The SEC: The Future Path of Enforcement

This is the first of a four part series projecting the path of SEC Enforcement. The remaining parts of this series will be published later this week.

SEC Enforcement is in transition. The agency has a new Chair, new Commissioners and a new Director of the Division of Enforcement. Aggressive new approaches have been outlined, building on the notion that the enforcement program has regained its swagger.

There are, however, questions about the vitality of the program. While the Enforcement Division has focused on speeding investigations and brought record numbers of cases in recent years, production is dwindling. A new enforcement doctrine, keyed to being omnipresent and selectively demanding admissions, backed with threats of trial is being questioned and may be stumbling.

For those who deal with the agency and its cornerstone Enforcement Division, the critical question is the direction of the program. That path can be projected by carefully examining recent key cases in view of positions being articulated by Commissioners various initiatives being implemented.

A Look Back: Where the Enforcement Division Has Been

Statistics:One measure of the enforcement program is statistics. Following the market crisis the agency and its enforcement program were not just in disarray but suffered from disrespect. Significant failures and more meant that an agency once little known on Main Street where most thought SEC stood for South East Conference became a subject of intense criticism.

In this context a new Commission and enforcement director boldly undertook the largest reorganization of the enforcement program since the founding of the Division in the early 1970s. New tools were created to enable and speed the investigative process. The effort yielded results. Record numbers of enforcement actions were brought. Those include the larges number of market crisis cases brought by a federal regulatory agency. While detractors argued about the types of cases and questioned the lack of individual accountability, it cannot be disputed that the Commission and its storied enforcement program pulled back from the brink, righted and set on a new course.

Now, however, under yet another new Commission the record numbers of enforcement actions are a thing of the past. Examination of the number of enforcement actions brought in recent months suggests that the program is again foundering. The number of actual enforcement actions brought last year declined by about 23% compared to the prior year despite all the recently crafted tools provided to the Division to speed investigations. In 2013 a total of 261 enforcement actions were brought compared to 339 in the prior year.

Actual enforcement actions include Federal District Court cases and administrative proceedings but excludes two groups of proceedings counted by the agency: 1) Those based on Exchange Act Section 12j brought to revoke an issuer’s registration for failing to file the required periodic reports and which largely resolve by default, and 2) “tag along” proceedings such as Rule 102(e) actions revoking a professional’s right to appear and practice before the agency based on the resolution of another enforcement case. The elimination of these two groups of proceedings provides a truer measure of actual enforcement activity and has a significant impact on the statistics. For example, for fiscal 2013 (October 1, 2012 through September 30, 2013) the Commission reported that 686 enforcement actions were brought. When only actual enforcement actions are counted the number is reduced to 261 or less than half that reported by the SEC.

Counting only actual enforcement actions reveals similar trends during other periods. For example, the number of civil injunctive actions brought by the Division in Federal District Court in 2013 declined by about 34% compared to 2012. Last year 157 actual enforcement actions were filed in Federal District Court compared to 240 in the prior year. In contrast the number of administrative proceedings ticked up slightly in 2013 to 104 compared to 99 in the prior year.

The same trend is evident from the time of the appointment of the new SEC Chair in April 2013 through the end of the year when compared to the same time period in the prior year. During the former only 195 actual enforcement actions were brought compared to 288 during the same period a year before, a declines of about 32%. While the numbers only tell part of the story, they clearly suggest that the productivity of SEC enforcement is diminishing.

Significant actions in 2013: Despite declining statistics, the SEC was involved in a number of significant actions last year. Those cases focus on five areas: 1) Court decisions; 2) Exchanges/SROs; 3) Insider trading; 4) Municipal markets; 5) PRC issuers; 6) Funds; and 7) FCPA.

Court decisions: The SEC had mixed results in major court cases last year, losing in the Supreme Court while winning one significant district court case tired to a jury and losing another.

Supreme Court: In Gabelli v. SEC, No. 11-1274 (S.Ct. Decided February 27, 2013) a unanimous Court rejected the SEC’s efforts to write a discovery provision into the five year statute of limitations for seeking a penalty under Section 2462 of Title 28. The decision is largely based on the plain language of the Section which does not include the kind of discovery rule advocated by the agency.

