SECURITIES ANDEXCHANGE COMMISSION

Washington, D. C. 20549(202) 755.4846

FOR IMMEDIATE RELEASE

RESPONSIBILITIES AND LIABILITIESFOR MUNICIPAL OFFERINGS

Remarks byJohn R. EvansCommissioner

Securities and Exchange CommissionWashington, D.C.

Public Finance ConferenceSecurities Industry AssociationScottsdale, ArizonaOctober 29, 1976

When the Federal securities laws were enactedduring the 1930's to protect the investing public by providingfull and fair disclosure of the character of securities andby preventing inequitable and unfair trading practices, issuersof municipal securities and professionals dealing only in suchsecurities were exempted from those statutes except for thegeneral prohibitions against fraud. This pattern of non-regulation continued until the Securities Acts Amendments of1975. In those Amendments a comprehensive pattern ofregulation for brokers, dealers, and banks engaged in theunderwriting and trading of municipal securities was enactedin response to changes in the municipal securities markets,a number of cases of outright fraud, and instances ofunprofessional conduct by participants in municipal securitiesmarkets.

Specifically, under the '75 Amendments, brokerdealers exclusively dealing in municipal securities, andbank dealers in municipal securities, are required to registerfor the first time with the Commission; a Municipal SecuritiesRulemaking Board was created to develop rules governing theoperations and trading activities of munici}al securitiesprofessionals; and the Commission's rulemaking authority wasexpanded to cover municipal securities activities. The

The Securities and Exchange Commission, as a matter of policy,disclaims responsibility for speeches by any of its Commissioners.The views expressed herein are those of the speaker and do notnecessarily reflect the views of the Commission.

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legislation, however, left untouched the exemption formunicipal securities issuers from the registration requirementsof the Securities Act with an explicit provision restating thefact that neither the Commission nor the Municipal SecuritiesRulemaking Board had authority to require issuers of municipalsecurities to file documents.as a prerequisite to the sale ofsuch securities.

The regulatory provisions of the '75 Amendmentswith respect to municipal securities had not yet begun to takeeffect when the fiscal crisis in New York City surfaced.Attention was suddenly focused on the risks associated withNew York's securities, on whether appropriate disclosure hadbeen provided to investors, and on the question of who shouldbe liable for the offer and sale of such securities if fulland fair disclosure had not been provided. There wereseveral responses. The SEC undertook a formal investigationto determine the facts surrounding the sale of New York City'ssecurities. Leglislation was introduced to remove theexemption for municipal securities in the Securities Act of1933, which would subject municipal issuers to the fullregistration and disclosure provisions of that Act. Anotherbill was introduced to amend the Securities Exchange Act of,1934 to require certain municipal issuers to prepare annualreports and to prepare and disseminate distribution statementsin connection with new issues of securities.

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The market itself responded dramatically asinvestors became aware that municipal securities are notwithout risk and as underwriters and other marketprofessionals became concerned about their potential liabilityto investors. Typical of the impact was the experience inSuffolk County, New York, where an attempt to market $54

million of bonds was thwarted because potential bidders werenot satisfied with the disclosure of the county's financingneeds. Another example, outside of New York, was thedetermination of underwriters not to submit bids on a $25million general obligation offering by the City of Richmond,Virginia, despite a 3D-page offering circular which cityofficials called "the fullest disclosure ever offered on amunicipal issue." Apparently, the marketplace was concernedwith the city's lack of disclosure regarding its ability topay principal and interest on all of its outstanding debt inthe event the city should lose an annexation suit.

About a year has passed since the peak of themunicipal securities market crisis. It is evident that therehas been a significant increase in the degree of disclosureby some municipalities, but there is no uniform standard ofrequired disclosure to which issuers and underwriters canrefer. Hearings have been held on legislative proposalsdesigned to bring about appropriate and uniform pre-saledisclosures, but no legislation has been enacted. Numerous

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suits !lave been brought in which investors seek redress onthe ground that there was not adequate disclosure, but forpast purchases of municipal securities, definitive answersregarding the responsibilities and liabilities applicable tomunicipal securities issuers and underwriters shall awaitfinal judicial resolutions.

