Wednesday, Nov. 15, 2006 | The Securities and Exchange Commission concluded its investigation into the city of San Diego on Tuesday, finding that the city committed securities fraud by misleading investors about its looming pension and retiree health care deficits.
The announcement of a settlement with the city marks the first public action in one of the SEC’s largest investigations into a governmental entity. It ends one chapter of the 33-month investigation into City Hall and removes one of many clouds that have long hung over City Hall. The SEC indicated it isn’t finished, however, noting that investigations into individuals and other entities who may have committed securities fraud are ongoing.
In the settlement, the city agreed to “cease and desist” all fraudulent activity and be monitored by an independent consultant for three years to ensure the reformation of its financial-reporting practices. The federal government issued no fine.
The SEC settlement order states that the city – through unnamed city officials – committed securities fraud in making materially misleading statements to investors that failed to disclose mounting deficits in its pension system and retiree health care obligations in 2002 and 2003. 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.
“The negative ramifications from this misconduct have extended beyond just bondholders. The city’s credit ratings were downgraded. The city has incurred enormous costs in attempting to deal with this issue,” said Randall R. Lee, director for the SEC’s Pacific region.
“The amount of time and attention the city has been forced to spend to make this issue right has clearly carried a cost to every resident of the city of San Diego,” he added.
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 city itself. 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 SEC settlement focuses 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.
As previous reports into city finances have, the order detailed the number of different sources, such as commissions, consultants or dissenters, that identified or warned against the impending problems. For example, it noted that a consultant hired to analyze the pension system stated that the city faced “significant credit and legal challenges” if it didn’t develop a plan for dealing with its pension burdens.
“The City’s disclosures in 2003 failed to inform investors of the financial adviser’s analysis,” the order states.
The initiation of the SEC investigation, as well as a parallel probe by the Justice Department, in early 2004 helped draw public focus to the city’s burgeoning financial problems. Since then, City Hall’s issues have unfolded very publicly, forcing the resignation or removal of former Mayor Dick Murphy and a long list of top administrators.
Mayor Jerry Sanders said Tuesday was a day of transitions. “Today we transition from a focus on our past to a focus on our future,” he said.
The settlement marked a victory for City Attorney Mike Aguirre, who hammered out the deal alongside outside counsel John Hartigan 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 question now is can we match this negative with positive action that will show the investing community, and really the rest of the country, that San Diego is not a corrupt city and we have learned our lessons,” said Aguirre, who advocated that the City Council atone for its mistakes by overturning a series of employee pension benefits central to the liabilities at issue.
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. In the last decade, the commission has also brought action against Miami, Orange County and the Massachusetts Turnpike Authority.
“It’s one of the most significant cases in this area that the commission has brought,” said Kelly Bowers, an assistant regional director with the SEC.
Sean O’Connor, a securities law professor at the University of Washington, said San Diego’s case will be talked about as one of the biggest municipal securities fraud cases handled by the SEC.
“Now you have the SEC saying this was a Ponzi scheme that the city thought it could grow itself out of,” he said.
An August report by private consultants from Kroll Inc. put the corruption of San Diego’s financial mismanagement on par with those of the Wall Street poster children of fraud such as Enron and WorldCom.
The resolution of the city’s portion of the investigation also clears the way for the SEC to pursue punishment against individual officials. The focus now 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. They opined 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 and attorneys for at least one council member, Atkins, have had settlement talks with the commission, according to attorney invoices.
Bowers, the SEC official, said the commission was “diligently pursuing” cases against individuals. He said the commission would normally bring cases against individual officials at the same time as the city, but said the city’s remediation steps paved the way for its early settlement.
“Generally we include individuals, but with all the facts and circumstances in this case it made sense to go ahead and bring the settlement with the city,” he said.
San Diego securities attorney Ed McIntyre, who isn’t involved in the case, said the commission will likely be bringing individual sanctions because the language of the order says city officials either knowingly or recklessly caused the city to commit securities fraud.
“As the SEC, I can’t imagine coming down with those kind of findings and turning around and saying, ‘Whoops, nevermind,’” he said.
McIntyre also credited Aguirre’s strategy for severing the individual officials from the city in settlement talks. “Here, clearly the strategy worked because the city is out from under this now,” he said.
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.
Rather than settle, the city could have chosen to fight any civil actions taken by the SEC in court, which would have continued to cast the pall of the probe onto City Hall.
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,” he said, “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.”
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.”
Much of the city’s pension problems came about because of 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 created short-term budget freedom, have proved disastrous in the long term, 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.
And, in the wake 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 restored once three years of overdue audits are completed. Some believe auditors have been withholding their long-delayed certification pending the SEC investigation.
The city has spent tens of millions of dollars in attorney, auditor and consultant fees as it has tried to unravel its fiscal mess. The consultants who produced the August report alone cost $20.3 million for their 18 months of work.
The order released Tuesday 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.
The commission generally doesn’t bring monetary punishment against governmental entities, and it held to form in the order released Tuesday. The SEC, however, does punish entities for a lack of cooperation.
City officials were scolded in early 2005 for their lack of cooperation. At the time, a city-funded investigation had been deemed insufficient, document production lagged and the retirement board refused give investigators access to its files.
“Particularly in the past year or so, the city’s cooperation has been pretty good,” said Lee, an SEC official.
The outside monitor will be contracted at city expense and be asked to complete a written report within 120 days of being hired. Two more reports are to be issued in the years afterwards and are meant to ensure that the city has followed through on its remediation plans, which can be recommended by the monitor.
Staff writer Evan McLaughlin contributed to this report.