What may become more significant is its application of the decision to a question not considered by the Court. In Gabelli the High Court did not consider whether the time limitation of Section 2462 applies to the Commission’s equitable remedies. That issue was examined in SEC v. Bartek, No 11-1-594 (5th Cir. Decided Aug. 7, 2012). There the Fifth Circuit not only rejected the SEC’s construction of Section 2462 regarding tolling prior to Gabelli, but also declined to issue and injunction or an officer and director bar in view of the age of the claims. The Commission initially requested that the Supreme Court review both rulings but later secured an order dismissing its petition in view of Gabelli. Thus Bartek stands and the agency has effectively acquiesced in the ruling which could significantly expand in the impact of Gabelli.

District court trial verdicts:The SEC won a significant jury verdict in SEC v. Fabrice Tourre, 10 Civ 3229 (S.D.N.Y.). That market crisis case focused on an action brought against, and settled with, Goldman Sachs & Co. The claims centered on the sale of interests in a synthetic collateralized debt obligation by Goldman. The CDO had been created at the behest of hedge fund Paulson & Co., Inc. which helped select the collateral and later shorted it. Interests in the CDO were sold to IKB Deutsche Industriebank AG and ABN AMRO Bank N.V. and unspecified domestic concerns without disclosing the role of Paulson, according to the SEC. Defendant Fabrice Tourre, the only Goldman employee charged in connection with the action, went to trial and lost when a jury return a verdict in favor of the Commission in August 2013.

In contrast, the jury found against the Commission in SEC v. Cuban, Civil Action No. 3-08-CV-2050 (N.D. Tx.), the other high stakes case tried to verdict before a jury by the agency last year. The case centered on insider trading charges against the owner of the Dallas Mavericks. The claims focused on whether Mr. Cuban had obtained inside information which precluded him from trading regarding a forth coming PIPE offering. Specifically, the SEC’s complaint claimed that Mr. Cuban engaged in fraudulent, insider trading when he sold a large stake in and avoided what later would have been a loss of about $700,000. The sale followed phone calls with Mamma officials in which Mr. Cuban, as the firm’s largest shareholder, was told about a coming PIPE offering. The company claimed Mr. Cuban was told the information about the PIPE was confidential. There were remarks by Mr. Cuban, according to the complaint, which suggested he understood he could not trade. The jury, however, rejected the insider trading claim, recalling the initial ruling of the district court which dismissed the Commission’s claims as insufficient before they were reinstated by the Court of Appeals.

Exchanges/SROs: The Commission brought two actions last year involving self-regulatory organizations and exchanges following its 2012 proceeding involving the New York Stock Exchange. In the Matter of New York Stock Exchange LLC, Adm. Proc. File No. 3-15023 (Sept. 14, 2012). (charging that the exchange made certain data available to select customers prior to its release).

In the Matter of Chicago Board Options Exchange, Inc., Adm. Proc. File No. 3-15353 (June 11, 2013). This is the first Commission action to sanction an SRO for conduct tied to its regulatory rather than business function. The proceeding centered on three key issues. First, the CBOE failed to adequately enforce the federal securities laws and its own regulations. Specifically, the CBOE failed to adequately enforce Regulation SHO regarding short selling. Second, during the course of an investigation by the SEC, Enforcement staff the CBOE “took misguided and unprecedented steps to assist the member which was under investigation . . . and failed to provide information to Commission staff when requested,” according to the Order. Finally, the exchange failed to adequately enforce its firm quote, priority and registration rules. The Order alleges violations of Exchange Act Sections 17(a)(1), 19(b)(1) and 19(g)(1).

After the SEC commenced its investigation the CBOE and its affiliate C2 Options Exchange, Inc., an affiliate, undertook a series of remedial efforts and initiatives which the Commission considered in resolving this action. The CBOE consented to the entry of a cease and desist order based on the Sections cited in the Order. C2 also consented to the entry of an order based on Exchange Act Section 19(b)(1). The CBOE also agreed to pay a civil penalty of $6 million and is continuing to implement a series of undertakings.

