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 SEC’s 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 SEC’s 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.