that issue bonds must assure that the financing documents that are used to sell the bonds do not contain misleading information.

The SEC’s action in March against the City of Miami was not its first foray into the field of municipal securities. As early as March 1994, the SEC issued its "Interpretive Guidance on the Antifraud Provisions," SEC Rel. No. 33–7049, Mar. 9, 1994, in which the SEC discussed its views on the applicability of the antifraud provisions of federal securities laws to the different players in the municipal bond marketplace. The antifraud provisions prohibit any person, including issuers of municipal bonds, from making a false or misleading statement of material fact or omitting any material facts necessary to make statements made by that person not misleading. Id.

The SEC noted that the test of whether a fact must be disclosed is whether disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available. Id. The SEC also discussed requirements for disclosing accurate information about the financial conditions—including investment risks of the particular bonds and accounting practices of municipal issuers in both primary disclosure documents (the basic bond offering materials) and also secondary disclosures—after the bonds have been sold to investors and are being traded in the market.

The SEC has been active in taking actions against municipalities that did not disclose bad financial news in bond documents. The SEC took action against Maricopa County, Arizona, for failing to disclose a decline in its financial position and the necessity for it to use bond proceeds to balance its budget. Maricopa County, Arizona, Securities Act of 1933 Rel. No. 33–7354 (Oct. 3, 1996). Likewise, the SEC took action against the City of Syracuse for misstating in bond documents a budget surplus when a deficit actually existed and for characterizing unaudited financial statements as having been audited. City of Syracuse, New York, Securities Act of 1933 Rel. No. No. 33–7460 (Sept. 30, 1997).

In perhaps the most significant enforcement action in recent years, the SEC took aim at Miami’s disclosures during times of financial difficulty. In the early 1990s, the City of Miami began experiencing fiscal difficulties. City of Miami, supra. The city’s financial advisers and auditors warned that it would run out of operating cash. Id. At a meeting of senior city staff, one elected commissioner, and mid-level staff, to discuss the potential and (under Florida law, illegal) operating deficit for FY 1994, the participants determined that based on past experience, the city council would not raise taxes or increase fees. Id. The only way they believed they could balance the budget was to issue bonds and use the bond proceeds to finance city operations. Id. The city began a program to eliminate waste and redundancy within the municipal government, but this program would not seriously impact the operating deficit confronting the city. Id. The city’s financial condition continued to deteriorate and the city eventually declared a fiscal emergency, prompting the governor to appoint a fiscal oversight board to take control of the city’s finances. Id.

Before the appointment of the state oversight board, the city faced enough of an operating deficit that it could not pay its bills and employees through legal means. Id. Nevertheless, despite the deterioration of its financial condition from bad to worse, in the official statements for three bond issues during this time, the city represented its budget to be balanced. Id. The disconnect between the city’s financial position as described in the official statements for the bond issues and the city’s financial position as described in its audits and comprehensive annual financial reports was problematic for the SEC. As the SEC dryly observed, "A reasonable investor would have considered it important to know that Miami could not generate sufficient revenues to pay its bills or employees. The fact that Miami needed to use bond proceeds to satisfy operational expenses demonstrated the gravity of its cash flow deficit, and, thus, the City’s need to disclose this fact to public investors and the market place." Id.

Miami countered by arguing that its auditors had not issued a "going concern" qualification to its financial report. Id. A "going concern" qualification indicates that the subject will not be able to meet its obligations in the next twelve months. The SEC found, however, that only the infusion of bond proceeds prevented the auditors from giving a going concern qualification. In other words, only the illegal use of bond proceeds enabled Miami to argue that it did not merit a going concern qualification.

Miami also argued that it had relied on its auditors and other professionals for information on what to disclose in its official statements. Id. The SEC rejected this argument on two grounds. First, "Primary responsibility for the accuracy of information filed with the Commission and disseminated among investors rests upon the municipality." Id. Second, the SEC noted, "the record is unclear as to whether and to what extent Miami consulted with or relied on professionals." Id. The SEC also found that Miami had acted with scienter, based on circumstantial evidence concerning what its officials knew, but also upon the city’s dismissal of the importance of the bond documents, as evidenced by the testimony of its then city manager quoted at the beginning of this essay. Id.

