Lessons From Recent SEC Municipal Enforcement Actions

July.19.2022

The Public Finance Abuse Unit of the U.S. Securities and Exchange Commission (the “SEC”) had a busy first half of 2022, bringing forth four enforcement cases alleging substantial violations of federal securities laws.  Unlike the previous two years, when most of the SEC’s enforcement activity focused largely on financial advisers and underwriters, all of these four actions directly involved municipal issuers, their employees and in most cases, their financial advisers as well.

While each case is unique, and though several cases are still pending, there are important takeaways that can be derived from the allegations set forth by the SEC, which can serve to inform municipal issuers and private obligors of watchouts regarding potential violations of securities laws. In addition to these key takeaways, summaries of each case are provided below.

Key Takeaways: What Can We Learn From These Cases?

  1. The SEC’s Public Finance Abuse Unit (the “Unit”) is alive and well, and continues to look into potential violations of securities law by municipal issuers (and private obligors) and their board members, staff and advisers. Getting caught in the crosshairs of this Unit can result in severe adverse consequences, including the substantial cost of defending the inquiry (even if the defendant is willing to consent to a cease-and-desist order), along with adverse publicity, a negative effect on ratings and the possibility of having to pay a civil fine.

  2. Internal financial controls are crucial. Three of these cases (all except City of Rochester, NY) arose because one person had control of financial information and/or use of municipal funds. Even small municipalities must be cognizant of the potential conflict of interest in such a situation. Outside advisers or auditors can help, although even this step is not foolproof, as in the case of Crosby Independent School District. Regardless, it is a good practice to require outside auditors to replace senior staff periodically.

  3. Individual culpability is a real risk. If the SEC brings an action against a municipality, it will in every case determine which individuals were culpable in allowing or causing the securities violation and will bring actions against the individuals. In many cases, the penalty against the municipality may be minor, while the penalties against culpable individuals may be more severe. All four of the cases reflect this lesson.

  4. Securities violations can occur outside the contents of an Official Statement. While many SEC actions are based on errors or omissions from official statements, the SEC in February 2021 issued a Staff Legal Bulletin which made clear that securities law standards can be applied to other instances where an issuer or its officials are deemed to be “speaking to the market.” In the case of Anthony Holland, the securities law violation involved posting false financial statements on the MSRB’s EMMA website, where they were able to be viewed by owners or potential purchasers in the secondary market of an issuer’s bonds. This case highlights the need for municipal officials who undertake continuing disclosure agreements for their bond issues, which continue for the life of the bonds, to be careful in monitoring any filings on EMMA or on other public communications dealing with financial matters. In the case of Sterlington, Louisiana, although bonds were privately placed apparently without any official statement, falsified information in applications to a state bond commission was shared with the purchasers, who were also not informed that city officials had a history of misuse of revenue bond proceeds for other than project purposes. All of these factors created a risk of nonpayment.

  5. It is risky to issue debt with outdated financial statements in the offering documents, and before the audit of the most recent fiscal year has been completed. However, if this is done, it is important to thoroughly investigate the issuer’s financial condition for the period after the old financial statements, to determine changes in the issuer’s financial condition which need to be disclosed. See City of Rochester, NY.

  6. Municipal officials, including members of the government board, need to be trained in their responsibilities for compliance with securities laws. Issuance of bonds or notes is a serious matter especially for a small entity.

  7. Be sure to check to see that the financial adviser working on the transaction is registered with the SEC. See Aaron Fletcher and Twin Spires Financial LLC.

Summary of Cases

  1. Crosby Independent School District (Texas), Carla Merka and Shelby Lackey, CPA

    The SEC stated that in connection with the issuance of $20 million of bonds in 2018, the District used financial statements which contained material misstatements and omissions.  The District’s Chief Financial Officer, Carla Merka, produced inaccurate financial statements and signed false certifications of the accuracy of the District’s financial statements for the bond offering.  When the financial problems were discovered by a new CFO, the District had to declare a fiscal emergency and had to be subject to a State oversight. 

