Tag Archives: SEC

Strong words from the SEC on Public Sector Pensions

As state and local governments begin to pull back the curtain on the true value of their pension liabilities with the implementation of GASB 68, Daniel Gallagher, Commissioner of the SEC issued an important statement last week, noting in plain terms that how governments measure their liabilities would have serious repercussions in the private sector. Here’s part of the remarks worth considering:

 …for years, state and local governments have used lax governmental accounting standards to hide the yawning chasm in their balance sheets…

The riskiness of a pension obligation depends on state law.[32]  If pension obligations have the same preference as general obligation debt, then the municipality’s own municipal bond yield (generally around 5%) would be the proper discount rate.[33]  Or, if as we’ve seen from Detroit, pensions will be saved before all else, then we should use a default-free measure to discount the liability:  specifically, the Treasury zero-coupon yield curve.[34]  This would result in a discount rate in the low 3% range.

Obviously, the higher the discount rate, the lower the present value of the liability.  The difference between a discount rate in the range of seven percent and one in the range of three percent is in large part responsible for the hidden $3 trillion in unfunded liabilities that are currently going unreported.

This lack of transparency can amount to a fraud on municipal bond investors, and it does a disservice to state and local government workers and retirees by saving elected officials from making the hard choices either to fully fund the pension promises that were made to public employees,[35] or not to make the promises in the first place.

In the private sector, the SEC would quickly bring fraud charges against any corporate issuer and its officers for playing such numbers games.  And, we would also pursue and punish the so-called fiduciaries who recklessly seek yield to meet unrealistic accounting assumptions.  We should not treat municipalities any differently.”

GASB 68 asks that sponsors use a high- yield, tax exempt 20-year municipal GO bond only on the unfunded portion of the liability. This will reveal bigger funding gaps in public sector pension plans. But it does not reveal the full value of the liability since it allows sponsors to continue using the higher discount rates on the funded portion of the liability.

 In addition to using the new GASB standards, Commissioner Gallagher advises that governments should also disclose their pension liabilities on a risk-free basis. This would have the effect of showing the value of these promises on a ‘guaranteed-to-be-paid’ basis. Commissioner Gallagher’s suggestions are extremely sensible and a call to basic transparency in public sector liability reporting.

Ignoring the value of pension benefits is not going to make them cheaper to fund, and the longer a state waits to accurately measure the liabilities and payments, the worse it gets. Just ask New Jersey –  which is struggling to balance its budget and meet a fraction of a fraction of the required annual pension contribution to its state pension system. The situation is so dire that it could trigger yet another downgrade for the Garden State.


Should SEC Be in Charge of Foreign Policy

Last week, the United States District Court for the District of Columbia ruled in SEC’s favor on the Conflict Minerals rule. The rule requires public companies to track their sources of coltan, cassiterite, wolframite, gold and derivative minerals. These so-called “conflict minerals” are often used to finance violent armed groups in the Democratic Republic of Congo (DRC). SEC ‘s rule aims to reduce funding that flows towards these armed groups. Yet despite its laudable goals, the rules will likely fail due to poor analysis:

  • The rule fails to examine the extent of the problem. The rule seeks to reduce funding for armed groups in DRC but fails to examine whether the identified minerals actually constitute a major source of funding for these groups. If they are not, targeting other sources of funding could be more effective.  Similarly, if the armed groups can easily shift to alternative funding sources (DRC is rich in minerals that are not on SEC’s list), the rule’s benefit would be rather limited.
  • The rule presents no alternatives. One can easily think of other ways to reduce armed violence in DRC, including military assistance to DRC’s government or US-led operations to disrupt arms flows into the country. It is difficult to say whether SEC’s approach is more effective when the rule presents no alternatives that its decision could be compared to.
  • The rule fails to estimate benefits. In contrast to its elaborate discussion of the rule’s costs, SEC devotes less than a page to describe the rule’s benefits (only to acknowledge that it is unable to quantify the benefits due to lack of data). While few would expect SEC to have internal expertise on armed conflicts in Africa, the agency’s failure to solicit expert opinions from external sources is inexcusable.
  • The rule makes no plans to measure its effectiveness. In light of the SEC’s admission that it lacks data to estimate the rule’s effectiveness in reducing violence in DRC, one would expect the agency to identify specific metrics to measure success and to establish plans to collect data on the rule’s progress. Yet, SEC seems uninterested in whether its rule will actually produce positive outcomes.
  • The rule makes no plans for retrospective review. Even the best-intentioned regulations can lead to unintended consequences. Given that SEC knows so little about the area that it is regulating with this rule, the chances for things to go wrong are even higher. In fact, some commenters suggested that the rule’s burdens may fall mostly on ordinary citizens and not the armed groups that the rule targets. It is possible that the rule may do more harm to ordinary Congolese than good. Since SEC makes no place to reexamine the rule, it will likely remain in place regardless of its merits.

