Last month, Gary Gensler was sworn in as the new chair of the Securities and Exchange Commission (SEC). Will he use his experience at Goldman Sachs and in senior government financial positions for the public good or will he just use this position to bolster his resume? His confirmation testimony in March of 2021 focused on protections for U.S. investors, but the SEC’s job is much bigger than that. While Gensler addressed shiny new issues such as Bitcoin and other digital assets, he failed to discuss one of the largest and longest-running frauds in financial securities to occur right under the Commission’s nose, fueled by an organization that they fund.
The antifraud provisions guarded by the SEC apply to both corporations and governments. According to a 1994 SEC release, these provisions mean that “official statements need to be clear and concise to avoid misleading investors through confusion and obfuscation.” In February 2020, the SEC indicated that these official statements are not limited to those made in documents that accompany municipal bonds, but also include public announcements, speeches and press releases.
Gensler should not shy away from reviewing the politically driven statements and deceptive accounting practices used to prepare state and local governments’ comprehensive annual financial reports. The 1994 SEC release also highlighted, “Although municipalities have certain unique attributes by virtue of their political nature; insofar as they are issuers of securities, they are subject to the prescription against false and misleading disclosures.”
In its 2013 investigation of Harrisburg, Pennsylvania, the SEC cited omissions and misstatements in the city’s financial information, including within its annual report. Like the Financial Accounting Standards Board (FASB) sets accounting standards used to prepare the corporate financial reports, the Governmental Accounting Standards Board (GASB) sets accounting standards used to prepare state and local government annual reports. Both FASB and GASB are funded by the SEC.
Unlike FASB, the SEC has no control over GASB. But the Commission is obligated “to protect investors in the municipal markets from fraud, including misleading disclosures [emphasis added].” Taken together, the SEC’s own statements make a strong case that it is obligated to prevent fraud in state and local governments’ financial reports, which are confusing and obfuscate the truth.
The state and local governments’ annual financial reports are based on shoddy accounting practices. If confusing and misleading disclosures are considered fraud, then annual reports produce fraudulent disclosures.
It is confusing and misleading that the GASB requires state and local governments to keep two sets of books. Annual financial reports include governmental fund statements that are prepared using an accounting basis called the “modified accrual basis,” which in essence uses short-sighted cash accounting, while the consolidated financial statements are prepared using accrual accounting standards similar to those used by corporations.
It is confusing and misleading that before the pandemic Governor Gavin Newsom touted that California had a huge surplus before the pandemic. California’s governmental funds statements included in the state’s 2019 comprehensive annual financial report noted a positive balance of $54.9 billion, including a general fund balance of $18.6 billion. Yet the consolidated financial statements included in the same annual report noted a negative net position of $60 billion. This means the state did not have a surplus, it was actually $60 billion in debt.
It is confusing and misleading for GASB to require California and other governments who follow generally accepted accounting principles to report their general and other governmental fund balances without including pension and other long-term liabilities.
It is confusing and misleading that government officials have claimed balanced budgets, even surpluses, while the 50 states have accumulated $855 billion in pension debt and $617 billion in retiree health care debt.
It is confusing and misleading that states do not have to disclose billions of dollars of deferred maintenance costs and their share of unfunded Medicaid benefits.
The SEC charged New Jersey, Illinois, and Kansas with securities fraud for misleading municipal bond investors about the funding status of their pensions. In the Illinois case the Commission's legal discussion pointed out “Issuers of municipal securities are responsible for the accuracy of their disclosure documents. Proper disclosure allows investors to understand and evaluate the financial health of the municipality in which they invest.”
State and local governments’ annual financial reports do not provide proper disclosure that allows investors to understand and evaluate the financial health of the municipalities in which they invest.
The SEC has stated that “high quality, reliable financial statements form the bedrock of our U.S. capital markets.” Gensler’s background will be very valuable in addressing accounting fraud that exists in government financial statements. In the wake of the Enron and WorldCom accounting fraud, such as not reporting massive liabilities, we must learn from past mistakes.
If Gensler would like to “strengthen transparency and accountability in our markets,” as he stated during his hearing, then the SEC must take a closer look at the state and local government financial reports produced using the shoddy accounting practices dictated by the GASB. By doing so, he will be protecting not just the municipal bondholder, but the American taxpayers and citizens. Afterall, the municipal bond market is the lifeblood of state and local governments and serves as the most reliable fixed income for retirees and other investors.