    The SEC brought an administrative action against the District, which consented to entry of an order to cease-and-desist from future violations of Section 17 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 enacted by the SEC pursuant to Section 10(b) (collectively the “securities fraud laws”). 

    The SEC also filed a civil suit in federal District Court against Merka, essentially finding her liable for the District’s securities lapses.  Merka consented to the entry of a judgment by the District Court which included (i) a permanent injunction against future violation of the securities fraud laws, (ii) a permanent injunction against participating in future offering of municipal securities (called a “bar”), and (iii) payment of a civil fine of $30,000. 

    Finally, the SEC brought an administrative action against Mr. Lackey, the partner in a national accounting firm (not identified) which audited the District’s financial reports.  The SEC alleged that Lackey, as the audit partner for this engagement, used improper practices to review the District’s financials, as a result of which the auditors did not discover the fraud in the District’s financial statements. 

    Lackey was suspended from the ability to appear before the SEC for a minimum of three years.  After that he can apply for reinstatement pursuant to an extensive set of procedures set forth in the court order.

    See case details here.

  2. Town of Sterlington, Louisiana, Vern Breeland, Aaron Fletcher and Twin Spires Financial LLC

    This was a straightforward case of fraud by Breeland, the Town’s Mayor, and Fletcher, sole owner and employee of Twin Spires, which was the Town’s financial adviser.  To further an existing sewer and wastewater project, the Town issued $4 million of revenue bonds in 2017 and $1.845 million of revenue bonds in 2018.  Under State law, these bonds had to be approved by the Louisiana State Bond Commission (the “SBC”), which required a detailed application and financial projections.

    In order to obtain SBC approval, Fletcher and Breeland created fictitious financial projections, which “backed into” a showing that the bonds would have a one-time debt service coverage.   Part of the information provided to the investors were copies of the false applications to the SBC and the SBC’s approval certificates.  Investors were also not told that Breeland had caused misuse of proceeds of prior sewer and water revenue bonds, and of the 2017 Bonds.   Investors were told that the bond proceeds would be used for sewer and water projects.  As noted in Paragraph 4 of the “Key Takeaways”, although there was no official statement for these bonds, the distribution to investors of a false government document gave rise to an SEC securities fraud charge.

    The SEC brought an administrative action against the Town of Sterlington.  The SEC noted that the Town cooperated with the SEC’s investigation and undertook remedial steps.  Accordingly, the Town consented to entry of a cease-and-desist order against future violations of the securities fraud laws, and did not suffer any other sanctions.

    Breeland resigned from his office in 2018, and was the subject of a state investigation which resulted in public reports confirming his improper activities.  He was subsequently charged with a felony under Louisiana law. In part using the state investigative results, the SEC brought a civil suit against Breeland, alleging that the actions recited above constituted violations of the securities fraud laws.  The SEC sought (i) permanent injunction against future violations of the cited securities fraud laws, (ii) a bar on participation in future securities transactions, and (iii) civil penalty to be determined by the court.  It appears Breeland is continuing to contest both the SEC and criminal cases.

    The SEC also brought a civil suit against Fletcher and Twin Spires.  In addition to their involvement in the fraud described above, Fletcher and Twin Spires never registered as a municipal adviser as required by the Dodd-Frank Act.  Fletcher and Twin Spires consented to entry of judgment in this case, which included (i) permanent injunction against violations of the securities fraud laws, (ii) permanent injunction against carrying out financial advisory activities without proper registration, (iii) permanent injunction against violations of various MSRB Rules governing activities of municipal advisers, and (iv) disgorgement of ill-gotten gains with prejudgment interest and civil penalty to be determined by the court.

    See case details here.

