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Why's the SEC Asking Governments to Tell on Themselves?

A new self-reporting initiative creates a prisoner's dilemma between governments and underwriters.

In game theory, the term “prisoner’s dilemma” refers to a scenario where two prisoners are separately deciding whether to betray the other and testify that the other committed a crime: each party's outcome (and possible punishment) depends on what the other side independently chooses.

Thanks to the Securities and Exchange Commission (SEC), prisoner’s dilemma has come to public finance.

This spring, the SEC announced the Municipalities Continuing Disclosure Cooperation (MCDC), a self-reporting initiative designed to clean the municipal securities market’s slate of any cases where an entity may have holes in the financial reporting requirements it makes to investors.

The program applies to bond issuers, obligors and underwriters, and basically asks them to review what has been disclosed in relation to bonds issued in the last five years. If they find that either they are late on anything they should disclose, or if they didn’t disclose new information that was relevant to the bond (like a credit rating downgrade), they have the option of reporting that omission to the SEC before the commission finds out itself. MCDC is part of the SEC’s push for better transparency in the municipal market so that investors know exactly what they’re buying.

A somewhat scary catch is that it creates a "modified prisoner’s dilemma” between issuers and the underwriters who helped them issue the bonds, said Elaine Greenberg, a former chief of the SEC’s Specialized Unit for Municipal Securities and Public Pensions during a webinar this month hosted by the Bond Buyer. “To obtain favorable settlement terms, each has to self-report. However if one party self-reports and the other doesn’t, it obviously creates a tension between the underwriter and the issuer." If that happens, one party will appear to be "caught" not admitting an error although the level of punishment will depend on the SEC's perceived severity of the omission. "The SEC views this as way to encourage self-reporting,” Greenberg added.

The parties concerned have until Sept. 10 to fill out a form with the SEC and issuers and underwriters should be communicating with each other if they are considering self-reporting, Greenberg said. After the deadline, the SEC warns, the opportunity for “standardized, favorable settlement terms” vanishes.

The penalties can be serious. Last summer, the commission charged a school district in Indiana and its municipal bond underwriter with falsely stating to bond investors that the district had been properly providing annual financial information and notices, as required as part of its prior bond offerings. The underwriting firm, City Securities, agreed to pay nearly $580,000 to settle the charges. Meanwhile, the underwriter and the school district’s settlement include a one-year ban from the securities industry. The underwriter was also permanently barred from serving as a supervisor.

Robert Feyer, a bond attorney with Orrick, Herrington & Sutcliffe, noted that governments or underwriters who do self-report won’t necessarily be subject to sanctions (although the government will legally be required to disclose the omission during future bond offerings). “We expect a lot of reports to be filed on minor things,” he said. “The SEC will be triaging reports into more and less serious cases and they’ll be focused on the more serious violations.”

Feyer also advises that governments seek advice from their bond counsel when they review their compliance to determine if anything relevant has been omitted. The SEC has not defined what rises to the level of material in these cases, so the municipal market players are left to interpret the rule themselves. At minimum, he said, issuers should take the opportunity to review their disclosures policy to make sure it can be reasonably followed.

Liz Farmer, a former Governing staff writer covering fiscal policy, helps lead the Pew Charitable Trusts’ state fiscal health project’s Fiscal 50 online resource.
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