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Wednesday, Aug. 23, 2006 | The worlds of accounting and Wall Street can seem a blur among the flurry of technicalities, statutes and terms of art. But after years of a financial crisis perpetuated by resignations and scandal, the fates of five sitting City Council members all appeared to settle down into the definition of one all-important word this month: fraud.
Were they found to have committed it, the council members likely would now face pressure to resign and feel the sting of reprimand from the Securities and Exchange Commission.
It appears the council members have escaped those public punishments two weeks after the release of the report that was supposed to answer all of those questions. Outside auditors seem confident with the finding that the city’s politicians simply acted negligently – and didn’t, therefore, recklessly or knowingly release false financial information to Wall Street investors. And, if the Kroll report is used as a guidepost, it is unlikely the SEC will pursue enforcement actions against them.
But that one word – fraud – isn’t as black and white as you would think.
Arriving at a finding of fraud requires interpreting an individual’s mental state at the time in question, such as whether someone accidentally or recklessly released false information to investors. Even once that judgment is made, delineating what can officially be deemed fraud can be a nuanced dance.
The authors of the Kroll report, private consultants and experts in their field, say that former Mayor Dick Murphy and current and former City Council members acted negligently but didn’t violate federal antifraud provisions in allowing the release of bad financial information.
However, other securities experts say that rules governing negligence are, in fact, antifraud provisions.
“The general understanding in the securities law community is that Section 17 is an antifraud provision,” said Sean O’Connor, a securities law professor at the University of Washington in Seattle, referring to the specific statute under which the elected officials would be judged in this case.
The debate might end up being largely academic, as experts agreed with or without the official stamp of fraud, the City Council likely won’t face official civil or criminal repercussions for their actions if federal investigators come to the same findings as Kroll. Fraud or not, negligence usually escapes punishment. However, if the report had been worded differently, the history of modern San Diego would be painted with a bit of a different tint – and headlines around San Diego and the nation very well could have focused on council members’ behavior, rather than consultants’ comparison of San Diego to Enron and the like.
There are essentially three levels of securities fraud, ranging from negligent to reckless to intentional, with each carrying differing severities of punishment. The latter two levels can result in everything from forced resignations and fines to jail time at the most severe, while the former is often ignored or handled with an administrative slap on the wrist.
The judgment is rather esoteric, especially in a forensic accounting world heavy with documentation and hard numbers. In assigning a level of fraud, investigators and attorneys seek to assess a person’s state of mind at the time in question.
The top two levels are reached when it is found that a person intentionally misled the investment world or made an “extreme departure” from ordinary standards of care. Negligence essentially means the financial disclosure error was an accident.
The laws exist in order to protect investors from being bilked by those offering investments in the public markets.
The group of private consultants from Kroll, led by former SEC Chairman Arthur Levitt, found that eight former top city staff members likely committed securities fraud either knowingly or recklessly and therefore violated Section 10(b) of the Securities Exchange Act of 1934. If the SEC follows Kroll’s logic, these eight staffers – who include a deputy city attorney, treasurer, auditor, wastewater director and retirement administrator – will likely face civil charges from the SEC.
The finding on council members was less exact. The report states they were: “negligent their fulfillment of their bond offering disclosure responsibilities.”
That finding has left a bit of confusion as to the consultants’ specific legal analysis on the council members’ actions.
Attorneys for Kroll said the evidence could have been sufficient to find that council members indeed violated Section 17(a) of the Securities Exchange Act of 1933 in their negligence. But they didn’t go as far as to do the actual legal analysis, leaving the more nuanced statement to stand for their assessment. They did perform other legal analyses on other unrelated laws in the same section, including a finding that current and former council members and Murphy – with the exception of Councilwoman Donna Frye – “knowingly and willingly” caused the city to violate state and federal civil laws in other arenas.
However, they stopped short of going that far in their analysis of securities law breaches because, they said, the auditors who had requested the investigation needed only to know if someone acted recklessly or intentionally – not necessarily accidentally.