  3. Anthony Michael Holland

    This is the only matter of the four recent SEC cases which solely involves an individual and not a municipal entity.  Holland was the Chief Administrative Officer of the City of Johnson City, Texas.  Holland was embezzling funds from the City, and to cover this up he created a fake financial report for fiscal year 2016 by essentially “marking up” the financial statements for 2015.  This false financial statement necessarily contained material misstatements and omitted to disclose Holland’s embezzlement of funds from the City.  After the embezzlement was finally uncovered, Holland was criminally charged by the U.S. Attorney’s office for the Western District of Texas and pled guilty to one count of theft from a government receiving federal funds.

    The reason the SEC became involved is that once the false 2016 financial statements were forwarded to the City, the City’s financial adviser posted them on the EMMA website to comply (although quite belatedly) with continuing disclosure obligations for an earlier bond issue.  They remained on EMMA for almost a year until the fraud was uncovered.  As the SEC has stated in such places as a Staff Legal Bulletin in 2021 and in its enforcement action against the City of Harrisburg, Pennsylvania, securities law violations can occur, separately from bond issuance documents, when an issuer falsely “speaks” in a way designed to reach investors and the “market.”  Posting the fake financial statements on EMMA was ipso facto speaking to the market.

    Hence, the SEC charged Holland in a civil suit with violation of Rule 10b-5.  Holland consented to entry of judgment including: (i) permanent injunction against violation of Rule 10b-5, (ii) a permanent bar from participating in any issuance of municipal securities, and (iii) disgorgement of ill-gotten gains, prejudgment interest and a civil penalty, all to be determined by the court.

    See case details here.

  4. City of Rochester, NY, Rosiland Brooks-Harris, Capital Market Advisers, LLC, Richard Ganci, Richard Tortora, and Everton Sewell

    Because of deteriorating financial conditions and severe reduction of fund balance, the Rochester City School District asked the City to issue bond anticipation notes (BANs) and revenue anticipation notes (RANs) on its behalf, as the District apparently could not issue its own debt.  Brooks-Harris was the finance director of the City; Capital Market Advisers (the “CMA”) was the City’s financial adviser and Ganci and Tortora worked for CMA.  Approximately $119 million of the BANs and RANs were issued by the City in early August 2019, mostly for the benefit of the District, which was the largest component of the City’s budget. It was noted that although the District would provide most of the funds to repay the notes, the notes were legally supported by the general credit of the City.

    The SEC stated that the offering documents for these notes failed to provide an accurate description of the District’s financial condition, which had deteriorated substantially in the prior year, apparently because of sharp increases in teacher’s salaries.  The SEC stated that Brooks-Harris and Ganci were generally aware of this condition before sale of the notes, but did not question District officials or make sure the offering documents included this information.  They also did not provide accurate financial information to a rating agency, which as a result gave high ratings to the notes.

    The notes were sold with copies of the City’s 2018 financial statements, which were more than a year old.   Less than six weeks after issuance of the notes, the District’s auditors revealed the dire financial condition and overspending on salaries.  In time the City’s debt ratings were reduced and the State of New York had to intervene with a $35 million loan and appointment of a monitor for the District.

    The SEC commenced a lawsuit in federal District Court against the City, Brooks-Harris, CMA and Ganci alleging that the offering documents for the notes had material misstatements and omissions in violation of the securities fraud laws.

    The SEC also filed a separate lawsuit against Everton Sewell, who was the former chief financial officer of the District.  Alleging that Sewell knew about the District’s severe financial problems but did not cause them to be included in the offering documents or in discussion with rating agencies, the SEC sought penalties against Sewell for violating the securities fraud laws.

    In both cases the SEC is seeking permanent injunctions against violations of the securities laws, civil fines against all the defendants (including the City, apparently), and a bar against working on future municipal finance transactions for Brooks-Harris and Sewell.  As these cases were just filed in mid-June, 2022, there has been no further activity or settlement announced.  A news report suggests some parties may contest some or all of the suits.

    See case details here.