STATES’ VERSION OF A PONZI SCHEME
- AUGUST 20, 2010
The SEC’s Jersey Score
At last, a state gets hit for securities fraud.
In the summer of 2001, legislators in Trenton wanted to raise pension benefits 9% for state and local government employees. But there wasn’t enough money in the pension system to fund the benefits and, only months before an election, the pols didn’t want to raise taxes. So the legislature cooked the books, valuing the existing assets in the plan as of their market prices on June 30, 1999, before the dot-com bubble burst. Voilà, the two main state pension funds magically had enough cash to pay higher benefits.
Rather than disclosing this political fraud to the buyers of its bonds, the state perpetuated it. In 79 offerings from 2001 through 2007, representing $26 billion in bonds, New Jersey “misrepresented and failed to disclose material information” about its underfunding of the pension plans, says the SEC. In a settlement this week, New Jersey neither admitted nor denied wrongdoing but promised not to commit such fraud in the future.
The New Jersey case is the SEC’s first-ever fraud charge against a state—amazing when you consider that the market for municipal securities, including bonds issued by states, is now roughly the size of the corporate bond market. It’s doubly amazing given that accounting by government issuers is “uniformly dishonest,” according to a former senior official at the SEC. This particular probe began under former SEC chief Chris Cox, and we hope current Chairman Mary Schapiro keeps it up, notwithstanding her desire to please public employee unions.
One obvious target is disclosures to investors about state retiree health and related benefits. According to a recent report from the Pew Center on the States, no fewer than 21 states have funded 0% of their retiree health care and other non-pension benefits. This is the definition of a Ponzi scheme, yet Pew charitably puts these states in a category labeled, “Needs improvement.”
The last two times Congress has legislated heavy new requirements on private companies that participate in the securities markets—the Sarbanes-Oxley Act in 2002 and this year’s Dodd-Frank bill—government issuers received a pass. Private firms that serve these issuers face new rules, and Dodd-Frank authorized a two-year study of the muni market, but the muni-bond issuers still have nowhere near the same disclosure obligations as private firms.
And get this: Congressman Barney Frank has been pressuring credit-rating agencies to give better grades to government issuers of securities, based on the fact that they’ve rarely defaulted in the past. Given the poor disclosure from states and cities, we don’t know how Mr. Frank can even guess whether they will perform as well in the future.
The SEC can’t require governments to disclose anything. It can only prosecute them for fraud after the fact, and while this week’s action against New Jersey is a promising first step, the double standard between public and private fraudsters is still alive and well.
When Goldman Sachs settled its far more dubious recent case on similar charges to those New Jersey faced, it had to pay $550 million. But New Jersey paid nothing. The SEC is apparently loath to make taxpayers foot the bill for the sins of politicians and bureaucrats. We share that sympathy but wonder why it doesn’t extend to shareholders in companies sued by the agency.
Beyond simple justice for taxpayers and shareholders, deterrence against bad behavior in business and government will only be effective when the SEC sues people, not institutions. Those people should include politicians who sell bonds under false pretenses.
