For the first time ever, the Securities and Exchange Commission accused a U.S. state of violating federal securities laws. In a recent CNNmoney.com article, it was reported that the SEC alleged that the state of New Jersey mislead investors in bond sales totaling $26 billion over a six year period ending April 2007. In fact, we had written a blog post discussing the severity of New Jersey’s public pension underfunding issues and the state’s failure to address such issues back in November 2009. New Jersey is one of a handful of states, which have pension funding crises, not just funding issues.
According to the SEC, offering documents connected to the bond sales created the false impression that the state could fund pension obligations with existing resources. However, the SEC alleged that New Jersey could not make contributions to its public pensions without raising taxes or cutting services that could impact its budget. As a result of failing to properly disclose its pension obligations, and the related financial issues, investors were not given adequate information to gauge the state’s ability to fund the pensions or assess the impact on its financial condition.
For several years now, cities and states have watched the funding of their public pensions worsen and many have filed to take any substantive action. Some of these public pensions have become dramatically underfunded, leaving the city or state in a fiscal crisis, but politicians continue to minimize the severity of these problems. They have glossed over the issues and are trying to push these issues off into the future, but the SEC has now sent out a warning that public pension underfunding can result in serious consequences. Besides penalties and fines, governmental units or responsible individuals may be criminally charged for securities fraud, which raises the stakes for the individuals involved. If the city or state creates a false impression with its citizens about its fiscal health when issuing bonds, it is also creating this false impression with potential investors.
In particular, the state of Illinois should be concerned by the SEC’s fraud charges brought against New Jersey. Recently, the state of Illinois issued a $3.5 billion bond issue and will issue another $11 billion bond issue in 2011. During this time, the state’s unfunded pension obligations have been estimated to be between $61 billion by the Illinois General Assembly’s Commission on Government Forecasting and Accountability and $166 billion by independent parties. If the state of Illinois makes misleading statements regarding its public pension underfunding issues when it issues bonds, Illinois may be the SEC’s next target. Full disclosure can solve these problems, but that would almost surely the raise the cost of borrowing funds during this time of economic uncertainty and reduced tax collections.
The SEC has taken a very important step to deal with how some cities and states mischaracterize their public pension obligations to its citizens and bond investors. Cities and states cannot be allowed to mislead investors about its pension obligations when it issuing bonds. Although there were no criminal charges or a financial penalty in the case of New Jersey, there is no guarantee this will occur again when the SEC files charges against another state or city. In fact, in San Diego, the SEC based remedies were much more severe. From this point forward, cities and states must be careful when they make statements about their public pension obligations and their ability to pay such obligations, because they could be the SEC’s next target if there is not proper and full disclosure.
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