On May 7, 2013 the Securities and Exchange Commission (SEC) and the City of Harrisburg, Pennsylvania concluded a years-long SEC investigation in a first-of-its kind settlement. The SEC imposed no financial penalties on the City and named no individual City officials in its order. Moreover, the SEC noted Harrisburg's cooperation in the investigation, and highlighted the fact that the City, with the assistance of counsel, had instituted new policies and procedures regarding securities disclosure to ensure compliance with the securities laws going forward. The authors, Pepper lawyers Ivan B. Knauer and John C. Snodgrass, represented the City of Harrisburg in the matter.
The case is unusual in that it is the first case in which the SEC charged a municipality with securities fraud under Section10(b) of the Securities Exchange Act of 1934 relating to municipal securities trading on the secondary market and outside the context of a securities offering. As a condition of settlement, the City accepted—without admitting or denying—the SEC's conclusion that the City had misstated its finances and had failed to disclose adverse financial information during 2007-2010, when Harrisburg's financial position was deteriorating quickly. In addition, the SEC alleged that the City's financial statements were submitted late and contained a number of errors, and that certain public statements made by city officials were incomplete or misleading. According to the SEC, by failing to comply with its continuing disclosure obligations, failing to submit its annual financial reports, and failing to make timely disclosures of "material events" (like the lowering of its credit rating), the City deprived investors of complete information regarding its financial decline and the potential impact on securities issued and guaranteed by the City of Harrisburg.
The SEC's order specifically highlighted Harrisburg's cooperation, noting that with the assistance of counsel, the City had taken steps to enhance its disclosure process, including "instituting formal written policies and procedures with respect to public statements regarding financial information made by the City." In addition, the SEC noted that Harrisburg has instituted annual training for city employees involved in the disclosure process, both to educate employees with regard to the new policy and "to provide an overview of the City's obligations under the federal securities laws." Harrisburg has submitted a copy of its enhanced disclosure policy on EMMA (the electronic system for municipal securities disclosure) and on the City's Web site.
In another unusual step, the SEC simultaneously issued a report pursuant to Section 21(a) of the Securities Exchange Act highlighting the potential liability of public officials for securities fraud in connection with municipal securities trading on the open market. (The SEC has the authority to issue such a report in connection with its investigations but rarely does so.) The report places public officials on notice that statements made by municipal officials must be accurate and must include material information about the city's finances. In just the past two months, the SEC has charged the State of Illinois and the city of Victorville, California, along with Harrisburg, with securities fraud relating to failure to provide accurate and complete financial disclosures.
Because the case involved securities trading on the open market, rather than the initial offering of securities, the case fell under Section 10(b) of the Exchange Act. Section 17(a) of the Securities Act, on which the SEC has relied in previous actions against cities, only covers the offer and initial sale of securities, not their aftermarket trading. This is significant in that securities fraud liability under Sections 17(a)(2) and (3) can be based on negligence, while Section 10(b) liability must be based on scienter, which is a higher level of intent that can be satisfied by a showing of recklessness.
The Harrisburg settlement and the SEC's Section 21(a) report provide a "teaching moment" for municipal securities issuers. Historically, municipalities and their officials may have focused their attention on issues closer to home, such as keeping cops on the beat, firefighters at the ready, and potholes filled, rather than on compliance with the federal securities laws. But the SEC's report makes it clear that municipal securities issuers need to be aware of their legal obligations: "Public officials should be mindful that their public statements, whether written or oral, may affect the total mix of information available to investors, and should understand that these public statements, if they are materially misleading or omit material information, can lead to potential liability under the antifraud provisions of the federal securities laws." The SEC accordingly warned public officials who make statements regarding financial issues that they "should consider taking steps to reduce the risk of misleading investors. At a minimum, they should consider adopting policies and procedures that are reasonably designed to result in accurate, timely, and complete public disclosures ..."
In sum, the SEC's report makes it clear that when a municipality or its officials speak on financial matters, those statements need to be accurate and complete in all material aspects. Failing to meet disclosure obligations may create an information vacuum that potentially exacerbates the harm to investors. Lessons learned include:
- Municipalities need to obtain—and maintain—institutional awareness of their continuing disclosure obligations.
- Annual financial reports (CAFRs) and any Material Event Notices (MENs) must be filed on a timely basis. Failure to timely file a CAFR may give rise to further disclosure obligations, such as the requirement to file a MEN.
- Public officials should be mindful of their obligations under the federal securities laws. Public statements on financial matters should be balanced and measured. If a city's financials are accurate, up to date, and publicly available, it may be useful for public officials to direct interested parties to the comprehensive financial information that is available to the public (e.g., through the municipality's Web site or EMMA).
- Municipalities should have complete and updated securities disclosure policies in place, and should regularly train relevant employees and officials on the policy and legal requirements.
Public officials should embrace the SEC order as a teaching moment and recalibrate their mindset regarding their responsibilities. The mayor of a small town is not just running a municipality. When the municipality issues bonds, the mayor effectively becomes the CEO of a securities issuer. The SEC has made it clear that it will hold public officials and municipalities to a higher standard in the future and that lapses in disclosure will not be tolerated.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.