August 18, 2010
New Jersey at the Frontier: A Sovereign Debt Crisis of Our Own
Posted by Erik Gerding

As usual, New Jersey leads the nation. Today, rather than Snooki showing the country a new level of reality t.v. debauchery, we have the Garden State itself becoming the first state of the union ever charged with violating federal securities laws.

According to the SEC release, New Jersey failed to disclose in 79 state bond offerings between 2001 and 2007 (totaling $26 billlion) that two public employee pension funds were underfunded. According to the SEC, the failure to disclose masked

the fact that New Jersey was unable to make contributions to [the pension funds] without raising taxes, cutting other services or otherwise affecting its budget. As a result, investors were not provided adequate information to evaluate the state's ability to fund the pensions or assess their impact on the state's financial condition.

Given that this post is about securities law from a securities law professor, I should note that Ma Gerding is a New Jersey state employee.

New Jersey is a special state in many ways, but my gut instincts tell me this SEC action is just the vanguard of a coming wave of state and municipal securities litigation. We have all the ingredients for an epidemic:

Start out with the dire budget situation of states and municipalities squeezed by the financial crisis.

Add the fact that many public entities have purchased complex derivatives whether to hedge interest rate risk, package together with bonds to work around statutory restrictions on public debt or get higher rating agency ratings, or just invest.

Pour in a hefty serving of accounting gimmickry which is a staple for getting around balanced budget rules

Mix in the fact that public bond deals are often dismissed as “cookie cutter” (I’ve posted before on how the “boring” areas of finance and law are often where the next crises lurk.)

Stir in some more obscure regulatory agencies (such as the Municipal Securities Rulemaking Board)

And voila! Crisis casserole.

Like most securities lawsuits, New Jersey’s problems could have been cured with disclosure. That is, the problem from the SEC's perspective was not that the state doesn’t fund its public pension funds adequately; it is perfectly natural for a public entity to get stuck in this jam of not wanting to raise taxes or slash spending yet still having to honor its contracts. Rather, the problem is that New Jersey failed to tell investors buying its bonds about this underfunding.

Why not simply disclose? There is the usual answer of not wanting to have to offer higher interest rates on bonds, which is no different than the motivation of any private securities issuer. My guess is that the more telling reason is political: what senior state Treasury employee wants to sign off on disclosure that will give ammunition to a Governor’s opponents and unions?

We’ve seen in other areas – like environmental law – that securities disclosure may be used as a tool to jump start discussions on political topics we might otherwise avoid – particularly those looming issues like climate change and now public debt.  I find it sad, though, that securities disclosure would be the impetus for confronting serious political problems.

Here is a more puckish thought for cheering up – would the SEC ever bring charges against the U.S. Treasury? Might certain federal programs be underfunded, and fixing the gap might be impossible for the country “without raising taxes, cutting other services or otherwise affecting its budget”?  

If the SEC clashing with the Treasury is fanciful, the prospect of massive litigation - public and private -- over state and local government bonds is not.  In Europe, we’ve already seen the private sector financial crisis morph into a public sector crisis. We are likely to see the same process play out domestically with states and municipalities.  Our Own Private Sovereign Debt Crisis.  Do you want to bet that the hullabaloo over the transactions U.S. investment banks put together for Greece to mask its debt won’t be echoed in the U.S.?  What about state and local bankruptcies triggering a request for federal bailouts?  Imagine this retro headline: Obama to California: Drop Dead.

A coming wave of state and municipal securities securities law litigation would be a boon for lawyers, who would have to untangle not only the usual bramble bush of federal securities laws and complex financial transactions, but also thorny issues of federalism and jurisdiction.  It won't be a boon for mom though.

Update (8/21): J.W. Verret responded to my tongue-in-cheek idea of the SEC suing the U.S. Treasury with both a careful analysis of the statutory provisions that would prevent that from ever happening and an analysis of the problems with the federal government acting as shareholder of private companies:


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