In the Matter of The NASDAQ Stock Market, LLC, Adm. Proc. File No. 3-15339 (Filed May 29, 2013) is a proceeding which names as Respondents the Exchange and NASDAQ Execution Services, LLC, or NES, its registered broker dealer. The Order centers on errors surrounding the May 18, 2012 IPO for shares of Facebook. Specifically, there were significant difficulties with the offering and the initiation of trading because of a design limitation regarding the manner in which orders are crossed or matched and the subsequent decisions of exchange officials. When it was discovered that a design mechanism impacted the cross of buy and sell orders, officials permitted the initiation of secondary trading without determining the root cause of the difficulty. Eventually the difficulty caused 30,000 Facebook orders to remain stuck in the system for about two hours. The errors also caused problems with trading in the shares of Zynga. In addition, the Exchange violated its rules by assuming a short position in Facebook shares of more than 3 million shares. Ultimately it realized a profit on that position of $10.8 million. NES also had net capital violations. The Order alleges violations of Exchange Act Sections 15(c)(3), 19(g)(1), Regulation SHO and Regulation NMS. To resolve the proceeding the Exchange will implement a series of undertakings. In addition, NASDAQ consented to the entry of a cease and desist order based on Exchange Act Section 19(g)(1), Regulation SHO, Regulation NMS and certain Rules. It also agreed to pay a civil money fine of $10 million, the largest against an exchange. NES consented to the entry of a cease and desist order based on Section 15(c)(3).

Insider trading:The Commission continued to emphasize insider trading last year. Many of its cases were parallel to criminal prosecutions brought by the U.S. Attorney’s Office in Manhattan. Significant cases brought last year included:

SAC Capital:The SEC settled two cases involving S.A.C. Capital entities for a record $600 million. In many ways it foreshadowed the eventual criminal case brought against Mr. Cohen’s business. The two cases are SEC v. CR Intrinsic Investors, LLC, Civil Action No. 12 (Civ 8466 (S.D.N.Y. Amended complaint filed March 15, 2013) and SEC v. Sigma Capital Management, LLC, (S.D.N.Y. Filed March 15, 2013).

The amended CR Intrinsic Investors case includes the initial defendants, CR Intrinsic, Matthew Martoma and Dr. Sidney Gilman and adds as relief defendants four hedge funds affiliated with S.A.C. Capital who are alleged to have benefited from the illegal trades. The claims in the amended complaint are essentially the same as in the initial civil and criminal actions. Those claims center on allegations that Mr. Martoma, who served as portfolio manager until 2010, obtained inside information from Dr. Gilman a professor of neurology at the University of Michigan Medical School who had a consulting contract with Elan Corporation, plc. The doctor consulted on certain clinical trials being conducted by Elan and Wyeth on clinical trials for the Alzheimer’s drug, bapineuzumab.

Dr. Gilman is alleged to have furnished Mr. Martoma with inside information on the Phase II trial for the drug as early as 2007, according to the court papers. In the period prior to the July 29 announcement of the trial results, the trader and the doctor spoke several times on the phone during which Mr. Martoma was given the then confidential results of the trials. Mr. Martoma was also furnished a copy of a power point presentation with detailed information. At the time funds managed by Mr. Martoma, and related funds at an affiliated entity, held a combined long position of over $700 million in Elan and Wyth securities. As a result of the inside information the long positions were liquidated. The funds immediately built a substantial short position in each security. Following the announcement of disappointing results, the funds had profits of about $82 million on the short positions. By liquidating their massive long positions the funds avoided losses of about $194 million. Overall the trading profits and losses avoided totaled over $276 million.

To settle the case CR Intrinsic consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The firm also agreed to pay disgorgement of $274,972,541, prejudgment interest and a penalty equal to the trading profits. S.A.C. Capital funded the entire settlement which totals about $600 million, according to Bloomberg (March 15, 2013).

