Report Puts City Among Elite Group of Frauds
Wednesday, Aug. 9, 2006 | A culture of obfuscation and denial so corrupted San Diego’s financial management that its meltdown reached the historic levels of such poster children of governmental and corporate malfeasance as Orange County, Enron and WorldCom, according to a long-awaited report released Tuesday.
The report likely cements San Diego’s collapse as one of the greatest in modern municipal history, stating that eight former city staff members likely committed securities fraud in acting with “wrongful intent” to withhold important information from the investing public – a finding that could foreshadow potential enforcement actions from the Securities and Exchange Commission.
Mayor Dick Murphy and a number of current and former City Council members acted negligently in approving false financial statements released to investors, the report states, a finding that would put their behavior on the bottom rung of the three levels of potential securities fraud.
In all, the report paints the picture of a culture premised upon “non-transparency, obfuscation, and denial of fiscal reality” that repeatedly sought to delay the impact of tough decisions, ignored pertinent advice time and again, and failed to inform investors of the consequences of its actions.
“It seems to us that no one in city government viewed himself or herself as accountable for the accuracy of the city’s financial disclosures,” said Arthur Levitt, the former SEC chairman who led the group of private consultants – known as the audit committee – in the probe that took 18 months and cost the city $20.3 million.
In light of the findings, it is unlikely that the SEC, which has been investigating City Hall since February 2004, would pursue any enforcement action against any current or former politicians unless it had unearthed distinct evidence.
“If the SEC’s investigation has produced the same evidence that Kroll has come up with and it has nothing stronger, then there’s probably no basis to proceed,” said Ed McIntyre, a securities attorney with Solomon Ward who is not involved in the investigation.
On the other hand, several former high-ranking city employees found themselves directly implicated in the report as having committed more serious levels of securities fraud.
The 266-page report, complete with about 200 more pages of appendices, issued a harsh assessment of city practices past and present, from critiques of the well-documented decisions at the pension system in 1996 to stern warnings regarding the centerpiece of Mayor Jerry Sanders’ current financial recovery plan, pension obligation bonds.
“Even today, there are serious indications that the city government has not completely come to grips with the depth of its problems and the need for fundamental reform,” Levitt said.
While oftentimes rehashing what was previously known of happenings in the pension and wastewater systems, the report offered for the first time a wide assessment on the legal culpability of key figures in the city’s financial collapse. The consultants also issued a detailed and lengthy remediation program.
They sounded an optimistic note on the future of a city with a “second chance.” However, they also chastised the city’s present-day bookkeeping and advocated that a monitor be appointed to oversee the reform efforts of the mayor and City Council. The monitor would be asked to periodically update law enforcement agencies, the SEC and the public on the progress of those efforts.
The consultants said they had great hope for a city with a vibrant economy, but said fixing the city would require the city’s leaders to change course.
“You need to change it from being Enron-by-the-Sea to that emerald by the sea that it once was and hopefully will be again one day soon,” said Lynn Turner, the SEC’s former chief accountant.
The report found that Murphy; sitting City Council members Toni Atkins, Donna Frye, Jim Madaffer, Brian Maienschein and Scott Peters; and former councilmen Ralph Inzunza, George Stevens and Byron Wear acted negligently in failing to ensure that the city’s financial disclosures were complete and accurate.
The disclosure deficiencies focused on two areas: the pension system and the wastewater department. For years, the city failed to inform investors about the deteriorating health of its pension system and a number of irregularities in the way it funded the system and hid liabilities in outside reserves, the report states.
City officials also knew for years that they were violating the terms of the Clean Water Act by harboring a user-rate structure in the wastewater system that overcharged residential users of the system to the luxury of large industrial users. The structure, changed in 2004, jeopardized $265 million in loans and grants the city had received and has opened it up to a $200 million lawsuit on behalf of residents.
Those liabilities were never disclosed to investors in the city’s bonds, the report states, despite City Council and top staff’s knowledge of the potential costs.
Murphy and Atkins, Maienschein, Madaffer, Inzunza and Peters “deliberately concealed from [San Diego] citizens both the City’s knowing violation of the law and just as troubling, the fact that the violation resulted in San Diego’s residents largely footing the bill for the industrial class,” the report states. “These facts were relegated to closed session discussions only, notwithstanding Councilmember Frye’s repeated efforts to bring the matters to the public’s attention.”
