Friday, March 15, 2013


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.