Intrigue is about the last thing that normally comes to mind
when thinking about the municipal bond market or public pension
plans. But both have plenty of it all of a sudden, courtesy of
a new wave of U.S. Securities and Exchange Commission (SEC)
investigations of disclosures about public pension funds to
muni bond investors. Historically this has been a very
conservative marketplace, but it is now under the SECs
microscope, says Steven Scholes, a partner at law firm
McDermott Will & Emery.
Reports surfaced in January that targets of the SEC
investigations include the State of Illinois and the State of
California. The agency does not publicly disclose its
investigations specifics. But they are apparently
looking at the actuarial methods being used to calculate
pension obligations, and whether pension disclosures made in
documents used to sell bonds fully and accurately disclose the
actuarial methods, says Steve Malina, an attorney and
shareholder at law firm Greenberg Traurig, LLP.
The actuarial assumptions and methods used are important
because they determine how much money a public pension sponsor
needs to contribute to its plan and that, in turn,
influences how much money it has on hand to pay the interest
and principal on its bonds. What the SEC is really
looking at is the possibility of violating federal securities
laws by masking a huge pension shortfall, Malina says.
If a plan is underfunded by a ton of money and that is
not disclosed, investors are arguably buying bonds with their
eyes closed. The investigation potentially includes any
muni-bond issuer that has a pension plan, whether a state,
county, city, or other government unit.
In August 2010 the SEC sued the State of New Jersey for
securities fraud, for failing to disclose to muni bond
investors that it was underfunding its two biggest public
pension plans; the state settled the case. The action
against New Jersey was the shot across the bow, Malina
says. It was, I believe, the first time the SEC brought a
case against a state for violating federal securities laws.
That just does not happen.
Why focus on public pensions now? There are a
tremendous number of municipal-bond issuers under severe
financial strain, Scholes says. The market for
municipal bonds is huge, north of $3 trillion outstanding, so
there is a tremendous amount of public investment at risk. And
this market has never been really looked at in a serious,
methodical way by the SECs Division of Enforcement.
That has changed: In January 2010 the SEC set up five new
specialty investigative units in priority areas, including one
that focuses on municipal securities and public pensions.
The discussion of the legal requirement of full and
fair disclosure has not changed, Scholes says. What
has changed is that due to the market conditions, some of the
rate-of-return assumptions used by these plans can no longer be
used. Another issue is whether some municipalities manipulate
the assumptions to reduce the liabilities, such as the
demographic assumptions and mortality assumptions. A very minor
adjustment can make a huge difference.
Look for more public pension funds to come under scrutiny in
this expanding investigation. That would not surprise me
at all, Malina says. The SEC has a dedicated team
on this now, so that would give me reason to believe that there
is more coming. And the SECs scrutiny could lead
many public pension plans to take a hard look at their funding
practices. Historically, many of these municipalities
have tried to get along without fully funded pension
plans, Scholes says. That may be coming to a