However, unlike previous reports from City Attorney Mike Aguirre, the report didn’t find that the city’s elected officials had knowingly or recklessly violated securities laws.
Rather, the consultants from Kroll Inc. determined that Murphy, Atkins, Frye, Inzunza, Madaffer, Maienschein, Peters, Stevens and Wear were “negligent in fulfillment of their bond offering disclosure responsibilities.”
There are essentially three levels of securities fraud, spanning from negligent to reckless to intentional. Responsible parties can be ordered by the SEC to stop engaging in the practice that was found illegal, be forced to step down from their current position as an officer or director at the entity where the wrongdoing occurred, or barred from ever serving as an officer or director of an organization that issues securities publicly.
The report cites only one known recent example of the SEC pursuing an enforcement action in a municipal securities case based on a finding of negligence.
“We don’t have any evidence or examples where the SEC prosecuted or pursued any elected official for negligence,” said Benito Romano, an attorney for the audit committee.
Although council members did rely on staff members and outside professionals for the preparation of financial disclosures and advice, they were notified of their responsibilities to ensure the accuracy of the statements, the report states.
Specifically, the investigation found that eight former city officials – all of whom have since left the city – recklessly or intentionally allowed the city to issue false reports regarding its true fiscal health.
They are: former Deputy City Manager Patricia Frazier, former City Treasurer Mary Vattimo, former Auditor and Comptroller Ed Ryan, former Assistant Auditor and Comptroller Terri Webster, former retirement Administrator Larry Grissom, former Utilities Finance Administrator Dennis Kahlie, former wastewater Deputy Director William Hanley and former Deputy City Attorney Kelly Salt.
McIntyre, the outside securities attorney, said he expects the issuance of the report to spur negotiations between these eight individuals and the SEC.
“If I’m the lawyer for one of these people, with the Kroll report in my left hand, I would pick up the phone with my right hand and call the SEC and say: Let’s work something out,” he said.
The city as an entity has also yet to settle with the SEC.
In total, the city’s outside auditors estimate the city issued $2.3 billion in bonds based on faulty financial disclosures.
“The City’s derelictions as to both its pension and wastewater treatment systems resulted in numerous violations of the federal securities laws as the City repeatedly obtained money from public investors through financial statements and related disclosures that were false,” the report states.
The revelation of the disclosure problems, compounded by a pension deficit now estimated to be at least $1.4 billion, precipitated the city’s financial collapse in 2004. Since then, it has been struggling to complete an independent investigation into what went wrong and to return to fiscal credibility.
Panning the Mayor’s Plan
The release of the Kroll report marks a significant milestone in the city’s financial crisis, as the city’s fiscal future has essentially been on hold for years awaiting the completion of a thorough investigation into its finances.
Without the report, the city’s outside auditors have been unwilling to sign off on three years of backlogged financial statements. That has left the city locked out from Wall Street with a suspended credit rating, unable to borrow money for the basic projects expected from a municipal government.
Officials from KPMG, the city’s outside auditor, offered positive statements regarding the Kroll report, but didn’t guarantee it would satisfy the auditor’s needs in order to issue the long-delayed fiscal year 2003 audit.
Ironically, Sanders has needed the release of the report in order to enact the centerpiece of his financial recovery plan, the issuing of $574 million of pension obligation bonds to fill the pension gap. That plan was panned Tuesday by the audit committee as a “quick fix” that doesn’t address the fundamental problems of the city.
By relying on pension obligation bonds, “in our judgment, the city would continue to push off the burden of these obligations to further taxpayers while avoiding the difficult decisions that must be made,” Levitt said.
Turner told the City Council they must go back to city residents and tell them clearly what they need to pay for in order to meet the long-term commitments the council has made.
Sanders reserved comment on the criticism, saying he hadn’t yet read the report. He said he and his staff would consider the report and release an outline Aug. 24 for releasing the audits and returning to the bond markets.
Council President Scott Peters said he wanted to move forward rather than dwell on the action of the past, although he said he disagreed with the finding of negligence against him.
“We may disagree on what happened in the past but we don’t disagree that tremendous changes need to take place,” Peters said.
Atkins said that she and her colleagues were “woefully” let down by professional staff and experts.
