Issuers need to watch their step. No one relishes getting in trouble with the Securities and Exchange Commission on charges of securities fraud, but the definition of fraud isn't limited to stealing somebody's money. In securities law, fraud can mean failing to give adequate data or supplying misleading information that leads investors astray.
Almost 30 years have passed since various amendments were made to securities laws regarding municipal bonds. The provisions affecting state and local borrowers have been slowly maturing as legal actions have been brought and various rules and interpretations promulgated. The process has been cumulative and subtle, as the particulars and nuances of the anti-fraud provisions have taken shape and bond disclosure practices attuned to them. It has not been so much the setting off of major bombs as the planting of a series of minefields. The unwary can get hurt.
The SEC is actively going after issuers who fail to supply adequate information in conjunction with their bond sales. Steering clear of trouble is not so easy. Asking the right questions (due diligence) or hiring the qualified experts (reliance) to help answer them may not be enough. What matters is how important questions (materiality) are answered and if those answers are clearly and completely revealed to the would-be investors (disclosure). As Robert Doty, a disclosure expert, wrote recently in California Dateline, issuers are the "responsible parties"--not the gaggle of advisers, underwriters, lawyers and other wizards hired to do a bond deal.
Bond issuers, of course, rely on a supporting cast of experts. But as an April 2004 SEC action against a school district in Pennsylvania illustrates, having experts does not automatically protect the issuer, even on admittedly complex questions and documentation. The Nashnunock School District borrowed money in the form of three-year tax-exempt notes without having a specific plan to spend the proceeds. Under federal tax law, if bond sale proceeds are not spent within a specific period, then the interest on the bonds becomes taxable, which obviously reduces their value to the investors who must now pay taxes on their interest income. Technically, the problem was that the "non- arbitrage certificate," a complex document prepared by the bond counsel, and the issuer's official statement did not disclose this risk. Even though district officials debated the use of proceeds and relied on experts for assurance, it was held liable for not disclosing the ramifications of what proved to be its faulty issuance process to investors. The school district was fined and had to pay restitution to keep the bond issue tax exempt.
In a similar case, a development authority (also in Pennsylvania) sold bonds to build a new office building that had as a major tenant a state government agency whose lease was due to expire soon after the bond sale. Sure enough, the state tenant moved out and, naturally, stopped paying rent, whereupon the bonds defaulted. Again, a key problem was tax-related: The bonds would fail a public-purpose test were the vacant space rented to a private party. While the official statement indicated that the government tenant's lease was to expire before the bonds matured and that there was no commitment to extend the lease, the SEC argued that the language in the Official Statement implied the possibility of renewal and did not reveal the lease's expiration date. The details and consequences--the lease represented 60 percent of the building's revenues--were not spelled out for investors. In other words, nothing said in the Official Statement was wrong; but it misled and omitted very material facts.
In the above situations, investors faced losses. But loss is not always necessary to arouse SEC watchdogs. Last year, the Massachusetts Turnpike Authority and its chairman were the subjects of an action based on failure to disclose the extent of large cost overruns involving the "Big Dig" tunnel project in Boston. The gist of the complaint was that even though the existence of cost overruns was generally known and was under investigation by the MTA, information about them was not provided in the Official Statements. The SEC argued that even if the exact scale of cost overruns was not known, the issuer had reason to believe that they were likely to be significant. Relevant facts and circumstances, even if not fully known with specificity, were omitted. Note that no MTA bonds had defaulted and many were either guaranteed by the state or carried bond insurance. It appears that the SEC was firing a shot across the bow of issuers and officials to the effect that full disclosure means reporting not only what is known "for sure" today but also tomorrow's "likely" events and circumstances.
The vast majority of issuers may be seemingly untouched by the above situations, but SEC actions and court cases show that the securities laws are being more sharply interpreted and actively enforced. Not much in life is getting easier these days.
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