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Solicitors: Help Avoid Targeting by the SEC in Municipal Bond Offerings

August 8, 2022
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By David Unkovic and Ryan T. Gonder

Reprinted with permission from the August 4, 2022 edition of The Legal Intelligencer © 2022 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

All attorneys representing municipal and other public sector clients should be aware of the potential for a U.S. Securities and Exchange Commission (SEC) investigation of their clients’ public bond deals. Issuers generally will hire a team of professionals with specialized experience in public finance to assist them in completing a financing; such professionals commonly include bond counsel, disclosure counsel, and a municipal advisor. But even the general practice solicitor that handles all day-to-day legal issues for the client will play an important role in the financing process.

Sometimes the best lessons are learned from studying the mistakes of others. In recent months, the SEC has publicized the results of multiple enforcement actions involving municipal bond financings. In each case, the issuers and other involved parties were charged with providing false and misleading information.

In this article we review two of those recent investigations, involving the Sweetwater Union High School District and Crosby Independent School District. While both actions involved “bad behavior” by the financial professionals involved in the deals, they present valuable lessons for all professionals involved in finance transactions, including attorneys serving as solicitor.

Sweetwater Union School District

The SEC’s investigation of Sweetwater Union High School District (Sweetwater), near San Diego, California, involved allegations that Sweetwater and its CFO, Karen Michel, provided materially misleading statements about the district’s financial status in connection with the sale of general obligation bonds issued by Sweetwater in 2018. Ultimately agreeing to a settlement of the charges in September 2021, Sweetwater was required to engage an outside financial professional (who was not involved in the bond issue) to clean up its financial operations; Michel agreed to a ban from participating in future municipal bond offerings and paid a $28,000 penalty.

Sweetwater’s troubles stemmed from its budget for the 2017-2018 fiscal year. Before the start of the fiscal year, Sweetwater implemented 3.75% raises for its employees. However, Michel failed to include the full cost of the salary increases in the budget. The effect of this omission was a projected ending general fund balance of $19.5 million. If the 3.75% increase had been considered, the projected ending general fund balance would have been $7.2 million in the red—a net swing of over $26 million. Even though internal analyses by her office recognized the problem, Michel took many steps to cover up the actual deficit.

Michel was able to “hide the ball” here because she was in charge of all aspects of the district’s finances—she oversaw the budget process, she prepared all periodic financial reports to the five-person school board, and she oversaw the debt issuance process for the district. In addition, in its resolution approving the issuance of $28 million of general obligation bonds in 2018, Sweetwater’s board authorized Michel to enter into all agreements and sign all documents related to the bonds.

The SEC determined that Michel misled her school board, the state of California, the rating agency, the underwriter and other professionals working on the bond issue, and the bond purchasers. Once the truth came out, Sweetwater’s credit rating was downgraded from “A” to “BBB+” with a negative outlook.

Crosby Independent School District

The SEC’s investigation of the Crosby Independent School District (Crosby), near Houston, Texas, also involved allegations of material misstatements by Crosby and its CFO, Carla Merka, about the district’s financial status in connection with the sale of general obligation bonds issued by Crosby in 2018. Here, the SEC charged the district, Merka, and the district’s auditor with providing the inaccurate information in connection with the sale of the bonds. The parties reached a settlement in 2022, resulting in a $30,000 fine and participation ban for Merka as well as a three-year prohibition for the auditor from practicing before the SEC.

Like Sweetwater, Crosby’s problems stemmed from issues with its financial statements. The district failed to report in its 2016-17 financial statements $11.7 million in payroll and construction liabilities, and also falsely reported $5.4 million in reserves. Merka was aware of these problems but did not inform the auditor who prepared the statements. She then provided the misleading financial statements for inclusion in the official statement for the bonds.

Perhaps not surprising, as this action involves a school district in Texas, the misstatements related to football. Crosby had previously issued bonds in 2013 to fund various capital projects, including improvements to its football stadium, but the cost of the stadium improvements exceeded the budget by a whopping $12 million after the district’s superintendent became actively involved in the stadium project and pushed for additional enhancements outside the original scope of work.

The district needed to bring another bond issue to market to cover the deficit, but to deal with the problem in the interim, it engaged in some creative accounting: the district changed its fiscal year end from Aug. 31 to June 30, resulting in a “savings” of $3.8 million in teacher payroll expenses. These savings were nonexistent, however, as they were simply pushed into the next fiscal year; Merka did not inform the district’s auditor that the amount was still outstanding and unpaid.

Like the CFO in Sweetwater, Merka was in total control of the financial processes for Crosby. She did not inform the professionals working on the 2018 bond deal of the issue.

It did not take long for this ruse to fall apart; Merka and the superintendent resigned shortly after the bonds were issued in January 2018, and by June, the district’s new CFO had discovered the problem and disclosed it to the market later that summer. The result of the disclosure: the bonds that were sold in January were downgraded by the ratings agencies that had previously rated them and assigned negative outlooks.

So, with both of these investigations involving bad behavior on the part of the financial professionals, what does all this have to do with the solicitor? Even though the other professionals may be more experienced in public finance, none of them knows the issuer as well as the solicitor. The solicitor handles a wide variety of legal issues and has regular contact with the issuer’s public officials and staff. Therefore, the solicitor should be attentive to what the issuer’s board and staff are doing and assist the issuer in developing policies and procedures to avoid the types of issues seen in Sweetwater and Crosby.

Be Attentive. If, during the year, the issuer makes major decisions or takes extraordinary actions—including, for example, approving staff raises, selling property, buying property, undertaking new capital projects, incurring debt and expending debt proceeds—the solicitor should ask the CFO how these actions will affect the issuer’s budget, in particular if they were not budgeted previously. The solicitor should ask the same questions of the issuer’s auditor with respect to the issuer’s financial statements.

When it comes to the bond issue, do not be afraid to ask questions if you do not understand what is going on. If you are confused, then your client is probably confused, too. Do not take “that’s just the way it is done” as an answer; insist on clear explanations. Read through the proposed official statement and speak up if anything looks wrong or if something significant related to your client is not being disclosed.

Assist in Developing Policies and Procedures. In the SEC enforcement actions discussed above, the governing bodies of the issuers had delegated power to a single person (the CFO) over all financial aspects of the issuer’s operations, including budgeting; reporting financial matters to the governing body and to state oversight entities; entering into contracts related to the funded projects; and controlling all information given to rating agencies, bond professionals and, ultimately, the bond purchasers. It is never a good idea to place all your eggs in one basket.

Issuers’ governing bodies should take care to set up internal checks-and-balances on the creation and dissemination of financial information. If the issuer’s staff is so small that one person must do everything, have the governing body designate one of its members (e.g., the Treasurer) to keep an eye on financial matters.

This is not to say that the solicitor is responsible for how others are conducting themselves in a financing. But, both of these SEC enforcement actions could have been avoided if the problems were noticed and addressed in a timely manner. Solicitors may be in a position to help head off problems before they mushroom—so long as they are being alert and ask the right questions.


David Unkovic (dunkovic@mcneeslaw.com) and Ryan T. Gonder (rgonder@mcneeslaw.com) are public finance attorneys with McNees Wallace & Nurick in Harrisburg, Lancaster and Devon, Pennsylvania. Gonder serves as solicitor to Steelton Borough, Dauphin County, and is also a school director at Central Dauphin School District.

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David Unkovic

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