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Wednesday, Nov. 15, 2006 | With the Securities and Exchange Commission’s probe behind it, the city of San Diego will press forward in its march back to the financial markets. But it will do so with visible scars of its past misdealing that could ward off potential financiers of the city’s much-needed infrastructure projects or draw new lawsuits.
Still, the crest of fog that has consumed the city’s financial outlook for the past two-and-a-half years partially lifted with Tuesday’s announcement, as the SEC settlement resolved one of the many issues that have drawn national focus to City Hall.
In light of the news, experts underscored their own indecision about how the financial world might respond to the SEC’s findings that the city government committed securities fraud.
“One way it’s a positive is that the uncertainty of what the SEC investigation would find is over,” said Amy Doppelt, an analyst at Fitch Ratings. “But the findings are difficult to accept for those in the market, especially in the ratings industry.”
Federal regulators found the city to have fraudulently downplayed the size of its looming pension and retiree healthcare deficits in the financial disclosures that accompanied five different bonds that went to market in 2002 and 2003. It also found that city officials misled the credit rating firms.
The settlement, which the City Council agreed to on Oct. 24, puts to rest the SEC’s 33-month investigation of the city’s past bookkeeping practices, although the agency said the possibility of charging individuals remains.
Known as a cease-and-desist order, the document requires the city to hire a consultant at its own expense to oversee the government’s progress in rebuilding its financial controls. Hiring an outside expert was a step city leaders had already been contemplating in light of the $20.3 million Kroll report.
By settling, the city avoids fines that can be levied against offending entities, while not having to officially admit or deny that it committed fraud.
However, the stench of the agency’s allegations will likely follow the city when it returns to Wall Street, a feat Mayor Jerry Sanders hopes the city can reach by next June.
“After a period of time, the market will sort of forget,” retired finance attorney Steve Simons said. “But in the next bond offering that San Diego does, they’re going to have to disclose this cease-and-desist action to bondholders of the new bonds, and people are going to be skittish about buying them.”
Simons, a director at the American College of Bond Counsel, said the settlement could draw out two negative reactions from the investment community.
“One is that the possibility that the holders of bonds could bring a lawsuit, a private lawsuit. The other is that it shakes the hell out of the confidence of the market,” he said.
City representatives were quick to point out Tuesday that the city has made good on all of its promises with respect to the $260 million it borrowed while using the defective financial information.
“I think it bears mentioning that the city has always honored its obligations to the individuals and entities that purchased our bonds,” Sanders said at a press conference Tuesday. “No bondholder ever lost any money.”
John Hartigan, the outside attorney who engineered the SEC settlement along with City Attorney Mike Aguirre, noted that two of the five bond offerings in question had been paid off entirely.
But defaulting on bonds, which is what helped propel the notoriety of Orange County’s financial meltdown in the mid-1990s, is not the only claim an investor can use to sue a borrower, experts said.
Because the city did not disclose its huge pension and retiree healthcare liabilities, it avoided having to pay a higher interest rate that financiers would have demanded in exchange for shouldering a greater amount of risk, they said.
University of Washington securities law professor Sean O’Connor said the settlement “pens up the doors for aggrieved investors to go after the city.” Even though the investors haven’t lost money, they could argue that they would have made more money had the city been forthright.
“That’s an edgier one,” he said of the theory.
Aguirre acknowledged the concern, but said the admissions – that the city misled investors – were already made by his office in February 2005 when interim reports about the city’s past disclosure practices were released. He said lawyers would have come knocking already if it was worth their while.
“There could be some law firms nationally that might try to contact the investors, I don’t know,” Aguirre said.
The city attorney instead claimed that investors would hold a higher regard for San Diego after the settlement because of the stricter accounting requirements that the city must follow.
Ed McIntyre, a local securities attorney, agreed, saying he thought the Wall Street would appreciate the SEC’s guidance.
“Frankly, investors may want to think, ‘Gee, the city did bad things, but they seem to accept all these remedial steps and maybe I should invest in them,” McIntyre said.
Doppelt, the San Francisco-based credit analyst, added that the consultant mandated by the SEC could ease some investors’ worries about the city’s path to recovery, but that Tuesday’s announcement was “just the beginning.”
Before the city can return to the bond markets, where it has been barred since 2004, it will have to convince outside auditors to bless its annual financial statements dating back to the 2003 fiscal year. The cease-and-desist order will be inserted into the 2003 audit to make investors aware of the SEC’s sanctions, Sanders spokesman Fred Sainz said.
Just days before the Oct. 27 deadline Sanders set for KPMG, which is conducting the 2003 audit, the city received from the audit firm a host of new questions that it wanted answered. Sainz said the city has sent its responses and is now waiting on KPMG to act.
A call placed to KPMG partner Steve DeVetter was not returned as of press time.
With its audits in hand, the city will ask financial ratings agencies to restore its credit ratings before it reenters the public markets to borrow for much long-delayed water, sewer and road projects.
But experts said they are curious to know the number of hurdles the beleaguered city government will have to clear before then – starting with the recommendations of the consultant that the city must hire in the next 60 days.
“A lot depends on what happens from here,” Doppelt said.
Staff writers Andrew Donohue and Vladmir Kogan contributed to this story.