Free speech or securities fraud?
Mark Funkhouser, the director of the Governing Institute and a former mayor and auditor of Kansas City, took a few swings at the SEC for its securities fraud prosecution of Harrisburg, Pennsylvania. Funkhouser has three concerns with the SEC’s case.
First, he correctly points out, as the SEC case contends, that the city of Harrisburg did not issue any financial statements between January 2009 and March 2011. The SEC says that because of this, investors had to seek out other statements made by public officials that included material misstatements. Funkhouser blames it on investors for poor diligence. He says:
You’d think it would be obvious to potential investors that if there’s not much current information available about a city’s finances they might want to think twice about buying its securities. But investors don’t always exercise proper diligence, and it wouldn’t have hurt for the SEC to have driven home that point.
This is not the way our municipal or corporate securities systems work. The system is structured so that the onus is on securities issuers to provide timely, accurate and truthful disclosure to investors so that they can do their due diligence. Pepper Hamilton, who represented Harrisburg in the SEC’s prosecution, wrote:
The case is unusual in that it is the first case in which the SEC charged a municipality with securities fraud under Section 10(b) of the Securities Exchange Act of 1934 relating to municipal securities trading on the secondary market and outside the context of a securities offering. As a condition of settlement, the City accepted—without admitting or denying—the SEC’s conclusion that the City had misstated its finances and had failed to disclose adverse financial information during 2007-2010, when Harrisburg’s financial position was deteriorating quickly.
Notice the old escape clause “without admitting or denying?” Hamilton makes it clear that it is the issuer’s responsibility to make timely disclosures:
In addition, the SEC alleged that the City’s financial statements were submitted late and contained a number of errors, and that certain public statements made by city officials were incomplete or misleading. According to the SEC, by failing to comply with its continuing disclosure obligations, failing to submit its annual financial reports, and failing to make timely disclosures of ‘material events’ (like the lowering of its credit rating), the City deprived investors of complete information regarding its financial decline and the potential impact on securities issued and guaranteed by the City of Harrisburg.
Funkhouser’s second concern is that the SEC identified former mayor Stephen Reed as having made false statements, but securities are issued by the municipality, not an individual. If we look at corporate securities issuers for a moment, this is like saying that if management provides material misinformation in a corporate issue, they should not be held liable for misstatements. But under securities law, the entity and the official are of the same body, and the official must speak truthfully of the entity. This is true for municipal issuers under the same anti-fraud provision of the law. From the SEC’s Section 21(a) report on Harrisburg:
‘Public officials should be mindful that their public statements, whether written or oral, may affect the total mix of information available to investors, and should understand that these public statements, if they are materially misleading or omit material information, can lead to potential liability under the antifraud provisions of the federal securities laws.’ The SEC accordingly warned public officials who make statements regarding financial issues that they ‘should consider taking steps to reduce the risk of misleading investors.’
Funkhouser’s last concern is that the SEC’s action impinges on the First Amendment’s right of free speech for the municipal official. The SEC has no interest in restricting political speech, but it is very clear that public officials speaking on financial matters have clear responsibilities. Hamilton again:
In sum, the SEC’s report makes it clear that when a municipality or its officials speak on financial matters, those statements need to be accurate and complete in all material aspects. Failing to meet disclosure obligations may create an information vacuum that potentially exacerbates the harm to investors.
All these issues came to mind last Friday when I wrote about the Puerto Rico government tweeting about possible bankruptcy if certain tax and fee increases are not approved. The messages from the Governor’s office seemed to have implications for municipal bond investors. According to the SEC, the line is not blurred when talking about public finances. Public officials must always tell the truth, or they may face SEC sanctions.