Law Review: Municipalities issuing bonds face more SEC scrutiny

Even in good times, borrowing by local government tends to be politically contentious, triggering taxpayer angst.

It is about to become a bit more tumultuous.

Ever since the 2008 financial-market collapse, municipal governments across Pennsylvania and New Jersey have been under duress. And while economic conditions have improved - more so in Pennsylvania than in New Jersey - balance sheets have ticked only slightly upward.

As Bill Rhodes, a municipal-bonds lawyer at Ballard Spahr L.L.P., explains, this has partly to do with conditions that are unique to local-government finance, which is based in large measure on property taxes. When property values are on the way down, it takes a while for deteriorating assessments to catch up with the real economy. The same is true on the way up.

Then there is the huge overhang of unfunded pension liabilities for some towns that are just now coming due, a looming nightmare.

Some places have already hit the wall, and there have been some wild, eleventh-hour rescue attempts, such as in Harrisburg, when the city narrowly avoided bankruptcy, or the ongoing travails of Detroit. Less dramatically, Franconia Township in rural upper Montgomery County voted Nov. 17 to lay off six police officers and four other staffers to deal with a $3.2 million deficit.

The next shoe to drop likely will be Securities and Exchange Commission enforcement actions. Earlier this year, the SEC gave municipal borrowers and bond underwriters until Dec. 1 to report previously undisclosed facts that reflect in a material way on their financial conditions.

Read: their ability to repay lenders.

The SEC offer has a certain appeal. Municipal governments and bond underwriters that stepped up would be subject to reduced penalties. Those that did not and were, as the SEC put it, "detected" would face increased enforcement.

How it will turn out is anyone's guess, but it's safe to say this is already creating a lot of work for lawyers practicing in the abstruse space of municipal finance.

"They have been very tough; they are not fooling around," says securities litigator M. Norman Goldberger of Ballard Spahr, who is advising clients on the SEC program.

In an unusual turn, the SEC is even going after local government officials.

Last month, the agency announced fraud charges against the City of Allen Park, Mich., saying it failed to disclose material information about its finances to bond buyers. The charges centered on a $31 million bond issue to build a movie studio. At the time of the issue, the plans had morphed from a movie studio into a much-less-lucrative vocational training school, raising questions about the ability of the town to service the debt. Bond buyers were never told.

Without admitting or denying the allegations, former Allen Park Mayor Gary Burtka agreed to pay a $10,000 penalty.

The problem for many municipalities, Goldberger says, is that they traditionally have been only lightly regulated. They don't have the relationships with SEC staff or the deep working knowledge of agency practices that sophisticated corporate filers have.

"My experience has been that they are a pretty sophisticated agency; they have a good understanding of markets, and you can talk to people," Goldberger says. "The problem is, many municipal issuers are just not used to dealing with them."

The new SEC enforcement effort is a consequence of heightened concern about municipal government finances. Harrisburg and Detroit have gotten the headlines, but the problems are piling up, says Gerald Cross, executive director of the Pennsylvania Economy League, Central Division.

In 2009, the league issued a study of five Pennsylvania cities - Reading, Lancaster, York, Bethlehem, and Easton - and found that none could fully pay for local services with tax revenue alone. Since then, Cross says, the problems have only intensified in some places because of huge pension bills now coming due and flagging property-tax bases. That has undermined the ability of many communities to borrow.

So lenders are likely to be more cautious. Even so, the benefits of tax-exempt municipal bonds will remain a substantial lure to investors looking for relatively safe places to park their money, says Goldberger.

"You will get better disclosure," he says of the SEC action. "There are some cities and towns and villages that are in distress. But there are many that are not."

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