Municipal Finance Straining under Growing Rules, Regs

By Shafroth, Frank | Nation's Cities Weekly, November 2, 1998 | Go to article overview

Municipal Finance Straining under Growing Rules, Regs

Shafroth, Frank, Nation's Cities Weekly

The federal government is intruding more than ever into the world of municipal finance. even though the 105th Congress is history, federal regulatory agencies are implementing and enforcing rules and regulations which can directly affect local authority and liability.

And voters, (tomorrow) and other beneficiaries of municipal bonds, are making decisions which can directly affect outstanding municipal bonds and credit ratings.

Cities Beware

In the last two years, the federal Securities and Exchange Commission (SEC) has brought enforcement actions against 50 municipalities. For cities and city elected leaders, these actions have meant federal investigations, threats, and a cloud over the cities' credit rating.

The actions have imposed significant costs on the cities to defend themselves and, in some cases, involved federal threats of fines in the millions of dollars, in addition to eliminating the tax-exempt status of outstanding municipal bonds. The actions by the independent federal regulatory agency have come as part of its crackdown on fraud and abuse in the municipal-bond market.

The intense federal scrutiny is not a result of pressure by the White House or Congress. Rather it appears to be part of an expanded attack by the agency on cities and municipal finance. The agency believes it has a responsibility to protect shareholders and bondholders, as opposed to taxpayers. The SEC has made "cleaning up" the $1.2 trillion municipal bond market a priority. This campaign is likely to grow.

1996 was the first time the SEC ever sought to bring charges against a single "general purpose" city or town for federal securities fraud. Prior to that time, the federal agency focused its attention on municipal bond dealers and advisors, or, in some instances, on special districts, or agencies that issue tax exempt debt, but cannot impose general purpose taxes or issue tax-exempt municipal general obligation bonds. Since 1996, the agency has widened its net and has even recently indicated its interest in holding cities liable for failure federal securities fraud for failure to disclose YK2 problems.

The SEC crackdown has targeted both small cities, without the resources to defend themselves against full-blown federal investigations and charges, and some of the nation's largest cities.

The widening SEC actions against cities and towns have come simultaneously with expanding investigations and actions by the Internal Revenue Service (IRS) against cities.

According to the IRS, the federal agency currently audits as many as 300 municipal tax-exempt bond transactions taken by cities and towns at any given time.

If the federal agency determines that a city or town has violated federal tax rules or regulations when it sells its bonds or notes to the public, the city's securities could lose their tax-exempt status, the city could find its credit rating in trouble, and the city's bondbolders could suddenly find themselves holding taxable instead of tax-exempt municipal bonds.

Arbitrary or Audits

Not to be outdone, the IRS is expanding its enforcement efforts against cities and towns. The agency plans to send questionnaires next year to 100 to 200 municipalities who issued tax-exempt municipal bonds in 1991 and 1992 as part of its expanding municipal bond audit program.

The federal agency is seeking to examine compliance with arbitrage and spending rules that applied to cities for the first time as a result of the Tax Reform Act of 1986. The IRS expects to send the questionnaires after April 1999 as the first phase of the project.

In the second phase, in 2000, the IRS may audit any of those surveyed cities or towns. The new effort will be starting at the same time the IRS moves to its next stage of following up its first bond audit program -- an examination of small-issue industrial development (idb) bond deals. …

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