The Sigma Capital action names the unregistered investment adviser as a defendant and two hedge funds alleged to have benefitted from the trades as relief defendants. The action centered on trading in advance of earnings announcements in the shares of Dell, Inc. and Nvidia Corporation. In each instance Sigma Capital obtained the inside information from Jon Horvath, later a key witness against former S.A.C. Capital principal Michael Steinberg who was convicted of insider trading. U.S. v. Steinberg, S4 12 CR. 121 (S.D.N.Y. Unsealed March 29, 2013). Mr. Horvath pleaded guilty to one count of conspiracy and two counts of securities fraud in the parallel criminal case. U.S. v. Newman, Case No. 1:12-cr-00121 (S.D.N.Y.).

In one part of the scheme Sandeep Goyal, an analyst at an investment adviser, periodically obtained inside information from an insider at Dell in 2008 and 2009. In each instance the inside information related to earnings announcements. The information was passed to Mr. Horvath and eventually to portfolio managers at S.A.C. Capital entities that traded and benefited.

A second facet of the scheme involved Danny Kuo, a fund manger at another adviser who was a member of the group which exchanged inside information. He previously pleaded guilty to one count of conspiracy and two counts of securities fraud related to this action. Mr. Kuo obtained inside information about Nvidia’s pending earnings which was later transmitted in May 2009 Mr. Horvath and to an S.A.C. Capital entity portfolio manager who traded and benefitted.

Sigma Capital agreed to settle with the SEC, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Ac Section 10(b). The firm also agreed to pay disgorgement of $6.425 million plus prejudgment interest and a penalty equal to the trading profits. While neither action charged S.A.C. Capital or Mr. Cohen, later the firm was named in a criminal indictment which essentially rolls up the convictions secured, and the insider trading charges against, then employees of the various fund entities. U.S. v. S.A.C. Capital Advisors, L..P., Case No. 13 cr 541 (S.D.N.Y.). The firm agreed to plead guilty to the five count indictment.

In the Matter of Steven A. Cohen, Adm. Proc. File No. 3-15382 (July 19, 2013. The week before the U.S. Attorney charged S.A.C. Capital, the SEC named Mr. Cohen in an administrative proceeding which alleges failure to supervise. That proceeding, like the subsequent criminal case, is built on the prior actions brought against firm principles. In contrast to many Commission administrative proceedings, the Order does not cite any statute, rule or legal authority as the basis for the charge. Mr. Cohen has vowed to fight this action.

Redefining insider trading cases:The SEC has been very aggressive in bringing insider trading cases, frequently pushing the edges as to what constitutes insider trading. Two examples of this are SEC v. Bauer, No. 12-2860 (7th Cir. Decided July 22, 2013) and SEC v. Moore, 13 Civ 2514 (S.D.N.Y. Filed April 16, 2013).

Bauer raises the question of whether there is deception and insider trading by an employee of an open ended mutual fund who sells her shares to the fund at NAV. Defendant Jilaine Bauer was employed at Heartland Advisors, Inc., an investment adviser and broker-dealer. Heartland advised a series of funds, two of which focused on municipal bonds. Those bonds can be difficult to price. Ms. Bauer was the general counsel and chief compliance officer to the adviser.

Beginning in 1999, and continuing through August 2000, the funds experienced substantial net redemptions. This created liquidity problems. In mid-August 2000 the co-manager of the municipal bond funds tendered his resignation. Ms. Bauer imposed trading restrictions on Heartland personnel aware of that event. On September 28, 2000 a press release announcing the co-manager’s resignation was issued. At the time the municipal bond funds continued to struggle. After the close of business Ms. Bauer lifted the trading ban as approved by the board of directors and subsequently redeemed all of her shares in one of the municipal bond funds which were still experiencing liquidity problems.

The SEC named Ms. Bauer in an insider trading complaint. The district court granted summary judgment in favor of the Commission. That ruling was based on the stipulation of the parties that Ms. Bauer was an insider who possessed non-public information at the time of the redemptions and the court’s conclusion that there was no dispute of fact as to the materiality of that information.

The Circuit Court reversed and remanded with instructions. In that Court the SEC sought to rely on the misappropriation theory of insider trading. Before the district court the agency initially relied on the classic theory. In addressing the latter Ms. Bauer argued that there was no deception because the redemptions were with the fund which, by definition, could not be deceived by that act. As to the former, she asserted that there cannot be insider trading because the board of directors of the adviser approved lifting the trading ban and, in ordering the redemptions, she identified herself to fund as an employee.

