Financial Regulatory Forum

Weapons against U.S. muni fraud difficult to wield

By Reuters Staff
November 2, 2010

By Lisa Lambert

WASHINGTON, Nov 2 (Reuters) – The strongest weapons that U.S. regulators use to combat fraud in the $2.8 trillion municipal bond market have long been financial disclosure requirements, but rules on their content and timeliness are proving difficult to wield.

A recent report by Merritt Research Services found states take an average of six months after their fiscal years end to complete financial audits. Some, namely Tennessee, Illinois, Arizona and Ohio, take close to a year.

“By the time many annual governmental audits are received, many capital markets analysts and investors believe that they have lost significant value for assessing the current financial position of a municipal bond issuer,” the report said.

The findings echoed another report that found in half of all bond sales the issuer had filed no financial statements, failing to provide vital clues to the riskiness of debt.

That study by DPC Data, a company that collects muni market data, was conducted nearly two years ago, indicating disclosure problems have persisted for a while.

The Municipal Securities Rulemaking Board, which writes the rules the Securities and Exchange Commission enforces, has built a centralized web database called EMMA to make trade information and financial disclosures available to investors over the last three years.

The MSRB requests that issuers post their annual financial reports on the site, which is also known as Electronic Municipal Market Access, within 120 days of the close of their fiscal year.

“But there are no enforcement penalties for noncompliance,” the Merritt report noted.

Because federal oversight of how states and local governments finance operations could invite accusations of interference, the U.S. government treads carefully in regulating the $2.8 trillion municipal market. Disclosure rules allow it to fight fraud without wading into more contentious issues such as spending.

A year ago, an SEC official called for tighter control of municipal bonds, saying the commission “should further leverage its current anti-fraud authority over municipal issuers to try to improve quality and timeliness of disclosures.”

The same commissioner, Elisse Walter, told Reuters in September that the SEC has recently renewed its focus on tighter enforcement in the muni market. Walter is currently meeting with traders and issuers about strengthening the fight against fraud.

NO NEWS IS BAD NEWS

In August the SEC settled with New Jersey over flawed bond disclosures, saying the state had not adequately informed investors of the costs of its pensions.

The SEC’s action sent a message to states and local governments selling debt that “problems be adequately disclosed when they’re going to raise money from the public,” its top enforcer for municipal bonds, Elaine Greenberg, told Reuters last month.

Municipal bond investors, whose ranks have historically been dominated by individuals, do not have to rely solely on disclosures to learn if borrowers are in bad shape as three rating agencies monitor states’ credit as well.

Still, the MSRB and the Financial Industry Regulatory Authority have said dealers should not rely on credit ratings as a substitute for their own assessments of bonds’ risks. FINRA said it found dealers do not completely understand the process of disclosing material information to customers.

Then there are issuers who are too small to make ratings news and also do not give bond buyers timely information. Merritt found disclosure problems are not confined to bigger cities and states, which can often have more difficult finances to report.

“There is a wide range of reporting times suggesting that more complicated accounting rules and complex activities are not necessarily an excuse for late audits,” the report said.

“New York City, which is the largest and possibly the most complicated of all cities, was able to complete its audit in 115 days,” it added.

Another New York town, Freeport Village, was the slowest to complete its audit after fiscal 2009 ended, taking 367 days.

Merritt, an independent municipal bond data and research provider that has been collecting bond audits for nearly 25 years, found wholesale electric utilities are the fastest when it comes to completing annual reports, at about three months. Nonprofit hospitals and private universities mostly take less than four months.

“The slowest reporting municipal credit sectors come from state and local governments themselves … and not their agencies or authorities,” the report said, adding counties and cities “generally finished their audits in approximately six months.”

(Editing by James Dalgleish) ((lisa.lambert@thomsonreuters.com; Tel: +1-202-898-8328; Reuters Messaging: lisa.lambert.reuters.com@reuters.net))

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