6.1.1 Antifraud Rules

Statements by municipal issuers to investors, or potential investors, and even statements to the public generally, if likely to be heard and relied upon by the securities market, are subject to regulation under two key anti fraud provisions of federal law: Section 17(a) of the 1933 Act and SEC Rule 10b-5 promulgated by the SEC under Section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”). These two anti fraud provisions, referred to simply as Section 17(a) and SEC Rule 10b-5, are presented below.

SECTION 17(a)

It shall be unlawful for any person in the offer or sale of any securities by the use of any means . . . of . . . communication in interstate commerce or by the use of the mail, directly or indirectly

to employ any device, scheme or artifice to defraud, or
to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or
to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

SEC RULE 10B-5

[It is] unlawful for any person, directly or indirectly, by the use of any means . . . of interstate commerce, or of the mails . . .

to employ any device, scheme, or artifice to defraud,
to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
to engage in any act practice or course of business, act, practice, which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Section 17(a) and SEC Rule 10b-5 require that there are no untrue statements of material facts in the POS and OS. Further, the regulations require that the material facts are not presented in a misleading manner in light of the circumstances. The POS and OS must include appropriate information to make sure the material facts are not misleading. “Materiality” is a context dependent concept and is not specifically defined by any SEC rule. Statements in court decisions and SEC enforcement actions about what “materiality” means, however, include the following:

A fact is material if there is a substantial likelihood that its disclosure would be considered significant by a reasonable investor.

There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having altered the “total mix” of information made available.

Materiality will depend at any given time upon a balancing of the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of [the affected entity’s] activity.

Because the SEC has consistently refused to provide any guidance on exactly what constitutes material misstatements or omissions, materiality ends up being decided only in hindsight, which puts a great deal of pressure on parties to a transaction to make an appropriate decision when deciding on a disclosure issue. Further, if an item of information is material to investors, the fact that it is confidential, or politically embarrassing, is not a defense to leaving it out of the document, nor is it possible to claim the information is subject to attorney client privilege.

To prove a violation of SEC Rule 10b-5, the SEC must prove, among other elements, that in connection with the purchase or sale of securities, the issuer108 intended to mislead or defraud investors or was reckless in not assuring that there was no misleading or fraudulent action in the securities disclosure (i.e., the issuer knew or should have known the correct facts). To find a Section 17(a) violation, however, the SEC only has to find that the issuer was negligent (i.e., acted with a lack of ordinary care). Either the SEC or private plaintiffs can file a claim of violation of SEC Rule 10b-5, but private plaintiffs must show not only that an issuer made a material misstatement or omission but also that they in fact purchased or sold the securities in reliance on that statement or omission and suffered damages as a result of that reliance.109 Private actions are not allowed under the more lenient negligence standard of Section 17(a).

The issuer is primarily liable for any material misstatements or omissions regarding the issuer and its debt made in the documents used to offer and sell the issuer’s securities. The issuer may not transfer this primary liability to its underwriters, municipal advisor, public agency counsel, bond counsel, disclosure counsel or any of the other parties involved in the financing. Those parties may have obligations of their own, but any liability of those parties will not absolve the issuer of its primary liability.

Municipal securities issuers and their directors, governing board members, officers, and staff may rely on the advice of professionals, including attorneys, municipal advisors, engineers, feasibility consultants, or accountants, in determining what information to disclose. Reliance on professionals must, however, be reasonable, and issuers and their boards must exercise independent judgment in approving securities disclosure. Further, reliance on the advice of professionals will not help deflect all potential claims. Consequently, the issuer and its staff must make every effort to ensure that its offering documents are accurate and complete.

Inadequate disclosure practices can lead to outcomes or consequences such as the following:

Investigation by the SEC
Investigation by a local district attorney or the U.S. Justice Department
Investigation or hearings by state or local legislative bodies
Requirement to enter into an order to cease and desist from future violations of securities laws
Imposition of fines or penalties, both on the issuer and any public official deemed culpable for the issuer’s violation of securities laws
Requirement to hire outside consultants to implement and/or supervise securities law procedures
Order barring a public official found culpable for securities violations from taking part in future securities transactions for some period of time
Substantial out-of-pocket costs to defend against government or private investigations or suits
Harm to the issuer’s reputation, investor confidence, or to political careers
Inability to obtain timely audit reports and lack of access to public securities markets
Rating agency downgrades

Liability for false, misleading, incomplete, or fraudulent statements under the anti-fraud laws attaches to the directors, governing board members, officers, and staff of issuers. Individual officials or members of the staff found to have violated the law may be subjected to penalties, fines, injunctions or, in extreme cases, incarceration, and there is no official immunity from these consequences.