City Abuses Citizens' Trust: Preventing Securities Fraud in Municipal Bond Issues

With the Obama Administration's infusion of billions for infrastructure improvements and repairs, CFEs soon will have the opportunity to bring their expertise to a vast number of government public projects. If San Diego is an indicator of fraudulent money management, some CFEs could be looking at a much busier professional life.

The people of San Diego - a city prized for its perfect climate and idyllic setting - must hope they've seen the last of municipal fraud scandals. In just seven years, a succession of fraud charges involving San Diego's government has unfolded that will leave the current and future citizens reeling under enormous financial burdens.

The Securities and Exchange Commission (SEC) charged the city of San Diego with nondisclosure to the investing public of its pension fund deficiencies when in 2002 and 2003 it issued municipal securities for sale. In an offshoot of this fraud, the commission also cited the city's independent auditor with professional incompetence.

The SEC then filed charges against five former city officials for withholding the information that they had intentionally underfunded the city's pension fund and misappropriated assets, clearly acting against the public interest.

In a January 2006 civil case predating the SEC's involvement, five former San Diego City Employees Retirement System (SDCERS) board members went to trial for violating California state conflict-of-interest laws. In still another case, a class action suit charged the San Diego Metropolitan Water Department with consumer fraud against the city's residential water customers - ironically, the settlement might enrage consumers as much as the fraud itself.

ENABLERS PAVING THE ROAD TO CORRUPTION 

Before discussing the details of the frauds, the obvious question is: How could this have happened?

Three factors existed in San Diego that enabled fraud to occur: (1) legal requirements for issuers of municipal securities were liberalized; (2) the city administrators held lax attitudes toward their fiscal responsibilities; and (3) the city was unable to control the SDCERS.

Legal requirements: Municipal security issuers have fewer requirements than others when accessing U.S. capital markets. The registration and reporting provisions of the Securities Exchange Act and a majority of federal security laws aren't applicable to state and local governments. Also, the SEC's power to establish accounting and financial reporting rules for security issuers doesn't extend to issuers of municipal securities.

The U.S. Governmental Accounting Standards Board (GASB) is the independent organization that establishes accounting and financial reporting standards for state and local governments. However, compliance with GASB pronouncements is voluntary. The GASB is powerless to take any action against a violation of its rules, and the SEC has no legal authority to require a change in the financial reporting of a state or local government unless it suspects fraud. This toothless legal environment contributed to San Diego officials' ability to issue fraudulent municipal security offerings.

Municipal security issuers are subject to the Securities Exchange Act's anti-fraud provisions for disclosures and any other statements made to investors. The act prohibits misrepresentations or omissions of material facts in offers of purchase and sale of all securities and prohibits municipal issuers and brokers, dealers, and municipal securities dealers from making any false or misleading statement of material facts or from omitting material facts. [A fact is material if there is substantial likelihood that its disclosure would be considered significant by a reasonable investor. See Basic Inc. v. Levinson. 485 U.S. 224 (1987)]

In 1996 - in the aftermath of the Orange County, Calif., bankruptcy - the SEC issued "Report of Investigation in the Matter of County of Orange, California As It Relates to the Conduct Of Members of the Board of Supervisors" that emphasized: (1) local officials' responsibilities, under federal securities laws, when authorizing the issuance of municipal securities and (2) the critical role such officials play in the disclosures for those securities.

Records show the legal consequences and lessons of Orange County were communicated to the San Diego City Council, orally and in written format, by its own outside legal counsel. However, the empowered San Diego officials apparently ignored the warnings contained in this communication.

Tone-deaf at the top: According to the independent, 18-month "Report of the Audit Committee of the City of San Diego," released August 2006, San Diego city officials engaged in unlawful conduct but didn't intentionally set out to defy legal mandates.

