The federal government’s crackdown on the State of New Jersey this week for misrepresenting the condition of its pension funds raises a question: Who else might have pension numbers that could draw regulatory fire?
Cities and states are scrambling to make sure their pension disclosures are in order, and investors in distressed debt — who make money off financial trouble — are scrambling too, sensing opportunity.
“No one knows exactly how to attack this market yet, but people are going to be watching the New Jersey case and others like it very closely from an investment point of view,” said Jon Kibbe, a lawyer who specializes in distressed debt. Though some advisers are urging caution, New Jersey and other states have continued to issue new debt at reasonable rates as investors clamor for high-grade securities in a low-rate environment.
Harry J. Wilson, a Republican candidate for New York State comptroller, said Friday that New York was not compliant with the standard that the Securities and Exchange Commission established in its cease-and-desist order against New Jersey. Dennis Tompkins, a spokesman for the current New York comptroller, Thomas P. DiNapoli, who is running for re-election, said that “it’s ridiculous, it’s wrong and it’s reckless to make those accusations” and added that the state’s financial disclosures were complete and correct.
“The cease-and-desist order has heightened awareness of the importance of accurate pension disclosure,” said John M. McNally, a partner at the law firm Hawkins Delafield & Wood, and the project coordinator of the newest edition of “Disclosure Roles of Counsel,” a treatise telling municipal bond lawyers what is expected of their clients.
Mr. McNally has also been serving as a special disclosure counsel to San Diego, the first government accused of securities fraud by the S.E.C. for faulty pension disclosures. New Jersey was the first state.
The S.E.C. and other regulators found that San Diego had numerous pension problems, but in general, regulators said its government did not adequately describe the size of its obligations to retirees. In addition, there were discrepancies between the pension numbers in the official statement distributed to bond buyers and the pension numbers in other documents.
Mr. McNally said it was important to give consistent information and to explain the status of the pension fund’s condition in plain English. “One of the critical disclosure points would be, what are the implications for an entity’s annual budget,” he said.
Instead of bristling with acronyms, he said, pension documents should tell an investor how much the government must put in the pension fund every year and whether it can afford the payments. At the moment, the municipal bond market’s players — advisers, investors and underwriters — are more concerned about Illinois than any other state. Its credit was downgraded this year, and all the main ratings agencies said the poor condition of its public pension funds was a primary factor.
A spokeswoman for Gov. Pat Quinn’s Office of Management and Budget, Kelly Kraft, said Illinois believed its pension disclosures were complete and accurate. The state has not hidden the fact that its pension funds have big shortfalls, she said, and there was no reason to think the S.E.C. might lodge a complaint against it, as it did with New Jersey.
She added that investors had been calling with questions in the wake of the S.E.C.’s action against New Jersey, but said that Illinois had been telling them not to worry — the regulator had not contacted state officials.
She said the state had no plans to revise any of its financial documents. Still, some actuaries are deeply concerned about Illinois’s pension numbers, particularly because of a pension law enacted earlier this year.
State officials claimed the measure had sharply lowered costs by cutting the benefits that will be earned by workers hired in the future. (The current work force will continue to earn the same benefits as before.)
When it enacted the reform, Illinois issued a report, explaining in detail how it would work. Actuaries who have reviewed the numbers say that report is at least misleading and appears to be based on a type of calculation not authorized for pension disclosures. The state has not issued new audited financial statements since the law was passed.
Numbers in the report show that the state will be able to reduce its contributions to its pension funds, saving the state money, starting with $300 million in its first year and adding up to tens of billions of dollars over time. That’s because Illinois could make smaller pension contributions, on the assumption that its work force would over time consist of people earning smaller pensions.
Paradoxically, even though the state will make smaller contributions, the report forecasts that Illinois will get its pension funds back on track to a respectable 90 percent funding level by 2045. It projects that costs will increase slowly and an economic recovery will make cash available for the state to make the contributions it has failed to do in the past.
Whether that is even possible is contested by some actuaries who note that its family of pension funds is now only 39 percent funded. (If a company let its pension fund dwindle to that level, the federal government would probably step in, but federal officials have no authority to seize state pension funds.)
Some actuaries who have reviewed the state’s plans said that shrinking contributions would make the pension funds shakier, not stronger.
Indeed, one of them, Jeremy Gold, called Illinois’s plan “irresponsible” and said it could drive the pension funds to the brink.
Further, Mr. Gold pointed out that Illinois’s official disclosures said that its pension calculations used an actuarial method known as “projected unit credit,” but that the pension reform report used another method, which had not been approved for disclosure.
“According to Illinois statute, the prescribed contributions are determined under a method that may not be in compliance with the pertinent actuarial standards of practice,” Mr. Gold said.
Actuaries from the two big firms that help Illinois with its pension funds conceded that the report relied on another methodology. Larry Langer of Buck Consultants said that a law allowed the state to use the alternate method outside of bond offering documents. Investors can look at both sets of numbers and draw their own conclusions, he said.
He acknowledged that using the latest pension reforms would lead to a lower funding level but said state officials were not concealing the magnitude of the problem. “They almost laud it,” he said.