Perhaps the best starting' point for a discussionof disclosure responsibility and liability is the questionof whether the Federal law dealing with municipal securitiesis constitutional. It is well known that New York City andPhiladelphia have each sued the Commission to test theconstitutionality of our authority to conduct formalinvestigations and informal inquiries with respect to theirsecurities. The assertion that securities issued by a stateor municipality are immune from the Federal securities law isostensibly based on the recent Supreme Court decision in theUsery case that the commerce clause of the Constitution doesnot authorize the imposition of Federal regulations thatinterfere with a state's freedom to structure "integraloperations" of its "traditional governmental functions." TheCommission does not desire to intrude into the jUdgmental andpolicymaking functions of State and local governments. Wehave sought in all of our comments on proposed legislationand our litigation activities to preserve 'the right for Stateand local governments to determine whether, when, and for

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what purposes they will issue securities. However, whenState and local governments voluntarily choose to raise fundsfor their operations by distributing securities to theinvesting public across State boundaries, such activitiesare no longer limited,to the integral operations of traditionalState or local-government functions. Rather, they involveimportant national matters of investor protection whichnecessarily and appropriately require the application of theFederal securit1es laws.

As I previously indicated, the application of theFederal securities laws to municipal securities is limitedby- speciflc exemptions. Thus, underwriters of municipalsecurities are not subject to the broad liability provisionsof Section 11 of the Securities Act which, in the words ofone court, makes an underwriter "responsible for the truthof the prospectus." Nor is a municipal underwriter sUbjectto the express 'liability provisions of Section 12 of theSecurities Act, which makes any person who offers or sells asecurity liable for misstatements or omissions in a prospectusor oral- communication. These exemptions, ~owever, are notan unmixed blessing because the securities laws, along withthe Commission-rules, regulations and interpretations, andcourt decisions with respect thereto, provide a great dealof guidance for those to whom they apply.

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For example, the Securities Act does not ,explicitlypermit a municipal underwriter to rely on the st~~~ment ~fan expert, such as an accountant or bond counsel, or o~~thestatement of an official person, such as a municipal officer,as a defense against liability. Moreover, the Securities Act,does not explicitly afford a municipal underwriter th~traditional "due diligence" defense that, "after reasor;lableinvestigation," he had "reasonable grounds to believe and didbelieve" that the issuer's disclosures were true and therewere no omissions of material facts. And finally, ~heSecurities Act does not provide an explicit statut~ oflimitations for filing suits relating to munf.c Lpa.l secur-Lt Lesunderwritings, nor does that Act even specifically limit theliability of a municipal underwriter to the dollar ~Qunt ofthe underwriter's offering.

These matters may eventually b~ resolved in acourt of law or by Congress. But, until that ~ccur.s,municipal underwriters may have significant questionsconcerning their risk of legal exposure. There is noquestion, however, that underwriters of municipal securitiesare subject to the general antifraud provisions of, theFederal securities laws and the requirement incumb~nt uponall brokers and dealers in securities to deal fairly withtheir customers.

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Sectio~ l7{a) of the Securities Act makes itunlawful for any person in the offer or sale of any securityto engage in fraud or to obtain money or property by meansof any untrue statement of, or omission of, any material fact.As of yet, the case law concerning private actions underSection l7{a) is not well developed. The Commission hastaken the position, however, that a private action should berecognized under Section l7(a) in the context of a casedealing with securities excempt from regis.tration. Absentlegislative amendment to the Securities Act with respect tomunicipal securities, and in light of recent judicialdecisions regarding Rule lOb-5, I would speculate thatplaintiffs may seek to utilize Section l7(a) in bringingactions against municipal underwriters.