Commonly called The Kroll Report, after the well-known firm, Kroll, which the city hired to conduct the investigation, it also states that "San Diego officials cultivated and accepted a culture of financial management and reporting premised upon non-transparency, obfuscation, and denial of fiscal reality. Under the pressure of short-term needs, city officials gave expedience a higher priority than fiscal responsibility and came to view the law as an impediment to be circumvented through artful manipulation. Exacerbating the city's culture was a deplorable lack of accountability and organization built within the structure of city government itself. It seems that no one within city government viewed himself or herself as accountable for the accuracy of [the] city's financial disclosures."

The Kroll Report continues, "As to some financial information, responsibility for its preparation was placed upon the city's outside auditor, a structure that is completely at odds with the auditor's role as independent examiner of the financial statements. This inadequate structure was compromised further by the fact that no one from the city took responsibility for seeing to it that information provided to, or prepared by, the auditor was actually correct. As to the financial information the city prepared itself, statements were rendered false not only as a result of design, but simply due to incompetence and neglect."

The Kroll Report found no evidence of bribery, kickbacks, corruption, or illegal gratuities. The exact motivation for city officials to commit and cover up fraudulent activities remains in question. Financial pressures to maintain the current level of city services and revenues, while increasing retirement benefits, were present, but these are common pressures for most local government officials.

Controlling the pension plan: SDCERS is a defined benefit plan that provides retirees with retirement, disability, death, and other benefits. Its board, which administered benefits and assets, normally included one representative from each labor union that represented city employees.

Conflict of interest was inherent in the board's makeup. For most board members (city officials, city employees, and union representatives), the obligation to protect the financial integrity and stability of the retirement system was overshadowed by pressures exerted by their regular jobs and/or allegiances. The city officials and city employees on the board were under pressure to act in the best interest of the city providing a balanced budget and a benefits agreement with the unions.

Union representatives on the board were under pressure to secure new benefits for their members within the budgetary constraints of the city. In the midst of these conflicts, the board lost its independence and ability to focus on its fiduciary responsibilities to the members of the retirement system.

The board assumed the role of negotiating member benefits, when, in fact, it should have been concerned with the maintenance and funding of plan assets and reporting to the system's beneficiaries. The city was responsible, not the board, for negotiating retirement benefits.

By assuming a negotiator's role, most board members were, in fact, voting to increase their retirement benefits while subordinating the interests of the system's beneficiaries to the interests of the city, their labor unions, and themselves.

The board's failure to assume its fiduciary responsibilities placed the financial integrity of the retirement system at risk. The first of the legal actions against the city took place in a January 2006 civil action - even before the SEC formally stepped in - when five former members of SDCERS's board were ordered to stand trial on a charge they violated state conflict-of-interest law by voting to allow the city to put less money into the retirement system, while increasing their own retirement benefits.

So the stage was set to understand how this cascade of malfeasance rained on San Diego.

RAIDING THE RETIREMENT SYSTEM: THE FRAUD THAT KEEPS ON TAKING 

On Nov. 14, 2006, the SEC sanctioned the City of San Diego for securities fraud committed during 2002 and 2003 in the sale of five municipal bond offerings, the first of three actions the SEC would take against the city. The charge cited nondisclosure of relevant information about the city's pension and health-care obligations to the investing public.

In a second action the following month, the SEC charged San Diego's independent auditor, Thomas J. Saiz, CPA (sole shareholder of the accounting firm Calderon, Jaham & Osborn), with primary violations of the anti-fraud provisions of the Securities Exchange Act because of his direct participation in the false and misleading disclosures made to investors in the city's 2002 and 2003 bond offerings.

The complaint alleged that during the audit, Saiz: (1) failed to comply with generally accepted auditing standards due to the lack of sufficient auditing proficiency (2) wasn't knowledgeable about the City of San Diego (3) failed to exercise due professional care and (4) didn't obtain sufficient competent evidential matter. This settled civil-fraud action represents the first time the SEC has obtained civil penalties against an independent auditor for a municipality.

