Recent actions by the U.S. Securities and Exchange Commission (SEC) indicate that the Commission will be taking a more active role in the municipal securities market. The SEC is dedicating additional resources to municipal securities enforcement with a particular emphasis on so-called pay-to-play violations, among others.
The SEC’s focus on municipal securities is due, in large part, to the sheer size of the market, and its importance to issuers and millions of retail investors. In the United States, there are approximately 50,000 state and local issuers of municipal bonds. Most of the significant transportation, education and health care facilities around the country are financed with municipal bonds. Approximately $2.8 trillion of municipal bonds are outstanding, including more than $400 billion in municipal bonds issued in 2009.
Despite the size of the municipal securities market, it is thinly regulated. For example, municipal securities are exempt from the registration requirements of the federal securities laws—though they are subject to the anti-fraud provisions. As a result, the SEC has traditionally relied on the Division of Enforcement to police the market through enforcement actions intended to affect the behavior of market participants.
Earlier in 2010, SEC Enforcement announced the formation of a specialized unit dedicated solely to policing the municipal securities markets. The unit is led by two senior enforcement lawyers with extensive experience in the municipal securities market—one of whom was a former bond counsel and partner at a major national law firm. The unit will have a large, dedicated team of enforcement lawyers around the country, supplemented with non-lawyer market specialists, focusing on municipal securities investigations.
The unit will likely concentrate on four areas:
Offering and Disclosure Fraud: Investigations will focus on potential material misstatements and omissions in municipal bond offering documents.
Tax- or Arbitrage-Driven Fraud: Investigations will focus on profits issuers may realize from borrowing at lower rates and then investing at higher, market rates. Arbitrage is generally impermissible under the federal tax code and can affect the tax-exempt status of bonds for investors. Recently, the SEC and Internal Revenue Service announced an initiative for closer cooperation on municipal securities arbitrage issues.
Valuation and Pricing of Municipal Bonds: Investigations will focus on thinly traded securities typically issued by small municipalities and authorities.
Pay-to-Play and Public Corruption: Investigations will focus on payments to participants in municipal securities offerings, and campaign contributions to government officials with authority over selection of municipal bond underwriters.
Recent Focus on Pay-to-Play
Pay-to-play is the practice of using campaign contributions to win underwriting business from an issuer. The pay-to-play rule, MSRB G-37, generally prohibits firms from underwriting municipal bonds for an issuer for two years after a “municipal finance professional” involved with the firm makes a campaign contribution to an elected official of the issuer.
In March 2010, the SEC took action, on two occasions, to enforce compliance with the pay-to-play rule. In the first matter, the SEC issued a Report of Investigation warning firms that pay-to-play rules apply to affiliated professionals, not just a firm’s employees. A securities firm underwrote bonds issued by California within two years of a campaign contribution to the Treasurer of California made by the vice-chairman of the firm’s parent (bank holding) company. The vice-chairman was not a director, officer or employee of the securities firm unit. However, the SEC determined he was a municipal finance professional because he functionally supervised the securities firm unit and served on the executive committee that oversaw it. As such, the SEC held that the vice-chairman was subject to the pay-to-play rule and that his firm violated the rule when it underwrote California bonds within two years of his political contribution to the state Treasurer.
The SEC’s Report of Investigation makes clear that an executive who supervises the activities of a securities firm is not exempt from the pay-to-play rule even though the executive may be outside the securities firm’s corporate governance structure.
This finding by the SEC regarding the reach of the pay-to-play rule indicates the SEC will be active and aggressive in this area. Indeed, within two weeks of the Report of Investigation, the SEC filed a settled enforcement action against a Dallas-based securities firm for violating the pay-to-play rule. A senior vice president of the firm’s public finance office made campaign contributions to the Treasurer of Massachusetts within two years of the firm co-managing 19 Massachusetts bond offerings. The settlement required the firm to disgorge all of the fees it earned from the offerings (plus interest) and to pay a substantial civil penalty.
These two recent actions by the SEC, in conjunction with the newly established municipal securities specialty unit, indicate a ramped-up enforcement effort in the municipal securities markets generally, and with respect to pay-to-play issues specifically. Securities firms and, if applicable, their bank holding companies or affiliates, must carefully analyze campaign contributions to issuer officials and have adequate procedures in place to ensure that the pay-to-play rule is not violated.