Monday, Aug. 14, 2006 | In 1993, Arthur Levitt Jr. took over the Securities and Exchange Commission and soon began to make municipalities around the country tremble in their boots.

Levitt admitted then that, from his past experience as a high-finance guy, he had handled a lot of deals involving municipal bonds. And in those deals he had realized that those investors who loaned cities and counties across the country money to provide services and facilities to taxpayers didn’t always know exactly what kind of risk they were taking.

He set out to change that. In 1995, he explained his new passion to The New York Times:

“Municipal finance is the No. 1 priority of the [Securities and Exchange] commission,” Levitt told the Times in a story that referred to either him or the SEC (or both?) as “The New Sheriff in Town.”

“It’s an obsession of mine, and we’re going to come down hard,” he said. “Municipal officials are the custodians of billions of dollars in public funds, and those who have committed fraud will be called to task.”

The comments came after Times reporter Leslie Wayne noticed that Levitt’s SEC was quite bold in this area – unlike ever before, it was applying the standards, faced until then only by corporations, to governments all over the nation. In Colorado, Levitt’s investigators were wondering why Denver had asked bond buyers for loans without disclosing some important information about the potential delays (and resulting costs) construction of its new airport had encountered. The SEC later dropped its investigation into Denver.

But there were others: Maricopa County, Arizona; Miami; and, of course, Orange County.

All three would eventually face the SEC’s wrath for not having properly disclosed their government’s money troubles to buyers of their bonds. It seemed logical. If you apply for a loan and lie about how much money you make or the fact that the IRS or your ex-wife garnishes all your wages, you can get into some trouble. Why shouldn’t a government and its leaders worry about something similar?

Levitt was all over it:

“When someone goes on a board, even if it is the school board, I want them to be as mindful of disclosure and securities laws as directors of a corporate enterprise. I have no patience with municipal officers who say that ‘we didn’t understand.’”

He may have grown more patient with age.

Levitt was the principal member of the city of San Diego’s so-called audit committee – run by Kroll Inc. – that last week presented its much-anticipated report on City Hall misdeeds.

Kroll determined, essentially, that a group of eight former city officials – all upper-level bureaucrats – intentionally and illegally deceived buyers of the city’s bonds.

The firm made a legal conclusion to this effect saying that these managers violated section 10(b) the Securities and Exchange Act of 1934.

But what about the guys in charge of the city at this time? What about the city managers? The City Council?

Kroll said those people were “negligent” and then said no more. Kroll wrote nothing about whether they violated any law. They said they intentionally left the question unanswered.


To be sure, I’m not clear that there is evidence that the City Council knowingly deceived investors. It’s quite clear that they just allowed the deceit to occur.

But that’s considered securities fraud too, and it seems very odd that Kroll didn’t decide to go ahead and say so.

Here’s Kroll on what the anti-fraud provisions of the Securities and Exchange Law are:

While the majority of federal securities laws do not apply to municipal issuers, municipal actors – including the City’s employees and the city itself – are subject to the anti-fraud provisions of the securities laws, in particular Section 17(a) of the Securities Act of 1933 …

What’s section 17(a)? Again, from Kroll:

Section 17(a)(2) and 17(a)(3) require only proof of negligence for statements made in connection with the issuance of securities.

There is a fundamental question here that I just can’t get over:

Why, when describing the eight city department managers, was Kroll willing to document the anti-fraud statute they violated but then, when it comes to the City Council and the two city managers who watched over the affairs of government, does Kroll only describe it vaguely?

Kroll clearly lays out the evidence that former Mayor Dick Murphy and Council members Scott Peters, Brian Maienschein, Jim Madaffer, Donna Frye, Toni Atkins and former Council members, George Stevens, Byron Wear and Ralph Inzunza civilly violated Section 17(a) of what they refer to in the report as the “anti-fraud provisions of the securities laws.”

In other words, Kroll is saying that they committed securities fraud, if only the lesser version.

There is something wrong with that: Kroll for some reason decided not to actually say it.