Troublingly, the court sided with SEC, singing off on the agency’s virtually non-existent economic analysis. My colleague Hester Peirce commented last week:

Although the court did not believe that the SEC had to do cost-benefit analysis for this particular rule given that Congress–not the SEC–made the public interest finding for this rule, the court signed off on the SEC’s analysis. The court reasoned that the SEC’s consideration of efficiency, competition, and capital formation sufficed; “to suggest that the [Securities] Exchange Act mandates that the SEC conduct some sort of broader, wide-ranging benefit analysis simply reads too much into this statutory language.” The need to assess benefits, according to the court, is particularly weak when–as here–a rule’s benefits are supposed to be humanitarian.

 The court’s assertion that humanitarian benefits need not be assessed is startling. One can reasonably argue that benefits of reduced violence cannot be easily monetized. Yet, the reduction in violence can and should be measured. How else would SEC know if its rule is having any impact?

Proponents of better economic analysis are often criticized that they only care about costs. As this example demonstrates, a better analysis can lead to a better rule – the one that actually saves lives.

The Economic Consequences of Misreading Statutes

When Congress adopted the Dodd-Frank financial reform law, it included a number of provisions that had nothing to do with financial markets.  One of these was a requirement that oil companies and other natural resources companies to report annually to the Securities and Exchange Commission payments they make to foreign governments in connection with extracting those countries’ natural resources.  Human rights advocates viewed the SEC’s disclosure system as a convenient tool for influencing how countries use their natural resource revenues.  The statute sets a bad precedent for using the SEC to accomplish goals unrelated to its mission.  To make matters worse, the SEC’s ruleinterpreted the statute in a way that would frustrate the SEC’s mission of protecting investors, fostering fair and well-functioning markets, and facilitating capital formation.   The rule was thrown out by a federal court today.

The SEC’s rule mandated that company’s disclosures—which were required to be very granular—be publicly available.  Because the requirement applied only to companies that file with the Securities and Exchange Commission, it would—in the SEC’s words—“impose a burden on competition.”  The SEC explained that affected companies “could be put at a competitive disadvantage with respect to private companies and foreign companies that are not subject to the reporting requirements of the United States federal securities laws and therefore do not have such an obligation.”  Rules like these are costly to companies and consequently serve as a disincentive for companies to list in the United States.  Moreover, because some countries prohibit public disclosure of the sort the rule required, the SEC acknowledged that companies “may have to choose between ceasing operations in certain countries or breaching local law, or the country’s laws may have the effect of preventing them from participating in future projects.”  Not a great choice.

The SEC was sued for, among other things, interpreting the rule in a manner that was a lot more damaging to companies than Congress intended.  The court agreed and threw the rule out.  The court faulted the SEC for reading the statute to require that company’s filings be made available to the public, when it plainly did not contain such a requirement.  Moreover, the SEC “abdicated its statutory responsibility to investors” by failing to even consider whether an exemption from the rule would be appropriate for payments in countries that prohibit disclosure.

The SEC’s unwillingness to exercise discretion afforded to it by Congress is just one example of how a regulatory agency’s actions can have real effects on the competitiveness of American companies and the returns to investors in those companies.

Bailouts and Municipal Bonds

City Journal‘s Steven Malanga writes at RealClearPolitics about the possibility of a municipal bond bailout on the horizon. The canary in the coalmine is the SEC’s cease-and-desist order to New Jersey for misleading investors by omitting key information in their bond offerings between 2001-2007. Specifically, the SEC charges that New Jersey misrepresented the state’s pension liabilities. The state indicated it was taking actions to ensure the solvency of its pension funds when in fact pension deferrals were frequently undertaken.

What’s interesting is that the day after this announcement, New Jersey easily sold an offering of short-term notes to banks. The state didn’t have to pay a premium to attract investors. Why aren’t investors more cautious? And why wasn’t New Jersey fined?

As Malanga noted earlier this week in the Wall Street Journal, for years states have been hiding the true size of their fiscal problems behind a range of fiscal manipulations (for a catalog of those, see my latest paper on Fiscal Evasion). Yet the signal sent by the SEC is that there is no penalty or risk for bad behavior. The question Malanga asks: do politicians and muni bond holders simply expect that in the event a state can’t pay its bondholders a federal bailout will pick up the tab?