Section lOeb) of the Exchange Act grants the SECbroad power to adopt rules, in the public interest or for theprotection of investors, relating to manipulative or deceptivedevices or contrivances in connection with the purchase orsale of any security. Our Rule lOb-5 thereunder makes itunlawful for any person, in connection with the purchase orsale of any security, to engage in any fraudulent, manipulative,or deceptive act or practice or to make any untrue statementof material fact or to omit to state a material fact necessaryin order to make the statements made, in light of thecircumstances under which they were made, not misleading.

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Rule :Ob-S has been interpreted quite broadly by many courtsand an implied right of private action is clearly established.

You have all probably been advised by counsel,however; of the Hochfelder-declsion, in which the Supreme'Court held that private plaintiffs could not recover damages

. -.under Rule lOb-S'by establishing that the defendant'sconduct was merely negligent, but rather, required suchplaintiff to establish'that the defendants had acted withscienter, Which the court defined as "a mental state embracing

- -an intent to deceive, manipulate-or defraud." I will not. 'attempt to discuss the legal ramifications of that decision,which was engendered by the peculiar facts involved, exceptto say that' the Court expressly left open the questionWhether scienter is a necessary element in an SEC action

-under lob-5. I believe that courts might be reluctant toapply the Hochfelder rationale broadly to private suits

-involving municipal underwritings. In any event, there areprobably' years' of iitigation ahead about the exact scopeof the Hochfeider decision.

The last general antifraud provision which I'want to mention is Section 15'(c) (1) of the Exchange Act

, .which, among other things, prohibits any broker dealer,'

. .including a municipai securities dealer, from effecting anytransaction in, or inducing or attempting to induce the

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purchase or sale of, any security by means of a manipulative,deceptive, or other fraudulent device or contrivance asdefined by the Commission's rules. The SEC has adoptedRule 15cl-2 which defines the term "manipulative, deceptive,or other fraudulent device or contrivance" to include: anyact, practice or course of business which operates as a fraudor a deceit upon any person and any untrue statement of amaterial fact and any omission to state a material fact,which statement or omission is made with knowledge orreasonable grounds to believe that it is untrue or misleading.To date, there has been no judicial or administrativedevelopment of the parameters of Rule 15cl-2 with respectto municipal securities dealers.

Existing statutory provisions and rules are notthe only bases upon which liability could be asserted inconnection with municipal underwritings. As I previouslynoted, the Securities Acts Amendments of 1975 vestedpervasive authority in the Commission to regulate theconduct of municipal securities brokers and dealers andestablished a Municipal Securities Rulemaklng Board whichis charged with the responsibility of prescribing rulesfor the municipal securities industry with respect totransactions in municipal securities. Included within theMunicipal Securities Rulemaking Board's authority is the

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responsibility to "prevent fraudulent and manipulative actsand practices, [and] to promote just and equitable principles. ,

of trade, .... " This grant of autpority.is similar tothat granted to the NASD for brokers and dealers in securitiesgenerally, and the courts have held that rules adopt~d by theNASD pursuant to this authority may give rise to a,privatecause of action by an aggrieved investor. There is, ofcourse, much to be done in the way of adopting rul~s by theMunicipal Securities Rulemaking Board. In my view, a

, ,

private suit based on a Board rule would not be subject to,

the Hochfelde~ restrictions.It should be obvious from this discussion that

statutory provisions and rules thereunder offer littlespecific guidance at the present ~ime re~arding theresponsibilities of municipal underwriters and litt,le comfortregarding the limits of municipal underwriters' liability.Some additional assistance may be obtained, however, from areview of the Commission's actions in this area.

