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July 5, 2022
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By David Unkovic and Ryan Gonder

Since September 2021, the United States Securities and Exchange Commission (the SEC) has brought five enforcement actions regarding municipal bond financings.  The issuers of these bonds are Sweetwater Union High School District (Texas); Crosby Independent School District (California); Town of Sterlington (Louisiana); City of Rochester (and its school district) (New York); and Johnson City (Texas).  In each case, the issuers and other involved parties were charged with providing false and misleading information to municipal bond investors.  Enforcement was not limited to entities; individuals representing the issuers were also targeted. Additional information about these cases (and earlier cases) is available on the SEC website.

Here are seven lessons to be learned from these cases:

1. Do not hide the truth and lie about the financial condition of the issuer, because the truth will eventually come out. The bad acts one may be tempted to hide may include the theft of public money (Johnson City); the application of bond proceeds to unauthorized projects (Crosby – proceeds spent on unapproved football stadium improvements; Sterlington – proceeds spent on unapproved sports complex improvements); and providing false, overly-positive projections of future revenues and expenses (all five cases).  Eventually, when a successor Chief Financial Officer (CFO) or the issuer’s auditor reviews the books, the discrepancies and falsehoods will become painfully clear to all involved.
2. Do not mislead third parties who provide support for the marketing of the bonds. In many of these cases, the issuers provided misleading information to rating agencies who were issuing ratings on the bonds.  Those ratings were used to help market and price the bonds.  When the truth came out, the rating agencies promptly lowered the ratings.  In addition, in the Sterlington case, the issuer provided misleading information to the state Bond Commission which then gave its approval to the bonds.  The issuer provided the state approval to investors as part of the marketing of the bonds.  The SEC is very focused on the misleading of third parties in bond issues.
3. The issuer’s CFO is often a target of the SEC in these situations. The SEC usually does not want to assess fines against the issuer, because the innocent taxpayers of the issuer end up paying the bill.  But the SEC has said that it “is committed to holding bad actors in municipal securities offerings accountable for their misconduct,” and the SEC does impose fines on the municipal officials that are responsible for the bad behavior.  In most of these cases, the CFO of the issuer was fined in the range of $25,000 to $30,000, and also prohibited from participating in future bond financings.  In some cases, the targeted individual was the mayor or the chief administrative officer. Ultimately, the SEC will target whoever has taken the lead in providing the false and misleading information.
4. Do not assist in covering up another official’s bad behavior. In one case (Crosby), the school superintendent directed the construction contractor to spend bond proceeds on football stadium improvements that were not approved by the school district’s governing body.  Instead of pushing back against the superintendent’s improper direction, the CFO tried to smooth over the problem by various means, none of which solved the problem.  As a result, the CFO was fined and prohibited from participating in any future bond financings.  It essentially ended her career.
5. Governing body: do not delegate all financial powers to one person.  In several of these cases, the CFO was delegated power to control all financial aspects of the issuer’s operations, including budgeting; reporting financial matters to the governing body and to state oversight entities; entering into contracts related to the funded projects; and controlling all information given to rating agencies, bond professionals and, ultimately, the bond purchasers.  If the person with all this control is the same person who has prepared the misleading financial information, any misdeeds are unlikely to be promptly caught.  Issuers’ governing bodies should institute internal checks-and-balances on the creation and dissemination of financial information by the issuer as an organization.
6. Bond professionals and auditors must include a healthy degree of skepticism as part of their due diligence efforts. In one case (Crosby), the SEC sanctioned the issuer’s auditor, stating that the auditor failed to “exercise professional judgment” or “maintain professional skepticism.”  In another case (Sterlington), the issuer’s financial advisor was a willing participant in developing the inappropriate misleading information.  Bond professionals must realize that it is in the best interest of the issuer whom they serve to provide full and truthful information to investors in bond issues. This means not participating in the creation and dissemination of misleading information.  And it means not accepting information provided by the issuer at face value; some healthy degree of professional skepticism is beneficial to the whole disclosure process.  Ask relevant questions.  Kick the tires.
7. The harm caused by the misinformation can occur at many stages of a bond financing. In many of these cases (Sweetwater, Crosby, and Rochester), the misinformation was included in the offering disclosure document – usually an official statement in a public offering, but it could also be stand-alone financial projections provided to investors in a direct placement (Sterlington).  If the misinformation relates to the current fiscal year (Sweetwater), the auditor will not yet have reviewed it.  If the misinformation relates to a prior year (Crosby), then the auditor may have unwittingly included the misinformation in the audited financial statements that are part of the offering disclosure document.  It is also possible that the misinformation arises after the issuance of the bonds (for example, misapplication of bond proceeds), and the investors are harmed when proper disclosure is not made in the issuer’s periodic filings on Electronic Municipal Market Access (EMMA) (Johnson City) and secondary market trades are made based on incorrect information.

In all of these SEC cases, something fundamentally wrong was done by a person involved in the bond financing.  When the bad act became publicly known, the SEC came in and took action against multiple parties involved in the transaction.  It is therefore in the best interest of the issuer, and all others involved in the financing, to take seriously from the start of the transaction the need to provide full and accurate disclosure in the marketing of the bonds.

David Unkovic (dunkovic@mcneeslaw.com) and Ryan T. Gonder (rgonder@mcneeslaw.com) are public finance attorneys with McNees Wallace & Nurick LLC in Harrisburg, Lancaster and Devon, Pennsylvania.  David regularly provides ethics trainings for the National Association of Bond Lawyers and the Pennsylvania Association of Bond Lawyers.  Ryan is also a school director at Central Dauphin School District.