SEC enforcer warns of investors trying to benefit from states' misfortunes

Some investors are seeking to profit from the financial strains of states and municipalities, Elaine C. Greenberg, chief of the new municipal securities and public pensions unit in the SEC's enforcement division, told attendees at the Council of Institutional Investors conference in Washington on April 12.

“There are people who may want to benefit from the financial stress that is out there,” she said. There are “financial products that would take advantage of that.”

Ms. Greenberg, who spoke as a panelist discussing her new unit's range of responsibilities, said it's now possible to buy credit default swaps (a type of hedging contract to protect against an investment loss) to short the state of California, which is betting that the state will fail to meet its debt obligations.

There is a question “whether that raises other policy concerns, but that product does exist,” she said.

Ms. Greenberg said the new unit — to which she was appointed its first leader Jan. 13 — will investigate cases in which public pension funds find themselves victims of investment fraud or cases of public pension funds engaging in actions that violate federal securities laws.

The unit “will focus on various types of misconduct in the municipal securities market in connection with public pension funds, including offering and disclosure fraud, tax or arbitrage fraud, pay-to-play and public corruption violations, valuation and pricing fraud (and) public pension accounting disclosure violations,” she said.

“Public pension funds are among the largest and most active institutional investors … and like any other investor they can fall victim to any number of frauds,” she said.

The unit also will investigate the failure of pension fund investment consultants to disclose conflicts of interest to their clients.

The SEC proposed a rule dealing with pay-to-play corruption, which also victimizes public pension plans. SEC staff members are “preparing recommendations for the commissioners for a final rule,” Ms. Greenberg said. The proposed rule, issued July 2009, would bar for two years any political contributions made by money manages that provide services to public funds. The prohibition would affect any direct or indirect contributions made to elected officeholders or candidates for positions that can influence manager selection, as well as contributions to candidates' local political parties, Ms. Greenberg said.

The new unit also will investigate “circumstances where a public pension fund … may engage in conduct that violates federal securities laws” such as by trading on non-public information, she said. Although public pension funds are exempt from the Investment Company Act and the Investment Advisers Act — the two statutes that regulate money managers — “they are subject to the anti-fraud provisions of federal securities laws,” Ms. Greenberg said.

Another focus will involve securities fraud committed by public issuers of securities with respect to pension liabilities, she said. Municipalities and states that have significant pension liabilities could make materially misleading statements about the nature and scope of those liabilities in official statements issued to potential bond investors and credit-rating companies. She cited a November 2006 enforcement action against the city of San Diego as an example. The city failed to disclose to potential investors important information on its pension and retiree health-care obligations in the $260 million sale of municipal bonds in 2002 and 2003, she said. “The commission found the city's disclosure about (those liabilities) and its ability to pay those obligations was materially misleading.”

“Given the changing and evolving nature of the markets and investment opportunities and products, (other) areas of concern may emerge” for investigation, Ms. Greenberg said. One goal of the unit “is to proactively seek to identify market activities that pose the greatest risk … and may be indicative of potential problems.”

“We are actively seeking to hire experts, particularly in the area of trading municipal securities (and) underwriting” to give the unit a fresh view of any areas of concern, she said. “The unit will be able to harness that expertise in our enforcement efforts,” she added.

The unit “will try to (fulfill its) responsibility by developing … and detailing specialized knowledge of the investment industry in order to gain insight and understanding of the operations, motivations and strategies of these market participants.”