SEC Action Against Underwriter Illustrates Enforcement of Disclosure Violations in the Muni World

On April 5, as one of several enforcement actions relating to an alleged Ponzi scheme, the Securities and Exchange Commission settled an administrative enforcement action against a municipal bond underwriter accused of turning a blind eye to bond issuers’ failure to file annual financial information. The action, In the Matter of Lawson Financial Corporation and Robert Lawson (April 5, 2017),¹ is not at all surprising in its outcome, but it does afford a useful primer on the roles of underwriters and dealers in the municipal bond reporting regime. It also demonstrates why enforcement in the municipal bond arena is largely the province of the SEC, where private actions have historically been hard to find.

The Facts

This is a case of egregious conduct, or at least neglect, all around — on the part of the sponsor of a series of municipal bonds and on the part of the underwriter. The action refers to these securities as a “conduit municipal revenue bond offering” in which the municipality technically serves as the issuer, but in reality it is a conduit for a private borrower who commits to make payments on the securities to bondholders. The sponsor here was Christopher Brogdon, who, during the period of 2010 to 2014, in 13 separate offerings that were the subject of the SEC action, raised some $87 million in municipal bonds, purportedly to finance the construction, acquisition and renovation of nursing homes in the Southeast and the Midwest.² However, the SEC alleged (in related proceedings) that the bonds actually financed a Ponzi scheme — Brogdon allegedly used proceeds of the bonds for personal expenses, with later bond proceeds allegedly funding debt service on older bonds.

The underwriter for the Brogdon offerings was Lawson Financial Corp., whose eponymous founder was Robert Lawson. Bank of Oklahoma, N.A. (known as BOKF), served as indenture trustee for each of the offerings.

According to the SEC, the Brogdon borrowers represented in their bond offering documents that the borrowers had not failed to comply with any prior municipal undertakings to provide continuing disclosure of financial information. In fact, Brogdon rarely posted such information to the Electronic Municipal Market Access (EMMA) system of the Municipal Securities Rulemaking Board (MSRB).

Lawson was aware, or ignored numerous red flags that should have made him aware, that the Brogdon borrowers were not complying with their disclosure undertakings. The SEC was probably being charitable in this regard, since all Lawson had to do was check the EMMA website to see that Brogdon’s compliance was spotty at best. But in one telling incident in October 2011, BOKF emailed Brogdon, copying Lawson, requesting certain updated financial information “because BOKF in its capacity as indenture trustee was ‘being bombarded by Financial Advisors and administrators.’” The SEC also cited to various other instances in which Lawson was made aware that the Brogdon-controlled entities were not complying with their disclosure obligations. Nevertheless, Lawson Financial continued to underwrite offerings for Brogdon, and reviewed and assisted in the preparation of the official statements for the Brogdon offerings.

The Legal and Regulatory Framework

Municipal issuers are not required to register the public issuance of their securities with the SEC under the Securities Act of 1933 (see Securities Act Section 3(a)(2)). Corporate and other issuers of debt securities are required to comply with the reporting obligations under the Securities Exchange Act of 1934 if they either are listed on an exchange (Section 12(b)) or have registered securities with the SEC under the Securities Act (Section 15(d)). Because municipal bond issues are not typically exchange traded and are exempt from Securities Act registration, issuers of municipal bonds are not required to comply with the reporting obligations of the Exchange Act. Moreover, Section 15B(d)(1) of the Exchange Act expressly prohibits the SEC and the MSRB from requiring an issuer of municipal securities to file with the SEC or the MSRB any application or report prior to the issuance, sale or distribution of municipal securities under the Exchange Act.

However, the SEC does have broad rulemaking and enforcement authority over dealers under Section 15(c)(2) of the Exchange Act. In 1989, the SEC adopted Rule 15c2-12. As initially enacted, the rule required any dealer participating as an underwriter in an offering of municipal securities to obtain, review and deliver to potential customers the official statement with respect to the offering. This was followed in 1994 by amendments to Rule 15c2-12, in which the SEC prohibited a dealer from participating in municipal securities offerings unless the issuer or other person obligated under the securities³ committed to provide continuing disclosure regarding the security and the obligated person. The required disclosure consisted of certain annual financial and operating information, including audited financial information, if available; notices of certain events; and notices of the failure to provide the required annual information. Rule 15c2-12 was further amended in 2008 to provide for the EMMA system. The rule was amended again in 2010 to require that event notices be provided not later than 10 business days after occurrence, and to add or modify the events requiring notification.⁴

The agreements under which municipal issuers or other obligated persons commit to provide the information required by Rule 15c2-12 are generally referred to as Continuing Disclosure Agreements, or CDAs. According to the SEC, the purpose of the CDAs is “to assist brokers, dealers and municipal securities dealers with satisfying both their obligations under the federal securities laws to have a reasonable basis on which to recommend securities in the secondary markers and their obligations under MSRB rules.”