The Seventh Circuit began by noting that the SEC had abandoned the classic theory and now must proceed on the misappropriation theory. The Court then concluded that this is the first case to consider if insider trading applies to mutual fund redemptions. In view of that point and, since the issue had not been addressed by the district court, the case was remanded to that court for consideration of the issue. A critical question on remand will be whether there was deception as required by Exchange Act Section 10(b). See, e.g., U.S. v. O’Hagan, 521 U.S. 641 (1997)(adopting misappropriation theory); Chiarella v. U.S., 445 U.S. 222 (1980)(discussing classic theory). See also SEC v. Dorozhko, 574 F. 3d 42 (2nd Cir. 2009) (deception supplied by hacking a computer); but see SEC v. Knight, Civ. 2:11-cv-00973 (D. Ariz. Filed May 18, 2011)(settled insider trading action against employee who traded before the window closed with the consent of the company but while in possession of inside information); Cf. SEC v. Obus, Docket No. 10-4749 (2nd Cir. Decided Sept. 6, 2012)(concluding that there can be a breach of duty when company decides otherwise).

Moore charged a Toronto based investment banker with insider trading based largely on what he pieced together about a deal while trying to win business for his company. SEC v. Moore, 13 Civ 2514 (S.D.N.Y. Filed April 16, 2013) . The action centers on the acquisition of Tompkins plc, whose ADRs are traded in New York, by Canadian Pension Plan Investment Board or CPPIB and a Canadian private equity firm. The deal was announced on July 19, 2010.

At Canadian Imperial Bank, or CBIC, investment banker Richard Moore’s responsibilities included pitching possible investment transactions to win business for his bank. He had three top clients, one of which was CPPIB. Over time Mr. Moore had developed a business and personal relationship with a Managing Director at CPPIB who was in charge of the Tompkins acquisition. Mr. Moore periodically contacted the Managing Director, seeking business.

In early February 2010 CPPIB was approached by a Canadian equity fund about a possible acquisition of Tomkins. CPPIB studied the transaction and began moving forward. The Managing Director was put in charge of the transaction.

Subsequently, Mr. Moore repeatedly contracted his friend and, based on those contacts and other information detailed below, he had inside information, according to the complaint. That information included:

· In March 2010 when he contacted the Managing Director, Mr. Moore learned that his friend was working on something big. When Mr. Moore asked if his bank could work on the deal, he was told they would have to wait and see.

· In a March 24, 2010 e-mail Mr. Moore asked his friend if debt was needed on the deal. The Managing Director responded by inquiring if CBIC would underwrite $2 billion. Mr. Moore indicated “part yes” and asked “in Canada.” He was then told the deal was probably not for him.

· As the Managing Director continued to work on the deal from March to May, Mr. Moore learned that his friend was traveling to London.

· In June 2010 the two men attended a charity event. Mr. Moore observed the Managing Director in a chance encounter with an unidentified man. Although his friend declined to identify the individual, another person told Mr. Moore the man was the CEO of Tomkins.

· In a June 24 e-mail a senior investment banker at CBIC complained that CPIB was working on a “big deal” and the bank had no part of the work.

The day after the charity event Mr. Moore inquired with contacts from another deal about purchasing securities outside the country. Four days after the CBIC e-mail he purchased 51,350 Tomkins ADRs. He also purchased 42,000 Tomkins common shares on an exchange outside the U.S. Later Mr. Moore purchased an additional 170,000 shares outside the U.S. Overall, the purchases represented about one third of his net worth. Following the deal announcement Mr. Moore had profits on the ADR purchases of $163,000. The complaint alleged violations of Exchange Act Section 10(b).

Mr. Moore settled with the Commission, consenting to the entry of a permanent injunction based on the Section cited in the complaint. Mr. Moore did not admit or deny the allegations in the complaint except as to certain admissions made in a parallel proceeding brought by the Ontario Securities Commission. Mr. Moore also agreed to pay disgorgement of $163,293, prejudgment interest and a penalty equal to the amount of the disgorgement.