As to members of the City Council, we believe the evidence supports a determination that the following council members were negligent in fulfillment of their bond offering disclosure responsibilities.

That sounds different than, say, “The City Council Committed Securities Fraud.”

The firm left it up to us to connect the dots that this means the council members likely violated 17(a). They were willing to draw the connection to the law violated for the eight department managers but not for the City Council or its managers.


Andrew Donohue did some reporting on this last week. He asked Benito Romano, Kroll’s attorney and a former U.S. attorney, the question for a This Just In the other day.

Romano said it was found that the council members’ behavior did not rise to the top two levels of securities fraud (wrongful or reckless). He said evidence did support a violation of 17(a), but the audit committee didn’t come to an ultimate conclusion.


Aguirre, before he became too much of a distraction, had tried to ask something similar of Kroll when the firm presented the report last week. The city’s auditors wanted Kroll to look to see if securities fraud had taken place. Why wasn’t the council considered to have committed or not committed securities fraud?

Romano said the firm had concluded that the council had only been negligent. Aguirre pressed him. At that point, Romano’s partner, Michael Young, swooped in to provide an answer (this is word-for-word transcribed from the City Council meeting last week available for viewing here.):

The negligence-based aspects of section 17(a) are not anti-fraud provisions. The reason that the auditor is less interested in negligence is that people make mistakes all the time and if somebody makes a mistake, it doesn’t mean they have to be fired. It doesn’t mean they have to resign. So the auditor is less interested in that.

OK, two things:

  • One, Young is completely disagreeing with, well, his own firm and his client. As we pointed out, Kroll says that the anti-fraud provisions include “in particular” the negligence-based elements of section 17(a).
  • Two, what’s this about “mistakes” and why people shouldn’t have to resign because of them? Arthur Levitt isn’t supposed to have patience for people who say this kind of thing.

Like I said, the council may not have intentionally done anything but they all plainly did not take the advice they had been given. They were told to pay close attention to what disclosures they approved. They didn’t.

In 2001, the very lawyer who had represented Orange County in front of Levitt’s SEC had come to a private meeting of San Diego’s City Council and told its members to be very cautious before they let any of those disclosures out the door. So dire was his warning, according to Kroll, that the council had been “somewhat shaken” by the lawyer’s presentation.

But did they ask any tough questions? They didn’t.

All of them, with the notable exception of Donna Frye, made a very conscious decision that they didn’t care that the city was in plain violation of state laws regarding its sewer rates system. Then they made another very conscious decision – despite the objections of Frye – that they should furthermore hide this information from the public, and therefore investors, along with the incredibly important fact that it might cost the city hundreds of millions of dollars.

Those are more than mistakes. They may not justify fines or punitive actions, but they aren’t just mistakes. A mistake is a typo.

But I digress. Where is Kroll’s conclusion about what violations of which statutes the council committed or expressly didn’t commit? The firm says vaguely that the council members were “negligent” and Romano admitted verbally that it was the type of negligence that would make them guilty of violating section 17(a) of the anti-fraud provisions of the Securities and Exchange Act of 1933.

So why not say this in the report?

The simplest answer for why Kroll worded it the way it did is unsettling because it only begs more questions: The firm wanted to say that the council was in violation of 17(a) without really ever saying it. Why would it do that?

That level of securities fraud may not justify action from the SEC and it may not even justify the resignations or punitive actions against the people who committed the violations. But they’re still violations of securities law.

Why go through such an exhaustive investigation at such a staggering cost and not go this extra step answering the question of whether the council violated this provision or not? Why do it to the eight managers but not to the council members? Why risk facing the questions that you weren’t independent enough from the council members to avoid protecting them from a determination that they committed securities fraud?

Arthur Levitt told the council last week that he was sure council members would admit that Kroll didn’t pull any punches.

I’m sure they would too.

Please contact Scott Lewis directly with your thoughts, ideas, personal stories or tips. Or send a letter to the editor.

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