SEC's New Jersey Fraud Case Seen as Harbinger in Muni Crackdown

The Securities and Exchange Commission’s fraud case against New Jersey may presage a wave of lawsuits seeking to crack down on misdeeds by public officials who raise money in the $2.8 trillion municipal bond market.

New Jersey yesterday settled claims it didn’t disclose to investors that it failed to put enough cash into its two biggest pension plans when it sold $26 billion of bonds from 2001 to 2007. The case is the first SEC fraud charge against a state and follows the creation of a unit set up this year to focus on municipal securities and pension funds.

“They will be looking for other cases,” said James Doty, a former SEC general counsel who’s now an attorney with Baker Botts LLP in Washington. “It’s a harbinger that they expect disclosure standards to be scrutinized and be increased.”

SEC Chairwoman Mary Schapiro has pressed for tougher disclosure rules for municipal bonds, whose history as a safe investment has been jeopardized by dwindling tax collections and record budget deficits by states and rising defaults by local borrowers. Investment losses also left states $500 billion short of funds to cover promised pensions by mid-2008, even before the collapse of Lehman Brothers Holdings Inc. sent stocks tumbling, the Pew Center on the States said.

Underfunded States

“There are a lot of states that are significantly underfunded,” said Lynn Turner, a former SEC chief accountant who served on an independent panel that investigated San Diego’s pension fund. The SEC sanctioned the city in 2006 for hiding gaps in its retirement system after the Internet stock bubble burst. “There’s likely to be a dozen that have the same type of problems as New Jersey, and it’s not just states but cities too.”

Miami has been under the SEC’s scrutiny since December for failing to tell investors that it used funds earmarked for capital projects to replenish its general fund in fiscal 2007 and 2008, according to documents for a bond sale last month.

The New Jersey case began in 2007 after the New York Times published a critical report on the state’s pension accounting. The SEC found the state masked years of underfunding by failing to inform investors that $704 million listed as pension payments in documents for 79 bond sales from 2001 to 2007 were actually transfers of money already in the retirement system.

The state also failed to disclose a $2.4 billion loss in the value of pension fund assets in 2001, the SEC said, which “created the false impression” that the Teachers’ Pension and Annuity Fund and the Public Employees’ Retirement System were adequately funded.

Legal Bills

New Jersey settled the SEC charges without admitting or denying guilt or paying a fine. The state was billed $7.9 million by Fried, Frank, Harris, Shriver & Jacobson LLP of New York through November 2009 for legal work on the case, according to documents obtained by Bloomberg News through the state’s Open Public Records Act.

Republican Governor Chris Christie, who took office this year and has sought ways to cut the state’s pension liabilities, said he was happy to close the matter.

“I’m glad to have this problem behind the state,” he told reporters at a bill-signing event today. “I’m glad that this administration has been able to end the bad practices of the previous administrations.”

Can Borrow Still

The resolution isn’t likely to affect the state’s ability to sell bonds, said Jeremy Ostow, a South Orange, New Jersey, attorney who served as bond counsel on more than a dozen sales during the time covered by the SEC settlement.

“I would be surprised if it had any material effect,” he said. “There was never any particular secret about New Jersey’s pension system.”

The SEC case didn’t hinder the state’s sale of a record $2.25 billion of short-term notes today. They sold to yield an average 0.33 percent after drawing bids from 11 banks. JPMorgan Chase & Co. was the largest buyer.

New Jersey may also be buffered from private lawsuits in the SEC’s wake. Investors would have trouble showing they lost money because of the state’s actions, said David A. Lipton, director of securities law at Catholic University of America in Washington and a member of the Municipal Securities Rulemaking Board.

“I think it would be a very hard case to prove,” he said, speaking for himself and not the MSRB.

Yields Have Slid

An index of yields on 10-year tax-exempt bonds maintained by Municipal Market Advisors has plunged to a record low 2.64 percent today from as high as 4.5 percent in 2001, when New Jersey began the bond sales that were scrutinized by the SEC.

“It’s great that the SEC is doing things that will enhance the transparency within our marketplace,” said Thomas Metzold, who oversees $7 billion of tax-exempt investments as co-head of municipals at Eaton Vance Corp., a Boston-based money manager. “At the same time, we have known that there are significant pension liability issues with the state of New Jersey for years.”

U.S. state and local governments have long been subject to looser regulations than those on corporations that sell securities to investors. Since 1975, the SEC has been prevented from requiring local governments to file offering documents before they sell bonds, as public companies must. Nor do federal rules mandate that local issuers follow standard accounting standards. And their disclosure requirements aren’t imposed directly but through the banks that underwrite their securities.

Changes Sought

The SEC has sought changes. In May, Schapiro said measures should be considered to require more-timely filing of financial information such as tax collections. She also called for standardized accounting. The financial regulatory overhaul signed by President Barack Obama last month calls for a two-year study into whether tougher disclosure is needed.

Elaine Greenberg, 49, an SEC enforcer for 20 years, was appointed in January to head the agency’s municipal securities and public pensions unit. It’s one of five task forces created after the global credit crisis and the SEC’s failure to detect Bernard Madoff’s $65 billion Ponzi scheme.

“We hope to alert other states and municipalities of their disclosure obligations under the federal securities laws as it pertains specifically to their pension fund liabilities,” Greenberg said in an interview, referring to the SEC’s New Jersey action. “The obligation is that the disclosure is current and is accurate.”

To contact the reporters on this story: Dunstan McNichol in Trenton, New Jersey, at dmcnichol@bloomberg.net William Selway in Washington at wselway@bloomberg.net

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