Social media/Reg FD:Finally, the SEC clarified its view on the use of social media in the context of making disclosures and complying with Regulation FD in an Exchange Act Section 21(a) Report of Investigation. Exchange Act Release No. 69279 (April 2, 2013), Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934, Netflix, Inc., and Reed Hastings.

Netflix has focused on expanding its streaming business for subscribers, according to the Report. In early January 2012 the company announced in a press release that it had streamed two billion hours of content in the fourth quarter of 2011. That metric was also featured in other subsequent disclosures and its import discussed by President Reed Hastings in a late January 2012 conference. In early June Netflix made a brief reference on its blog to the metrics regarding the streaming service. In a July 2012 post on his personal blog Mr. Hastings made a specific statement about the adoption of the streaming service which was not contained in company press releases. The stock price began to rise and reporters circulated the story.

In the Release the Commission clarified its guidance regarding the use of social media in the wake of the Netflix investigation. The agency decided not to bring an enforcement action. Generally, Regulation FD requires that an issuer discloses material nonpublic information to securities market professionals or shareholders in a manner reasonably designed to achieve effective broad and non-exclusionary distribution to the public. While no particular method of distribution is required, if an issuer deviates from its customary approach, it may impact any determination as to whether the method selected is reasonable under the circumstances. Consistent with these principles, in earlier guidance the Commission focused largely on corporate websites, providing a non-exclusive list of factors to be considered in evaluating if the corporate website constituted a recognized channel of distribution.

In considering the use of social media as was done by Netflix, there are two critical issues. The first centers first on the application of Reg FD. In this regard it is important that the company evaluate statements made through the social media in the context of Reg FD. Specifically, when an issuer “makes a disclosure to an enumerated person [in FD], including to a broader group of recipients through a social media channel, the issuer must consider whether that disclosure implicates Regulation FD . . . if the issuer were to elect not to file a Form 8-K, the issuer would need to consider whether the information was being disseminated in a manner ‘reasonably designed to provide broad, non-exclusionary distribution . . . ’” of the information.

Second, the August 2008 Guidance, while not directed specifically at the social media, should be considered. The critical point here is to “alert the market about which forms of communication a company intends to use for the dissemination of material, non-public information, including the social media channels that may be used and the types of information that may be disclosed through these channels . . . “ While every case must be evaluated based on its specific facts “without advance notice to investors that the site may be used for this purpose, [it] is unlikely to qualify as . . . “ an appropriate method for Reg FD. Applying this two prong approach should result in adherence to Reg FD and the August 2008 Guidance “with minimal burden,” according to the Release.

Municipal markets: The SEC also stepped-up its efforts in the municipal markets, bringing a series of cases centered on disclosure issues and issuing a Section 21(a) Report on the potential liability of officials.

In the Matter of Greater Wenatchee Regional Events Center Public Facilities District, Adm. Proc. File No. 3-15602 (Nov. 5, 2013); In the Matter of Piper Jaffrey & Co., Adm. Proc. File No. Nov. 5, 2013). These actions involved a Washington state municipal issuer and its underwriter. They are the first in which the Commission imposed financial penalties on a municipal issuer.

Wenatchee Regional names as Respondents: a municipal corporation formed by nine cities and counties to fund a Regional Center; Allison Williams, the Executive Services Director of Wenatchee, Washington who executed the closing certificate for the bond issue; Global Entertainment Corporation, the developer of the Regional Center; and Richard Kozuback, Global’s CEO and President. Piper Jaffrey names as Respondents the underwriter of the bonds involved here and Jane Towery, a Managing Director at Piper.

The underlying facts trace to 2005 when Mr. Kozuback made several presentations regarding potential funding sources to develop a Regional Center to interested groups. The next year the City of Wenatchee, Washington, along with eight neighboring municipalities and counties, formed the District which in turn entered into a development contract with Global, although the firm had limited experience in the area.

Global developed a series of financial projections for the operation of the Regional Center over the course of project. The projections were prepared for the budget and inclusion in the District’s Official Statement. After the initial projections were prepared in the summer of 2006, the City Council requested that an independent consultant review them. The consultant determined that the Regional Center might operate at a deficit and that its projected annual net operating income could be overstated by as much as 16% to 25%. The next month the City entered into a contingent loan agreement which would provide financial support for all or part of the project if necessary. Construction began.

