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San Diego Charges


San Diego Charges

November 27, 2006
Urban PolicyOther

The SEC has announced that it has resolved its pension-fund fraud case against San Diego, with the city agreeing not to commit illegal shenanigans in the future and to hire an "independent monitor" to help it avoid doing so. Although the SEC went easy on the residents and taxpayers of San Diego in its settlement, it still has an opportunity to make an example of the former officials who the SEC determines committed the fraud. The feds should seize that chance to show they're serious about policing a sector of the investment world that remains vulnerable to similar fraud.

San Diego ran into legal trouble with its pension fund because elected officials wanted to keep its municipal workers happy by awarding them more generous pension and health-care benefits, but also wanted to keep taxpayers happy by sticking to a lean budget. The two goals were mathematically irreconcilable. So San Diego officials, with the cooperation of the board members of the city employees' retirement system (the majority of whom were also city officials), intentionally underfunded the pension plan for years. They used the "savings" to award workers and retirees more benefits, some retroactive. Because taxpayers couldn't see how much retirement benefits for public employees eventually would cost them, they couldn't protest against those high future costs. The fund also violated sound investment principles by using "surplus" earnings in boom years to pay extra benefits to retirees, including a "13th check" in some years. Trustees should have put such "surpluses" aside for years in which the market was down.

But the scheme escalated in 2002 and 2003, when city officials brushed aside warnings from outside groups, as well as from an analyst it had itself commissioned, about the fund's parlous financial straits. Although figures clearly showed that the pension fund would face a seven-fold increase in its deficit, to more than $2 billion, over less than a decade, San Diego didn't disclose what, according to the SEC, it "knew or was reckless in not knowing" was an inevitability, instead maintaining its charade. City officials disclosed not a word of the fund's financial troubles to potential investors or bond analysts as it raised nearly $300 million in new municipal securities during those two years.

The SEC elected to go easy on the city. The feds won't levy a fine against it, reasoning that it would end up being the taxpayers who would pay. This argument has merit, since these taxpayers are already on the hook for the $1.5 billion deficit—roughly equal to the city's operating budget—the pension-fund fraud had concealed. Taxpayers could face fallout if wronged investors sue the city. But while SEC won't punish taxpayers, it can't afford to go so easy on the officials it's still investigating. (The SEC doesn't name the current and former officials under its scrutiny, but former Mayor Dick Murphy, former city manager Michael Uberuaga and former auditor Ed Ryan, as well as members of the City Council, all had degrees of responsibility for and knowledge of the pension fund's operations.) The SEC must demonstrate that it considers the fraud officials committed against the city's bondholders to be just as grave as similar frauds in the private sector.

People who invest in municipal bonds do so because they feel that such investments are safer than investing in the common stocks of corporations. That's why cities and states enjoy access to capital at affordable interest rates. And, for tax reasons, municipal-bond investors often invest in the bonds of the city in which they reside, so they face double jeopardy. In the first place, if city officials are committing fraud, their bonds will turn out not to be as sound (and thus not as valuable) as they thought they were. The second risk is that they will have to pay higher taxes, or suffer lower government services, to cover pension-funding shortfalls in their city's budget if that is the case.

The SEC's settlement with San Diego doesn't preclude it from levying fines or recommending criminal charges against culpable high-level city officials. The SEC mustn't pass up this chance to hold up San Diego as a warning to other municipal officials who may be tempted to treat taxpayer-guaranteed pension funds as slush funds whose resources can be used to curry favor with public employees.