In a third action, in April 2008, the SEC filed charges against five former San Diego city officials who had played key roles in the city's 2002 and 2003 inadequate municipal securities disclosures. The five were charged with failing to disclose to rating agencies and the investing public material facts in the bond offering documents and the related continuing disclosures.

Specifically, they withheld knowledge that (1) the city had been intentionally under-funding its pension obligations since 1997 (2) the city had granted additional retroactive pension benefits since 1980 (3) the city had used pension fund assets to pay for additional pension and retiree health-care benefits since 1980 (4) the city would face severe difficulty in funding its future retiree health benefits unless new revenues were found and/or retiree benefits were reduced and/or city services were cut and (5) the projection of the city's unfunded pension and retiree health-care liabilities would dramatically increase from $284 million at the beginning of fiscal year 2002 to $3.1 billion by fiscal year 2009. Clearly, the actions of these individuals violated the public's trust.

The city's misuse of retirement assets arose out of transactions and agreements with its related party, SDCERS. Agreements between the city and the SDCERS board to exchange increased pension benefits for reduced funding of the city's pension obligation became accepted as normal business activities.

The roots of the misappropriation of pension assets go back to the early 1980s when city officials, wanting to increase retirees' inflation-eroded benefits, passed a resolution that said any of the plan's investment income in excess of 8 percent needed to be used to pay enhanced retiree benefits, according to The Kroll Report. With this directive, city officials started down a path using "creative accounting techniques" to fund retirement-related benefits without using city assets.

More recent raiding of pension assets can be traced to two principal agreements between the city and SDCERS that increased pension benefits while simultaneously allowing the city to make pension contributions that were less than the amounts required by GASB's acceptable actuarial methods.

Manager's Proposal 1 (MP-1), approved by the city council and the SDCERS board in 1996, allowed the city to make contributions to SDCERS based on amounts contractually agreed upon rather than amounts based on the actuarial contributions required by the plan documents.

The city granted immediate retiree benefits and promised to keep the total retirement liability funded above 82.3 percent. The city also agreed to make a one-time payment to the retirement system if the funded portion of the SDCERS' liability fell below 82.3 percent. Thus, it granted new benefits to city employees and retirees without making any provisions for their funding, so the city effectively pushed the repayment of that relief onto future taxpayers.

Manager's Proposal 2 (MP-2) followed in 2002. Based on a projected breach of the 82.3 percent level, the city would be required to fully restore the SDCERS' funded ratio by a one-time payment of about $160 million, according to The Kroll Report. City officials wanted to avoid the serious financial consequences of such a breach.

In closed-session discussions, the mayor and city council devised a plan to increase future general employee retirement benefits by altering the benefit computational formula in exchange for the elimination of MP-1's required lump-sum payment. This plan, again, deferred funding of pension liabilities into the future.

No restitution and no conviction might be the finale. It's unclear if civil damages can be recovered from public employees. The January 2006 civil case in which five former SDCERS board members were charged with violating California conflict-of-interest laws is still winding its way through the courts, but it received a major setback in November 2007 when California's Supreme Court ordered the appellate court in San Diego to hold a hearing on whether the case should be dismissed.

BILKING CITY RESIDENTS 

The San Diego Metropolitan Water Department owns three sewage treatment facilities and provides sewage services to residents and businesses in the city. Federal grants and loans administered by the state of California fund these facilities. As a condition for receiving this funding, the city expressly agrees to comply with certain federal and state laws and guidelines that include maintaining a sewer rate structure that complies with Clean Water Act regulations. The act requires that no grant shall be approved unless the recipient jurisdiction "has adopted or will adopt a system of charges to assure that each recipient of waste water treatment services … pays its proportionate share" of the cost of treating the wastewater. This allocation requirement is at the heart of the city's fraud against its residential water customers.