By early 2007 the facility had to be redesigned and reduced in size because of cost overruns and unexpected building costs. Global crafted new projections. Again, the City Council brought in a consultant. Again the Consultant raised questions about the projections, although it concluded that the reduced project might be viable. In May 2007 the City Council voted to proceed with the Regional Center. Shortly thereafter the District authorized a lease agreement for the Center. Construction resumed.

By April 2008 Mr. Kozuback became concerned that sales of luxury seats were not proceeding as expected. Global provided new projections for the official bond statement which was in preparation. Funds from the issuance needed to be available by the completion of the center in September 2008 for its acquisition by the District. Based on the projections, the underwriter advised that a bond issuance might be difficult. The Mayor, who had cast a decisive vote at the City Council meeting which approved continuation, demanded that the projections be revised to be more optimistic. The revisions were made. The revised projections were included in the Official Statement without revealing the issues surrounding the revisions. The underwriter was unable to complete the financing.

Piper Jaffrey was retained in late 2008. The City and the District were searching for financing avenues. While various options were considered, the only viable one called for the issuance of short-term Bond Anticipation Notes or BANs that would mature two years later. The short term instruments would be refinanced through the issuance of long-term bonds. At the time the District and Mr. Williams knew that that if the revenue from the Regional Center was not adequate to support a bond issuance to repay the short term instruments the support of the City would be necessary. In the offering materials for the short term bonds a section discussing the constraints on the financial ability of the City to assist was deleted.

In 2011 the District defaulted on the outstanding $41.77 million short term BANs which had been issued. The State legislature then passed a sales tax to assist. In late September the District sold the long term bonds secured by the sale tax revenues to refinance the short term instruments.

Order alleges that the Official Statement for the short term instruments was false and misleading as was the certification of full disclosure. The papers did not adequately disclose the facts regarding the projections for the project and the limitations on the City finances, according to the Order. It alleges violations of Securities Act Sections 17(a)(2) and (3).

The Respondents in both proceedings settled. The District undertook to establish appropriate policies, procedures and internal control, institute training and certify completion of these steps to the Commission. It also consented to the entry of a cease and desist order based on Securities Act Section 17(a)(2) and a directive to implement the undertakings and pay a civil money penalty of $20,000. Ms. Williams and Mr. Kozuback both consented to the entry of cease and desist orders but based on Securities Act Section 17(a)(3) and will each pay a civil penalty of $10,000.

Piper revised its due diligence procedures and Ms. Towery agreed to implement undertakings which include limiting her activities as an associated person of a securities professional and to retain a consultant to review Piper’s municipal underwriting due diligence polices and procedures. In addition, the firm and Ms. Towery each consented to the entry of a cease and desist order based on the Sections cited in the Order and to a censure. The firm will pay a penalty of $300,000 while Ms. Towery will pay $25,000.

In the Matter of the City of Harrisburg, Pennsylvania, Adm. Proc. File No. 3-15316 (May 6, 2013) is an action against a Pennsylvania municipal issuer in which the Commission for the first time charged a municipality for making false and misleading statements outside of its securities disclosure documents. The Commission also used the occasion to issue a Report on the potential antifraud liability of officials for their public statements about the financial condition of the issuer. Release No. 69516, Report under Section 21(a) of the Exchange Act, Report of Investigation in the Matter of the City of Harrisburg, Pennsylvania Concerning the Potential Liability of Public Officials with Regard to Disclosure Obligations in the Secondary Market.

The Order alleges that by December 2007 Harrisburg, the capital of Pennsylvania, had outstanding obligations from both its general obligation bonds and the primary guarantees to its various component units totaling about $498 million. This represented eight times the city’s annual general fund revenues of $61 million for that year. A substantial portion of this debt had been issued by the city Authority, an entity with the power to issue debt. That debt, related to a Resource Recovery Facility or RRF, was guaranteed by the city. Although the specific disclosure obligations differed for various types of debt, Harrisburg executed a series of Continuing Disclosure Certificates which imposed certain financial disclosure obligations. The information was to be placed in a specified depository for investors.