What then, are elected laypeople to make of these actions? On the one hand, trying to ascertain whether a municipality relies too much on interest income seems a little much to ask of politicians. On the other hand, the failure to mention in bond documents that the municipality has trouble meeting payroll seems akin to lying on a mortgage application. Moreover, blaming the finance professionals does not seem to be a productive strategy. To the extent that the SEC has to bother with a municipal debt issue, it is a safe bet that the SEC will be examining the conduct of all the professionals connected with the transaction.

The dangers inherent in the blame the professionals approach are obvious in the Miami litigation. First, the SEC reiterated that professionals notwithstanding, the primary responsibility for accuracy of information in an official statement lies with the issuer. Second, the SEC questioned the record evidence concerning how much the city had, in fact, relied on professional advice. One may well question the degree of finger pointing and backside covering going on from the financing professionals back toward the city. The third consequence is found in statements in the SEC opinion: "The fact that Miami has pointed its finger at Deloitte, and other bond professionals, without taking any responsibility for its own conduct, suggests that Miami has not accepted fully its responsibility for the City’s financial disclosures. . . . The City must be given the clear message. . . that Miami is responsible for the adequacy of its financial disclosures when seeking money from the investing public." City of Miami, supra. Notionally, it is a bad thing when a federal regulatory agency feels compelled to "send a message" to a municipality.

There are, however, general steps and specific steps that, if taken, could prevent municipalities from having to receive messages from federal regulators. At the general level, lay elected officials must have some awareness of the financial condition of their municipality. They must pay attention to what is going on around them. They must also respect the bond documents. It is no longer acceptable to have a "who reads these documents?" attitude.

As a specific guide, there are certain questions that elected officials should ask and to which they should receive answers. The questions are found in a brochure the SEC published in 1996, entitled "Questions to Ask Before You Approve a Bond Issue." This brochure contains ten questions elected officials should ask themselves and their staffs and five questions that they should ask their outside professionals. The questions are set forth below. If these questions are asked, and accurately answered, and the elected officials make their decisions based on these answers, elected officials can avoid the need for the SEC to have to send them a message.

1. How have we allocated responsibilities for the preparation of the official statement? Have we clearly defined the responsibilities of all participants in the transaction?

2. What processes or procedures have been established to select qualified outside professionals? How are we relying on them and is our reliance appropriate? How are they being compensated?

3. What have we done to establish the accuracy of financial and operating information and its disclosure in the official statement? Has anything happened since the date of the financial statements that needs to be disclosed?

4. What policies and procedures have we developed to determine whether material conflicts of interest exist that need to be disclosed?

5. What procedures have we established to accurately describe the project, the bond terms, the sources of repayment, and the risks associated with the project? What procedures have we established for the investment and disbursement of the bond proceeds?

6. Do our procedures permit the underwriters to carry out their "due diligence" and other responsibilities?

7. Have we fully considered any questions asked by the rating agencies?

8. What continuing disclosure responsibilities have we assumed and what procedures have we established to meet them? Who will determine and file the annual financial and material event disclosure information? Have we designated an individual to speak to the market on our behalf?

9. If we are relying on the bond counsel, financial advisor, or trustee to evaluate and meet our continuing disclosure requirements, what procedures are in place to keep them apprised of our financial condition and other material information?

10. Have our procedures produced an official statement that we feel accurately presents our financial condition and discloses the information a reasonable investor needs to know? Have all the right people reviewed it?

1. What is the nature or scope of the written opinion or certification, if any, that you are giving in this transaction and relating to the disclosure document? Have we given you access to the information you need?

2. Have you explained to us all aspects of the structure or nature of this transaction so that you are confident we fully understand all critical aspects? Does our official statement adequately address any concerns you have about this transaction that a reasonable investor would consider important?

3. Are there any matters regarding your participation in this transaction about which you should make us aware, including potential conflicts of interest?

4. Has your review of the relevant financial documents and other materials, including the official statement, raised any concerns regarding this borrowing? Do these concerns need to be disclosed?

5. Are you aware of any circumstances in which we, our staff, or others have not complied with our procedures so that we can make sure that our official statement adequately and accurately describes this transaction?