SEC Sanctions City for Securities Fraud

Posted: 2:09 p.m.

Tuesday, Nov. 14, 2006 | The Securities and Exchange Commission announced a settlement with the city of San Diego today, finding that the city failed to reveal the gravity of its financial problems and misled investors about its looming pension and retiree health care deficits.

The federal regulators announced the settlement with the city this morning, ending one aspect of the SEC’s two-and-a-half year investigation into city finances and removing one of many clouds that have long hung over City Hall. The SEC indicated it isn’t finished, however, noting in a statement that investigations into individuals and other entities who may have committed securities fraud are ongoing.

The SEC settlement order states that the city committed securities fraud in making material misleading statements to investors that failed to disclose mounting deficits in its pension system and retiree health care obligations. The false statements were made in connection with the sale of $260 million in city bonds and continuing updates related to an additional $2.29 billion on outstanding bonds.

“Despite the magnitude of the problems the city faced in funding its future pension and retiree health care obligations, the City conducted five separate municipal bond offerings, raising more than $260 million, without disclosing these problems to the investing public,” the order states.

The city to date has made good on its repayments to investors. But the regulators found that the undisclosed information was important to the investing public because the size of the deficits called into question the city’s ability to repay its investors.

“Under such a scenario, the City could be forced to choose between paying pension contributions, paying what the city owes on bonds and notes, reducing services, and/or raising fees and taxes,” the order states.

The SEC order portrays a city that worked to avoid confronting its debts and disclosing its future obligations to potential investors. The order doesn’t name officials specifically, as individuals are expected to be dealt with after the entity. However, it does note that officials from offices of the former city manager, city attorney and city auditor were aware of the city’s obligations and had a hand in preparing the statements to Wall Street.

The city avoided paying any fines as part of the settlement and instead has agreed to cease its previously fraudulent activities and to be overseen by an independent monitor for three years. Hired at the city’s expense, the monitor will ensure that officials have reformed past practices.

City Attorney Mike Aguirre and outside counsel John Hartigan hammered out the settlement over the course of the last year. Aguirre last year severed the city as an entity from its officials in settlement talks, leaving city officials – including the City Council – to fend for themselves on the hope that he could resolve the city’s issues sooner.

The order’s practical impact is unclear. The city shook from its back one of the bevy of state and federal investigations into city finances. However, with the order, San Diego etched itself a place in history as one of the largest municipal governments in the United States to be found to have committed securities fraud.

And, as a result of the disclosure issues and deficits, the city’s credit rating has been suspended, as has its access to Wall Street. That access is expected to be granted once three years of overdue audits are completed. Some believe auditors have been withholding their certification pending the SEC investigation.

The resolution of the city’s portion of the investigation also clears the way for the SEC to pursue punishment against individuals. Focus now likely shifts to whether or not the federal government goes after any of the five sitting City Council members who served in 2002 and 2003 – Scott Peters, Toni Atkins, Donna Frye, Brian Maienschein and Jim Madaffer.

Outside consultants have alleged that eight former top staffers knowingly or recklessly committed securities fraud, while opining that council members and former Mayor Dick Murphy acted negligently – a lesser charge. If the SEC were to come to similar findings, it would likely bring enforcement actions against the eight former staffers, but not the elected officials.

SEC agents have met repeatedly with attorneys for several sitting City Council members.

The federal regulators also signaled that they looked to make an example out of San Diego at a time when governments at all levels across the nation grapple with growing pension and health care deficits.

“This action signifies our resolve to hold state and local governments accountable when they commit fraud while seeking to borrow the public’s money,” said Linda Chatman Thomsen, SEC enforcement director, in a statement.

Council President Scott Peters said the settlement allowed the city to close a “very painful chapter” in its history.

“Although we could have fought this sanction in court where the SEC would have had to prove its case, the council unanimously agreed that it was in the best interest of the city to settle the case and allow the city to move forward,” he said.

Councilwoman Donna Frye credited Aguirre and Hartigan for their hard work and said in a statement that the settlement “allows the City of San Diego to continue making progress in addressing our financial disclosure problems.”

“However, this settlement should serve as a lesson for all of us to show that we have learned from the past and will fully disclose and address the city’s financial problems,” she said.

The SEC focused squarely on the pension and retiree health issues, although investigators had turned their focus to potential disclosure problems related to the city’s wastewater department.

The SEC order found the city failed to disclose that:

• It intentionally underfunded the pension system “so that it could increase pension benefits but push off the costs associated with those increases into the future.”
• The pension deficit was “expected to grow at a substantial rate,” reaching approximately $2 billion by 2009. Additionally, the order found the city to have not disclosed that its annual payment into the pension system was expected to quadruple by 2009.
• The debt was a result of intentional underfunding, the granting of retroactive benefits, the siphoning off of investment returns to pay additional benefits, and lower-than-expected investment returns.
• The city would have “difficulty funding its future annual pension contributions unless it obtained new revenues, reduced pension benefits, or reduced City services.”
• It carried an estimated $1.1 billion liability for future retiree health care costs.
• The retiree health care costs were paid from a reserve expected to be depleted by 2006, at which time the $15 million-a-year costs would have to come from its annual budget.

The SEC found that the city, through its officials, acted with scienter – a term of art in the securities world that defines someone’s state of mind when acting knowingly or recklessly.

“The fact that a federal agency has found our city to act with scienter, in essence intentional deception, is unacceptable,” said Mayor Jerry Sanders.

Much of the city’s pension problems came about because of pension deals crafted in 1996 and 2002. The deals allowed the city to annually shortchange the pension system while at the same time offering employees enhanced benefits.

The deals, which allowed short-term budget freedom, have in the long-term proved disastrous, as they coupled increased burdens with decreased funding. The growing burdens are expected to chew up increasing chunks of the city’s annual budget, meaning that services likely will have to be cut or taxes increased.

As a result of the 2002 pension deal, state and federal prosecutors have brought criminal corruption charges against eight current and former pension officials. Aguirre is also challenging the legality of both deals with the goal of voiding the benefit increases and wiping away hundreds of millions of dollars from a $1.4 billion pension deficit.

The order noted that the city had implemented a number of reforms since 2005, including terminating or allowing to resign a number of officials in the City Manager’s Office and the Auditor’s Office. The federal regulators also acknowledged that former Mayor Murphy resigned and a number of outside professionals had been added or replaced.

Mayor Sanders, upon urging from outside consultants, is also pushing a 121-point plan with the goal of reforming the city’s financial disclosure process.

Walter J. St. Onge III, a board member with the National Association of Bond Lawyers, said the settlement sounded relatively standard.

“The cease-and-desist proceedings, I think is pretty common, particularly with governmental issuers,” he said. “I think there have been cases where fines have been enforced, and other draconian measures, but that’s uncommon with issuers. So this sounds like this is fairly within the mainstream with the type of sanctions that they will impose.”

Staff writers Evan McLaughlin and Vladimir Kogan contributed to this report.

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