The Commission's authority with respect to brokersand dealers in securities, including brokers and dealers ;nmunicipal securities, is rather broad and expansive. Almostforty years ago, the Commission held that a broker dealerimplies to the public--merely by engaging in the business ofbeing a broker or dealer in securities--that his advice and

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statements concerning any security are sound.l/ Courts haveseized upon this implied representation and have noted thata securities dealer "occupies a special relationship to abuyer of securities in that by his position he implicitlyrepresents that he has an adequate basis for the opinions herenders. "2/

Almost ten years ago, the Commission considered theprecise subject of what constitutes fairness to customers andreasonable care in the sale of municipal securities. In adisciplinary proceeding, the Commission held that, beforepromoting certain municipal bonds, Walston & Co. should haveat least inspected the tract of land involved and inquired asto the financial condition of the developer of that land.The Commission's language in that case is quite instructive.It stated:

It is incumbent on firms participating in anoffering and on dealers recommending municipalbonds to their customers as "good municipalbonds" to make diligent inquiry, investigationand disclosure as to material facts relatingto the issuer of the securites and bearingupon the ability of the issuer to service suchbonds. It is, moreover, essential thatdealers offering such bonds to the public makecertain that the offering circulars and otherselling literature are based upon an adequateinvestigation so that they accurately reflectall material facts which a prudent investorshould know in order to evaluate.the offeringbefore reaching an investment decision.l!

l/Duker & Duker, 6 SEC 386 (1939).2/Hanly v. Securities and Exchange Commission, 415 F. 2d- 589, 496 (C.A. 2, 1969).l/Walston & Co., Inc. 43 SEC 508, 512 (1967).

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During the past four years, the Commission hasbrought nine municipal securities enforcement proceedings.Six were secondary trading cases, five of which involved alltypes of municipal securities, and one of which involvedindustrial revenue bonds. Three were primary distributioncases, two of which involved industrial revenue bonds andone of which involved general obligation bond anticipationnotes of a California water reclamation district.

In these cases, the Commission has taken actionagainst promoters, a municipal issuer, bond counsel,underwriters and broker dealers. The broker dealers werecharged with such things as boiler-room selling tactics,churning, excessive mark-ups and other fraudulent activities.In a recent administrative proceeding against a major brokerdealer for certain secondary market activities in an industrialrevenue bond which it had underwritten, a settlement wasreached in which the sanctions included a partial reimbursementto customers for their losses and the imposition of internaloperating procedures in its municipal bond department withrespect to the underwriting and trading of industrial revenuebonds.

Underwriters have been named in our lawsuits forfailing to disclose material facts with respect to the natureand viability of the project for which the bond proceeds wereto be used, relying on unverified information and selling

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municipal securities through misrepresentations and withoutexercising due diligence. The Commission has held that bond

. .counsel who prepared a prospectus used in the sale ofmjnicipal bonds has a responsibility to make a reasonableinquiry as to the accuracy of the information contained inthe prospectus. And the Commission has argued, in a pendingcase, that bond counsel aided and abetted violations of theregistration provisions of that Securities Act and the anti-fraud provisions of that Act and of the Securities ExchangeAct where he was responsible for altering the terms of acertificate required under the bond lease agreement so asto permit the proceeds of the offering to be paid incontravention of the terms of the lease, and issued anopinion that the interest on the bonds was tax exempt withoutdisclosing that the availability of the tax exemption wasjeopardized by such payment.

In the one case against a municipal issuer, the,

Commission named a quasi-governmental agency, its generalmanager,' its bond counsel and others for offering and sellinggeneral 'obligation bond anticipation notes without disclosingmaterial facts concerning, amone other things, the issuer'stax base, revenues and sources of funds other than revenues

,available to repay the notes, the absence of any liability. .

for the State'or the county to repay the notes and thepreparation and use of offering circulars and television

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statements which contained false and misleading statementsand omitted to state material facts.

These cases indicate that the Commissi.on is nothesitant to use its authority over brokers, dealers,underwriters and other securities participants to assurethat investors have access to.material information and thatthey are protected from fraudulent and unfair sellingpractices. However, because the cases are limited to specificfacts and virtually all of them involve rather egregious.situations, they do not, in and of themselves, establishall-purpose guidelines or standards concerning the disclosureand due diligence responsibilities and the liabilities anddefenses with respect thereto for issuers, underwriters, andothers involved in the distribution of municipal securities.

