Banks may be skirting oversight in muni bond sales: SEC

Investors warned about risks in $3.7 trillion market

March 19 (Bloomberg) -- Wall Street banks may not be exercising adequate oversight of state and local government bond sales, the Securities and Exchange Commission said, warning investors about risks in the $3.7 trillion municipal market.

Reviews of underwriters showed that some may not be sufficiently examining bond documents for evidence of fraud, the agency’s Office of Compliance Inspections and Examinations said today. Banks are required to review bond documents to guard against false statements and can face sanctions if they don’t.

“To protect investors, it is important that broker-dealers perform adequate due diligence to assess the financial and operational condition of states and municipalities before selling their securities,” Carlo di Florio, the director of the compliance office, said in a statement.

The SEC has stepped up oversight of the municipal market as states and cities continue to deal with the effects of the 18- month recession that ended in June 2009. Amid such strains, the number of U.S. municipal-bond defaults doubled in the past two years, compared with the average from 1970 to 2009, driven by bonds sold for health-care and housing projects, according to Moody’s Investors Service.

Rising Pressure

Governments have also been affected, including Stockton, California, which is working to avoid becoming the biggest U.S. city to enter bankruptcy. Alabama’s Jefferson County’s Chapter 9 filing last year made it the biggest U.S. municipal bankruptcy ever, in terms of debt. Pennsylvania’s capital of Harrisburg skipped bond payments this month after a takeover by a state receiver, while Detroit is striving to prevent a receiver from taking control there.

The SEC has set up an enforcement unit to police the municipal market for fraud. In August 2010, it settled fraud claims against New Jersey that the state had misled investors by masking inadequate pension funding in $26 billion of bond sales. Later that year, four San Diego city officials agreed to financial penalties to settle the agency’s claims that they failed to inform investors of “fiscal problems’ tied to municipal retirement plans.

While the agency can bring fraud claims against municipal officials, securities laws, including those on disclosure, apply to securities firms because of decades-long exemptions given to state and local governments from direct federal regulation.

Compliance Concern

Compliance by securities firms with SEC rules when lining up investors for municipal-bond offerings is a concern at the agency, according to today’s statements. Securities laws require underwriters to review financial disclosures in bond documents for potential inaccurate or fraudulent claims.

“By participating in an offering, an underwriter makes an implied recommendation about the securities,” the SEC said in its Risk Alert. “A municipal underwriter also makes a representation that it has a reasonable belief in the truthfulness and completeness of the key representations made in any disclosure documents used in the offering.”

The agency didn’t single out any companies by name or indicate that any civil charges are pending as a result of its examinations of underwriters. During its reviews, the SEC said it found that some firms may not do enough checking of an issuer’s finances or keep documentation to show that they have.

“The best way for investors to protect themselves is by making fully informed decisions,” Lori Schock, the director of the SEC’s investor education and advocacy office, said in a statement. “This is true for any investment, including investments in municipal bonds.”

Bloomberg News

--With assistance from Romy Varghese in Philadelphia. Editors: Ted Bunker, Mark Schoifet.

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