Drawing Blood Still to Come in Muni Business: Arthur Levitt

By Arthur Levitt - Aug 19, 2010 9:00 PM ET

Bloomberg Opinion

At first blush, the punishment delivered to the state of New Jersey over its misrepresentations to municipal bond investors might look severe. Look deeper and it’s hardly even a mild spanking.

Don’t blame the Securities and Exchange Commission for this largely symbolic action. Blame Congress.

Earlier this year, Congress had a chance to give the SEC new authority to oversee the municipal bond market, but decided not to. It did this in spite of evidence this market is rife with the hallmarks of abuse: poor disclosure, little regulatory oversight, made-to-order accounting rules and insider deals driven by banker and consultant fees.

Yet Congress, at most, recommended further study. In Washington, further study is tantamount to burial.

Nevertheless, SEC Chairman Mary Schapiro has indicated she will use whatever authority she does have to crack down on muni market abuses. This is the first enforcement action taken by the SEC’s Municipal Securities and Public Pensions Unit.

Expect more. The balance sheets and income statements of governmental authorities are a mess. The growing crisis in public pensions, which are underfunded by as much as $3 trillion, is already beginning to shake up municipal bond investors, who recognize the risk of default even if offering documents papered over those liabilities.

Attention Getting

A chorus of investors is agitating for more accurate and relevant accounting standards for the pensions, which will only highlight their weaknesses. Clearly, the SEC can do plenty, even if Congress sits on the sidelines.

If the SEC wants to really get the attention of those who routinely abuse investors, here are four easy ways to do it:

No. 1. Name the wrongdoers, and sue or charge them individually. Bond documents bear the names of elected and administrative officials, attesting to their truthfulness. Let’s take them at their word. Those responsible for malfeasance should be held to account personally.

Think of the difference it would make when public officials, knowing their careers, reputations and even personal freedom are on the line, are asked to sign off on documents for bond offerings. Expect a reaction much like that which followed the Sarbanes-Oxley requirement for corporate filings bearing the signatures of company executives: more transparency, faster disclosure and more truth.

Offering Details

No. 2. Whatever misdeed is identified, the SEC has the power to describe the malfeasance in detail. A comprehensive summary of how municipal bond offerings go awry can serve as a textbook for investigators looking at similar scams, schemes and frauds.

States, counties and cities also can learn from each other, and recognize the patterns of deceit that are always lurking.

No. 3. Take on the bond advisers, not just the issuers. In every fraudulent bond deal, there are underwriters, legal counsel, auditors and a cast of others whose advice paved the way. Let them bear some of the responsibility when bonds are issued in bad faith. Charge them alongside the municipal authorities, and have them share in the fines.

No. 4. Leave a mark. When the SEC came down hard on the city of San Diego for misleading investors on a bond deal, it conducted a grueling investigation of the fraud, sued several of the people responsible for the misleading disclosures as well as the city’s independent auditor, and required the city to put in place an outside monitor to make sure it complied with necessary reforms.

Indelible Memory

Assuming the evidence was as strong, there was no reason to spare New Jersey the same treatment. Enforcement should leave everyone involved with an indelible memory of the price paid for the offense. Sterile settlements don’t inspire fear in the hearts of municipal authorities.

Of course, the SEC should still have the power to go further than it can now. It should be unshackled to confront the widespread abuses of municipal bond investors the same way it regulates the corporate bond market.

That would require congressional action to repeal the 1975 Tower Amendment, which prevents such SEC oversight of the municipal bond market. There is no other law in the U.S. with the same capacity to harm investors ­- and despite repeated calls for its repeal, the new financial regulatory reform legislation did nothing significant on it.

Tools at Hand

Therefore, we should assume such a repeal will have to wait until there is an implosion. The SEC has to do its job with the tools it has. Sadly, there is plenty of work to be done.

New Jersey’s sins were pedestrian: Its officials didn’t fact-check offering documents, didn’t tell investors proceeds would be used to cover general-fund deficits, and didn’t disclose the extent of pension obligations.

In the municipal bond market, such violations are commonplace. The real question isn’t why New Jersey was tagged, but why more states and localities haven’t been.

Here’s hoping that we won’t have to wait much longer, and that when it brings the next enforcement action, the SEC draws blood.

(Arthur Levitt was chairman of the SEC from 1993 to 2001 and is a director of Bloomberg LP, parent of Bloomberg News. The opinions expressed are his own.)

To contact the writer of this column: Arthur Levitt at alevitt@bloomberg.net