From at least 1995 to 2004, the city was out of compliance with these requirements and, as a result, was in violation of its grant and loan covenants, according to The Kroll Report. Compliance would have reduced residential customer rates and increased industrial consumer rates.

The city's violation resulted in residential users subsidizing the rates of industrial users thus putting the city at risk of having to repay the federal grants and loans it had received. By May of 1998, a consultant's report had already provided the city council with the knowledge that it wasn't in compliance with the Clean Water Act and a plan to correct the problem. City officials shelved the report. For six years they continued to ignore the requirements of the act and hide their compliance failures from the public.

On May 18, 2007, the Superior Court for the County of San Diego approved a settlement of a class-action lawsuit that alleged the city had overcharged single-family residential customers while undercharging other customers for sewer service until October of 2004. This settlement requires the city to reimburse single-family residential customers a total of $40 million, less legal costs, over the next four years.

The catch-22 solution: Ironically, to fund the terms of this settlement, the city has temporarily adjusted the rates of all city sewer customers, thus the injured citizens bear the burden of financing their own court-approved benefit.

WHERE DO WE GO FROM HERE? 

Municipal securities are an integral part of United States security markets. State and local governments meet increasing demands of their citizenry by ever-growing investments in public projects financed through municipal bond offerings. The outstanding debt associated with these public offerings amounts to trillions of dollars. To prevent similar scandals associated with the sale of municipal securities, the following suggestions are offered:

1. Federal intervention: More federal regulation should be imposed on issuers of municipal securities. Private-sector regulations should also apply to the public sector. The GASB should be empowered, as is the federal Financial Accounting Standards Board, to issue mandatory accounting rules for the content and disclosures of government financial statements. The SEC should have regulatory authority over issuers of municipal securities. A law similar to the Sarbanes-Oxley Act, which requires the presidents and CFOs of private-sector companies to sign off on financial statements, should apply to governors, mayors, and CFOs in the public sector. It's time to regulate the municipal bond market.

2. Education: The electorate must find ways to be more knowledgeable about proposed and enacted legislation. Unlike the private sector, in which corporate boards and management can take appropriate action to terminate and prevent fraud in business organizations, most local governments have to rely on an educated electorate, through the voting booth, to voice their objections to the actions taken by elected officials.

3. Written policies: State and local governments should develop written policies and job descriptions that clearly identify responsibilities for financial statement disclosures including formal processes for drafting, review, and dissemination. It's clear in the San Diego scandal that city officials took no responsibility for the drafting and content of the financial disclosures.

4. Codes of ethics: Municipalities should adopt and effectively communicate codes of ethics to all individuals conducting business on behalf of the municipality or its agencies. These codes would help ensure that individuals who are free from biases caused by personal economic interests would make the local government decisions. The code should include:
The monitoring of personal financial interests of officials and employees
Prohibitions relating to conflicts of interest
Restrictions ensuring that public resources are used to benefit the public interest rather than private or personal interests
Post-employment limitations to eliminate improper influence of former officials or employees

5. Internal audit function: Local governments should invest in strong internal-auditing departments. Internal auditors should be the first to identify financial problems and accounting issues that exist. Internal auditors are in the best position to review financial information and disclosures and express their findings to the appropriate official(s).

6. Qualified outside auditors: When engaging outside auditors, give priority to firms that have the reputation, technical skill, and resources to perform the audit. Discourage the hiring of an auditor who is politically connected, preferred locally, or who has submitted the lowest bid.

CRUCIAL QUESTION 

Certainly frauds perpetrated against citizens and investors in San Diego and Orange County, Calif., have shaken the public sector. The question that remains is: Are these frauds isolated instances or only the tip of an iceberg? Given the explosion of fraudulent activity in our society, we wonder when the next public-sector fraud will be uncovered.

George A. Dasaro, CFE, CPA, is professor of accounting at the College of Business Administration, Loyola Marymount University in Los Angeles, Calif. 

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