Brian Murphy of Gabriel, Roeder, Smith & Company, another of Illinois’s actuarial consultants, said the numbers were for illustrative purposes only and unlikely to reflect what the state would actually do in coming years.
“They’re going to fund it at the proper level,” Mr. Murphy said.
In a separate article, the WSJ wrote an op-ed on the SEC's Jersey Score:
The movement to clean up state pension funds is gaining momentum, and the latest evidence is that even the Securities and Exchange Commission is getting in on the action. In the Wonders Never Cease Department, the SEC has scored the state of New Jersey for lying to bond investors that its state pension funds were adequately funded.
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.
In a related topic, Janet Morrissey of TIME reports, SEC Now Offering Big Payoffs To Whistle-Blowers:
In what could give new meaning to the phrase — "If you see something, say something" — a clause within the financial reform legislation is offering big cash rewards to whistleblowers who report fraud and other wrongdoing at U.S.-listed companies and Wall Street banks.
Under the program, which is already live, anyone who provides a tip that leads to a successful Securities and Exchange Commission action will be able to collect between 10% and 30% of the amount recovered — as long as the total amount exceeds $1 million. This means the minimum payout is $100,000. The whistle-blower could be a company insider or a private investor, if they're able to offer information or analysis that leads to an action. And with potential payoffs netting millions — or even tens of millions — of dollars, experts are bracing for a surge in tipoffs. (See the worst business deals of 2009.)
Money can be "extraordinarily effective" in getting people to blow the whistle when they see fraud, says John Phillips, whose law firm Phillips & Cohen LLP specializes in whistleblower cases. The U.S. Government evidently agrees. "We expect the awards will prompt a significantly greater number of insiders to come forward with high-quality evidence of fraud," says SEC spokesman John Nester.
In the past, the SEC's whistleblowing program was limited to insider trading cases and offered only small discretionary, rather than mandatory, rewards ranging from 0 to 10% of the money recovered. "It was completely ineffectual, completely discretionary," says Phillips. (Read about a whistleblower case involving ignorance.)
The narrow scope and poor cash rewards generated little response: Since the program's launch in 1988, only 14 applications led to actions where a civil penalty was ordered, and only eight cash awards were handed out totaling $1.16 million, according to SEC officials. The largest award came last month when the ex-wife of a hedge fund adviser at Pequot Capital Management was awarded $1 million for her role in providing information that led to Pequot paying $27 million to settle an insider trading case involving Microsoft securities. The ex-wife had discovered a key email on her computer hard drive that led to the action against her ex-husband's former employer. (Read about the new sheriffs of Wall Street.)
But this legislation extends the program beyond insider-trading cases to all securities law violations and, most importantly, offers bigger payoffs and therefore bigger incentives to speak out. People can report almost any securities violations, ranging from money laundering, accounting fraud and ponzi schemes to bribery. Also, the SEC will be looking at not only independent knowledge, but even analysis as proof. The means an academic, private investor, or even a journalist or a securities analyst who conducts independent research and uncovers fraud based on that research could collect an award if their information is new and leads to an action.
"So you can have people who might have done analysis for academic reasons or personal trading reasons or research that they sell, that they may now, in addition, provide to the SEC with an eye toward getting a bounty," says Paul Leder, a partner at Richards, Kibbe & Orbe LLP and former SEC official for 12 years. He noted how the options backdating scandal in 2006 stemmed from academic articles that described how the option grants to executives and board members were extraordinarily well-timed. The SEC picked up on the analysis and wound up filing dozens of cases against companies and executives. (Comment on this story.)
Even a CEO could squeal on his own company as long as he wasn't personally convicted in connection with the fraud. "Yes, to the extent that they themselves are not culpable," says Phillips. "You can't initiate the fraud and then go collect on it."
The legislation bars certain people from receiving awards — officers or employees of a regulatory agency, the department of justice, a self-regulatory organization, the Public Company Accounting Oversight Board or a law enforcement organization, as well as company auditors and anyone convicted of a crime related to the securities violation.
The program also protects squealers against company retaliation. Any whistleblower who is fired, demoted, suspended, threatened, harassed or discriminated against by a company for providing info or testifying in an SEC investigation, can file an action in the U.S. District Court. If they succeed in proving their case, the legislation guarantees the person's reinstatement, two times the amount of backpay owed, and coverage of all court and attorney fees—so long as the action is filed within a certain time period.
The potential payoff is high. The recent judgment against Goldman Sachs resulted in a $550 million penalty. "If you got 10% of that, it's pretty good money," says Leder.
Even a mid-cap company could wind up with a consent order or suit in the millions of dollars, says Daniel Karson, executive managing director and counsel at Kroll, a risk consulting company. "So 10% for making a phone call is a pretty good payday," he says.
One obvious question overhanging this new lure for whistleblowers is whether the SEC will have the staff to handle it. "The government always has limited resources," says Karson. "I think the SEC is going to be overwhelmed in short order with people bringing these kinds of actions — they're going to have to sort through what has substance and what doesn't." The SEC has indicated it will be opening a whistle-blowing office and chairman Mary Schapiro told a House committee the agency would need to hire 800 new people to fully implement the financial reform bill's changes.
"There's real money to be made," says Leder. "I think it's a powerful incentive."