I believe that the uncertainty bhat may now existas to the full scope and effect of present law can best beresolved through new federal legislation, preserving therights of municipalities to determine when, whether and forwhat purposes to issue securities, but explicitly insuringthe right of the investing public to receive full and fairdisclosure. The legislation should also clarify the specificobligations of issuers, underwriters and other participantsin municipal securities markets and provide an express causeof action for damages against such participants who have notmet their responsibilities. It would also be appropriate toprovide express due diligence defenses.

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As you know, a number of bills dealing withdisclosure procedures in the municipal securities marketswere considered during the last session of Congress, however,none of them was enacted. The Commission supported legislationthat would require certain municipal issuers to prepareannual reports and reports of any events of default. Theannual report would contain a description of the issuer andm~terial financial and other information regarding the issuer,including financial statements audited and reported on by anindependent public or certified accountant. The reports ofevents of default would contain similar information, asprescribed by the Commission through rule or regulation.The issuer would be required to make the annual report andreports of events of default available to the public uponrequest.

The legislation would also require an issuer thatoffers or sells an issue of municipal securities exceedinga certain size to prepare a distribution statement prior tosuch offer or sale. The distribution statement would containthe type of information required in the annual report to theextent prescribed by the Commission and other materialinformation concerning the offering. The issuer would berequired to make the distribution statement available to theunderwriters of the security offering for delivery toprospective purchasers. It is also pertinent to note that

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the proposed legislation contained a narrow provision limitingunderwriter's liability.

I expect municipal securities disclosure legislationto be considered again next year. At that time we should allhelp Congress establish explicit reasonable standards andprotections, which I believe'should be patterned afterSection 11 of the Securities Act. The legislation should notonly set forth, clearly, the precise d t.s oLoaur-e obligat ionsof municipal issuers, but also make explicit the full extentof their liability and concomitantly, the legislation shouldestablish an express means whereby investors may recoverdamages on the basis of issuers' material misstatements oromissions of material facts in connection with the offer andsale of their securities. Issuers should, however, be ableto rely on facts and figures obtained from other officialsources such as census reports.

Professionals such as accountants, bond counsel,engineers, appraisers, and other experts should be liable,with respect to the portions of the distribution statementswhich they prepare, just as experts are liable under Section11 with respect to corporate offerings.

The questions become more difficult when we ccnsiderlegislation to define precisely the scope of municipalunderwriter's liability because a majority of the issues areunderwritten by competitive bid. I see no reason why an

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in a negotiated transaction should not be subject to the. .

same Section 11 liabilities and have the same defenses asan underwriter of 'corporate securities. But it has beensuggested that this approach is not appropriate forcompetitively -bid underwritings.

The Commission's experience with competitivebiddi)g is primarily limited to public utility underwritingswhich are held to the same standards that apply to negotiatedofferings. Utility companies generally designate independentcounsel to perform a due diligence investigation prior tothe bidding on behalf of the successful underwriter. Thismay not be a perfect solution but it is an attempt to protectinvestors and yet permit securities to be sold as soon aspracticable by the successful bidder. I'm not sure what thebest solution is with respect to municipal underwritings butinvestors in all types of offerings deserve to be protectedfrom false and misleading information. In my opinion, a duediligence investigation must be performed either by theunderwriter or some other party which is inlependent of theissuer.

The need for legislation is clear. This does notmean, however, that the Commission should, or will, ceaseits pending enforcement activities or refrain from futureenforcement actions. Present law imposes responsibilities

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on all participants in the offering of municipal securitiesbut the most equitable and efficient marketplace is o~e inwhich the rules governing major facets of its operation~ arearticulated, known, and understood. Legislation to helpbring about that result for the municipal marketplace would.be in the interest of issuers, market professionals, investors,and the general public.