During 2008 and 2009 the financial condition of Authority deteriorated. Various reports detailing this fact were furnished to the City Council and city administrators. By late 2008 the Authority did not have sufficient revenue to meet its debt service obligations for 2009 and beyond without a significant rate increase for a waste disposal unit at its Resource Recovery Facility. At the same time a report prepared by the Authority projected that debt service for 2009 would increase significantly. A rate increase for its RRF facility was sought. As a result of a dispute with the county, only a minimal increase went into effect. The Authority would not be able to service its debt. The city, as guarantor, was responsible.

Harrisburg did not complete the required financial reports for 2007 until December 2008. Those reports were not submitted to the repository until January 2009. Likewise, the required financial reports for 2008 were not completed until late December 2009. They were never submitted to the repository. The 2008 report was available on the website of the city. Both reports contained material misstatements and omissions.

During this two year period when accurate information regarding the finances of the city was not available, bond investors could only rely on public statements by the city, according to the Order. The little information that was available was materially incomplete. Thus, although the 2009 budget and a transmittal letter were available on the city website, they failed to include funds for the guaranteed obligations of the Authority despite the fact that it was unlikely to have the ability to service the debt. The budget also misstated the city credit rating, claiming that Moody’s had assigned a rating of Aaa rather than the correct Baa1 rating. Similarly, in an April 2009 address the Mayor made misleading statements by failing to detail the impact of the repayment obligations from the bonds.

During the period the city did not have policies and procedures to ensure that the financial information released to the public was accurate in all material respects. It did not have any policies and procedures to ensure that compliance with the Continuing Disclosure Certificates. The Order alleged willful violations of Exchange Act Section 10(b).

To resolve the matter the city agreed to a series of undertakings and consented to the entry of a cease and desist order based on Exchange Act Section 10(b). The Commission considered the cooperation of the city in resolving the proceeding.

In the accompanying Section 21(a) Report the SEC emphasized the applicability of the antifraud provisions to the statements of public officials: “Public officials should 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 the antifraud provisions of the federal securities laws.”

In the context of the proceeding involving the City of Harrisburg, the Commission noted, the statements made by public officials could have altered the total mix of information available to bond investors. As a result public officials who make such statements “should consider taking steps to reduce the risk of misleading investors. At a minimum, they should consider adopting policies and procedures that are reasonably designed to result in accurate, timely, and complete public disclosures . . . “

Other actions centered on the municipal bond market brought last year by the Commission include: In the Matter of the City of South Miami, Florida, Adm. Proc. File No. 3-15329 (May 22, 2013)(settled proceeding against the city based on a bond offering made to finance a public parking garage alleging incomplete disclosure regarding the project); In the Matter of Public Health Trust of Miami-Dade County, Florida, File No. 3-15472 (Sept. 13, 2013)(settled proceeding against a public health trust based on financial projections which lacked an adequate basis, the disclosure of incomplete information and the failure to inform investors about an adverse arbitration award); In the Matter of West Clark Community Schools, Adm. Proc. File No. 3-15391 (July 29, 2013)(settled proceeding centered on inadequate due diligence regarding the offering and inadequate procedures to ensure the prompt disclosure of information); In the Matter of State of Illinois, Adm. Proc. File No 3-14237 (March 11, 2013)(settled proceeding against the state tied to is pension plan).

The Commission also brought civil injunctive actions tied to the municipal markets. See, e.g., SEC v. City of Miami, Florida, Civil Action No. 1:13-cv-22600 (S.D.Fla. Filed July 19, 2013)(action against city and former budget director based on three bond offerings and violation of prior consent decree); SEC v. City of Victorville, Case No. EDCV 13-776 (C.D. Cal. Filed April 29, 2013)(action against city, its manager and the deal underwriter and broker along with its principal alleging fraud in connection with the issuance of bonds regarding a city airport authority).

Next: The completion of the segment considering significant actions brought in 2013.

This is the first of a four part series projecting the path of SEC Enforcement. The remaining parts of this series will be published later this week.

Tagged with: , , , ,