CDAs for the Brogdon offerings were generally executed between BOKF and the Brogdon-controlled borrowers. However, in one Brogdon offering underwritten by Lawson Financial in April 2013, no CDA was executed, even though the official statement represented that there was such an agreement.

The Claims Against Lawson

The SEC brought its administrative proceeding against Lawson and Lawson Financial under Sections 17(a)(2) and (3), which are the anti-fraud provisions of the Securities Act.⁵ Unlike Section 10(b) of the Exchange Act and Rule 10b-5, a violation under Sections 17(a)(2) and (3) can be established by a showing of mere negligence.⁶ This makes prosecution of a claim easier. The catch is that there is no private right of action under Sections 17(a)(2) and (3), so enforcement under this statute is limited to the SEC and the Department of Justice.⁷According to the SEC, Lawson and Lawson Financial violated Sections 17(a)(2) and (3) by failing to form a reasonable basis through adequate diligence that the official statements for the Brogdon offerings that they underwrote were truthful and complete.

For good measure, the SEC also threw in a willful violation of Section 15(c)(2) and Rule 15c2-12. Presumably, these claims were brought pursuant to Section 32 of the Exchange Act, which imposes civil and potentially criminal penalties for a violation of any section or rule under the Exchange Act, but it does so only if the violations are willful.

As for penalties, both Lawson and Lawson Financial received a cease-and-desist order; Lawson Financial was censured; Lawson was barred from associating with any broker-dealer, etc.; and financial disgorgement and civil money penalties were assessed against both Lawson and Lawson Financial.

Observations

The Lawson action offers a good illustration of how the SEC enforces disclosure obligations in respect of municipal securities through the authority it wields over broker-dealers. The violations covered by the action seem rather egregious, and it appears to have taken the SEC some time before it got around to commencing an administrative proceeding. Private enforcement might have gotten there sooner. But the tools that the SEC has at its disposal to bring the action — Sections 17(a)(2) and (3) of the Securities Act and Section 32 of the Exchange Act — are not available to private litigants. Section 10(b) and Rule 10b-5 are available as a basis for a private suit, but they require scienter, making the bar quite a bit higher. For the time being, it appears, the SEC will remain the primary sheriff on the muni beat.

___________________________
¹ The SEC brought and settled a companion administrative enforcement proceeding against John T. Lynch Jr., who served as an investment banker and purported to serve as underwriter’s counsel even though he was not admitted to the bar, in connection with the Brogdon offerings. In the Matter of John T. Lynch Jr. (April 5, 2017).

² Separately, the SEC has brought a civil action against Brogdon, accusing him of, among other things, misappropriating the proceeds of his offerings to fund a lavish lifestyle. SEC v. Christopher Freeman Brogdon, No. 15 Civ. 8173 (KM) (D.N.J.).

³ In conduit offerings, the municipality is the nominal issuer, but the obligor is a promoter affiliated borrower. See Rule 15c2-12(h)(10) (Definition of “obligated person”).

⁴ See Debt Dialogue, November 2016, “Overview of Municipal Securities Law Framework and Recent SEC Enforcement Activity.” Recently, the SEC has proposed new amendments to Rule 15c2-12, expanding the list of event notices to include incurrence of financial obligations of issuers and other obligated persons, and defaults under such financial obligations. The SEC is concerned that the market is not receiving timely information regarding direct placements and other debt obligations that may be of importance to investors in publicly offered municipal securities. See Exchange Act Release 34-80130 (2017).

⁵ Section 17(a)(2) makes it unlawful to obtain money or property in the offer or sale of any security “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.” Section 17(a)(3) makes it unlawful in connection with the offer or sale of securities “to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.” Although municipal securities are exempt from registration under the Securities Act, they are subject to its anti-fraud provisions.

⁶ See Aaron v. SEC, 446 U.S. 680, 695-97 (1980) ("the language of § 17(a) requires scienter under § 17(a)(1), but not under § 17(a)(2) or § 17(a)(3)").

⁷ Although the Supreme Court has not spoken to the issue, most circuit courts have held that there is no private right of action. See, e.g., Finkel v. Stratton Corp., 962 F.2d 169 (2d Cir. 1992).