SEC CHARGES ILLINOIS WITH SECURITIES
FRAUD OVER PENSION FUNDING DISCLOSURES
On March 11,
2013, the Securities and Exchange Commission (SEC) charged the State of
Illinois with securities fraud for misleading municipal bond investors about
the State’s approach to funding its pensions – specifically, the Illinois State
Employees’ Retirement System; the State Universities Retirement System; the Illinois
Teachers’ Retirement System; the Judges’ Retirement System; and the General
Assembly Retirement System. This is only
the second time that the SEC has used its anti-fraud statutes against a state in
order to underscore what the Commission sees as flawed public pension
disclosure by municipal bond issuers; the first involved New Jersey in 2010.
According to
the SEC’s investigation, Illinois did not inform investors about the significant
impact of problems with its pension funding and failed to disclose that it had “structurally
underfunded” the State’s pension obligations and increased the risk to its overall
financial condition as a result. Illinois, without admitting or denying the
findings, agreed to settle the SEC’s charges and entered into a “Cease and
Desist” Order with the agency.
Elaine
Greenberg, Chief of the SEC’s Municipal Securities and Public Pensions Unit, said
that the area of public pension disclosures “continues to be a top priority of
the unit.”
There are
several aspects of the Cease and Desist Order that are worth noting:
· The
SEC provides some insights as to what it views as an acceptable public pension
funding policy – or at least what it does not.
Specifically (see Finding 9(a)), the SEC believes that contributions to
a plan must be sufficient “to prevent the growth of its unfunded liability” and
should cover both the normal cost and a payment to amortize the accumulated
amount of pension liabilities that have been deemed earned but are not funded
(the unfunded actuarial accrued liability, or ‘UAAL’) for an identified group
of plan participants.
(What is an acceptable amortization period? The SEC does not say. But the Commission does observe that a 90
percent funding target “allowed the State to amortize the UAAL in a manner that
would not eliminate it entirely,” thus increasing the “economic cost” of the
pensions and delaying the cash outlays necessary to fulfill the pension
obligations. Also, the SEC noted that
Illinois spread costs over fifty years, “in contrast to the thirty-year
amortization period adopted by the pension plans of most other states.”)
If a funding policy does not at least prevent the growth of a
plan’s unfunded liability, the SEC found that the result could structurally
underfund pension obligations and backload the majority of pension
contributions “far into the future,” thereby resulting in “significant stress”
on a pension system and on a state’s “ability to meet its competing
obligations.”
In short, the SEC found that, at least in the Illinois
situation, the “State’s pension contributions were calculated in accordance
with State law, not in accordance with the ARC,” and therefore Illinois “deferred
funding of the State’s pension obligations and compounded its pension burden.”
Granted, the violation of law was not due to Illinois’ failure
to follow some SEC model for funding, but the Commission’s preference for the
ARC, as it defines it, over state law, is informative. Does it mean that if a state has a stautory contribution rate that is less than the ARC, that it is "structurally underfunding" its pension obligations and needs to disclose this in its bond offering statements?
·
The
SEC does not like the projected unit credit (“PUC”) actuarial cost method. It found that Illinois’ use of it “compounded
the risk” of the state’s Statutory Funding Plan and that Illinois “did not
inform investors that other aspects of the State’s funding method, such as the
State’s use of the PUC method, delayed contributions and increased the unfunded
liability.” (See Findings 9(f) and 13(c).)
· Beware
of consultants. The SEC was quick to point
to a pension consultant retained by the Governor’s Office of Management and
Budget who wrote that the Illinois pension system “is now so underfunded that
the State likely [would] never be able to afford the level of contributions
required to ever reach 90 percent funding.” The SEC found it problematic that this information
was not disclosed to bond investors in bond offering documents. (See Finding 10(b).) How broadly, and to whom, does this term
“consultant” apply?
· Policies
and procedures related to pension disclosures are important. In the Illinois situation, the SEC found that
the State’s misleading disclosures resulted from, among other things, various
institutional failures, including failures to adopt or implement sufficient
controls, policies, or procedures designed to ensure that material information
was assembled and communicated to individuals responsible for disclosure
determinations; to train personnel involved in the disclosure process
adequately; and to retain disclosure counsel. “As a result, the State lacked proper
mechanisms to identify and incorporate into its official statements relevant
information held by the pension systems and other bodies within the State,”
according to the SEC.
The Commission also found that the State and its advisors “did
not scrutinize the institutionalized description of the Plan adequately and
made little affirmative effort to collect potentially pertinent information
from knowledgeable sources—in particular, actuaries for the pension systems.”
Finally, the SEC refers favorably of the remedial steps taken
by Illinois, including, prior to dissemination of official statements, a review
by the pension systems, as well as the Office of the Comptroller, the Office of
the Treasurer, and the Office of the Illinois Attorney General. (See, generally, Findings 23 through 26.)
In general,
this Cease and Desist order is more focused that the SEC’s action involving the
State of New Jersey. It is shorter (11
pages compared to 17 pages for the New Jersey order, and it makes fewer
findings (31)as compared to New Jersey (51).
Perhaps more importantly, it does not get into the pension plans’
preparation of the numbers reported to the state, as it did with New Jersey,
but focusses instead on the Illinois’ “structural underfunding” of its pension
obligations.
For example,
the New Jersey order found problems with the fact that the State’s bond
offering documents “did not disclose the effect of the State’s use of a five-year
smoothing method to measure the actuarial value of assets,” which, despite the
fact that such smoothing was permissible under applicable GASB standards at the
time, the SEC nevertheless found troublesome because New Jersey‘s contributions to its pension plans were based on an actuarial value of assets
that differed significantly from their market value and thus “reduced the
State’s statutory contributions to the pension plans.”
In
the New Jersey order, the SEC also found it problematic that the bond offering documents “did not
provide asset and funded ratio information on a market value basis.” The SEC found that “Investors lacked
sufficient information to assess the current financial health” of the New Jersey
pension plans “as a result of the absence of asset and funded ratio information
on a market value basis.’
The Illinois
order did not discuss either of these issues.
Perhaps the SEC viewed the Illinois disclosures as being adequate in
this area, or that it had sufficient bases for fraudulent action and did not
need to discuss these matters. However,
it is worth noting their absence.