“Because if management is dominated by defrauders, then the auditor will probably want to have nothing to do with them,” said Michael Young, an attorney representing Kroll, in an interview. He literally wrote the book on dealing with the types of troubles faced by the city, titled “Accounting Irregularities and Financial Fraud.”
In the presence of fraud, the auditor would likely walk away from the engagement unless the top officials resigned. But with a negligence finding, the auditor is comfortable leaving those elected officials in place. The logic: Just because someone makes a mistake doesn’t mean they should be fired, Young said.
In the end, the consultants determined that council members weren’t involved enough in the disclosure process to carry greater culpability.
Upon questioning at the Aug. 8 release of the report why a further legal analysis wasn’t performed to answer whether the law truly was violated, Young responded: “The negligence-based aspects of Section 17(a) are not antifraud provisions.”
A number of securities experts contacted for this story disagreed with that statement. They said that the laws governing negligence are indeed part of the SEC’s antifraud provisions, even if a negligence finding is unlikely to incite agency punishment.
Indeed, documents from an SEC administrative hearing in 1999 indicate that the SEC has considered a violation of the statute to be a violation of its own antifraud provisions. In those documents, the SEC asserts that Richard Davis, a 28-year-old businessman in Duncanville, Texas, “violated the antifraud provisions of the securities laws, set forth in Sections 17(a)(1) and 17(a)(3).”
The first statute referenced requires intentional defrauding; the second simply refers to negligence.
A memo given to City Council members in 2001 containing securities law advice also stated that “the SEC need only demonstrate that the person acted negligently to establish a violation of … antifraud provisions.”
“You could accidentally do something that operates as a fraud,” said Lynn Stout, a securities law professor at the University of California, Los Angeles.
However, Stout said, the final implications are purely academic.
“You could say that technically it’s a violation, but it’s not a violation that provides basis for civil or criminal action,” she said. “So it’s really a moot point.”
O’Conner, the professor from the University of Washington, said the debate is emblematic of larger problem in the field.
“What concerns me in all of this is as we’ve gotten more hyper-technical with our disclosure and rules, we’ve given people more opportunity to defraud the public,” he said. “You give people enough leverage to say, ‘I technically agreed with one law.’”
It is rare that the SEC pursues a negligence finding with civil charges in a municipal setting. In 2003, it did enter into a cease-and-desist order with the chairman of the Massachusetts Turnpike Authority for approving three bond disclosures that failed to include projected cost increases. Kroll investigators said they were unable to find a case in which an elected official was punished for negligence.
Young dismissed the 1999 SEC document, saying “it’s a writer generalizing.”
“To be sure, there are those who from time-to-time generalize and include aspects – all aspects – of 17(a) as so-called antifraud provisions. Technically, that’s not right,” he said.
Young and his law firm, Willkie, Farr & Gallagher, represent the accounting profession – the Big Four accounting firms. That includes KPMG, which has been auditing the city’s long-delayed fiscal year 2003 financial statements for a year and a half. The city has been under investigation by the Securities and Exchange Commission since early 2004 after errors and omissions were found in its financial disclosures to investors.
The report completed by Young and his associates was commissioned to lay out for KPMG who at the city violated securities and other laws. Young said auditors are more interested in the reckless and intentional violation of securities laws, and less interested in the negligent ones.
“When we talk about violation of the securities laws, what the auditor really wants is to distinguish between members of management who had what we called ‘wrongful intent’ and members of management who were simply negligent,” he said.
The Kroll findings will also be given to the SEC. Young said it wasn’t necessary to lay out a legal violation for the SEC either because the commission will use the factual discussions in the report to come to its own conclusion.
He said he bases his definition of “fraud” based on the 1976 Supreme Court decision, Ernst & Ernst v. Hochfelder, in which the justices rebuffed a securities fraud lawsuit because the plaintiff alleged only negligence.
City Attorney Mike Aguirre has contested the Kroll findings, backing his earlier findings that elected officials’ actions rose above negligence and reached the more serious levels of securities fraud. The city attorney met with the SEC on Monday to discuss the Kroll report. He said at a press conference Tuesday that the SEC assured him it was working independent of Kroll. Aguirre said he thought the SEC’s judgments could be significantly harsher than Kroll’s.