The audit committee report found that relying on staff and experts isn’t sufficient for elected officials to escape all culpability, as council members are expected to ask questions and not simply act as a rubber stamp.
“The law required the council to take steps to ensure that the city was not disseminating wrong or accurate information to investors,” Romano said.
“Today we’ve been given some bitter medicine,” Madaffer said. “We’ve heard some very unpleasant things and I certainly accept full responsibility for moving this city forward from here on out.”
Councilman Tony Young, who joined the council after the disclosure problems had occurred, said he was disappointed in the actions of some city officials – including those of his current council colleagues.
“It’s pretty clear that they didn’t act in the best interest of the citizens on everything from wastewater to the other issues,” he said.
The legal and fiduciary failures of the pension system had already been documented in similar reports in the past. Likewise, Aguirre had touched, like Kroll, on the City Council’s decision in 2001 to vote to shelve a report that found that its user-rate structure for the wastewater system violated the Clean Water Act, exposing the city to hundreds of millions of dollars in potential liabilities.
“While San Diego homeowners were shouldering the burden for the City, the industrial users were getting a free ride in the same amount,” the report states.
Aguirre estimated that city residents subsidized the industrial class by as much $20 million a year. The Kroll consultants found that the rate was kept in place, in part, so the city could remain “business-friendly.”
In its report, Kroll found that Murphy, Atkins, Maienschein, Madaffer, Inzunza and Peters deliberately concealed the fact that the rate structure violated the terms of the Clean Water Act. Under the act, the federal and state governments gave grants and loans on the terms that the city employ an equitable rate structure. Violating the terms of the grants and loans meant that the city could be liable to pay back up to $265 million. And, it also meant the city could be vulnerable to lawsuit from residents.
This is all information that should have been disclosed to investors, the report states.
“More than failing to make the requisite disclosures, in some instances it appears the city may have gone further, and made conscious efforts to mislead both investors and rating agencies,” the report states.
At one point, when confronted with the possibility of being sued because of the structure, Madaffer quipped: “Let ’em sue us,” according to the report.
The report also states that Frye worked to try to change the structure or make the information – which was discussed in closed session – public.
The City Council received a report and memo in 2001 informing it of its financial disclosure responsibilities and was obligated to oversee the city’s financial information, the report states.
But the findings of negligence against the council didn’t go as far up the securities fraud ladder because the City Council wasn’t actively involved in the preparation of the financial statements, Romano said. Rather, they were simply asked to approve the statements.
To that end, the report did find that a number of top staff members involved in the preparation of financial statements and the inner workings of the city’s finances did knowingly or recklessly allow the release of inaccurate financial information.
The report states that:
- Webster, former assistant auditor, and Ryan, former auditor, “deliberately and intentionally” concealed the threat of the city’s looming pension crisis in order to deceive the public.
- Frazier, former deputy city manager, and Vattimo, former treasurer, were responsible for “recklessly” concealing the city’s violations of the Clean Water Act and its consequences.
- Kahlie, former utilities finance administrator, and Hanley, former wastewater deputy director, intentionally and improperly misled a bond rating agency.
- Salt, former deputy city attorney, recklessly discharged her duties by not communicating pertinent facts to bond counsel and allowing misleading disclosures.
- Grissom, former retirement administrator, acted at a minimum recklessly and more likely intentionally in failing to ensure that pension information was properly disclosed.
- Former City Managers Mike Uberuaga and Jack McGrory, former City Attorney Casey Gwinn and former Assistant City Attorney Les Girard were “negligent in the fulfillment of their duties to the city.”
Pamela Naughton, the attorney who represents Murphy and Peters, said she strongly disagrees with any finding that her clients have acted negligently.
“The disclosures, as far as my clients knew, were completely accurate,” she said.
Erik Acker, who represents Atkins and Maienschein, declined to comment on the report’s findings noting that, “the SEC investigation in respect to our clients continues.”
David Hahn and Thomas McNamara, who represent Vattimo and Frazier respectively, said they have not yet had the opportunity to review the report and declined to comment.
Calls to the homes, offices or attorneys of the other 11 individuals accused of securities violations were not returned.
In addition to the Kroll and SEC investigations, the Justice Department and District Attorney’s Office have also brought criminal charges in relation to the pension system. Grissom and Webster were indicted on federal corruption charges in January, and Webster also faces state conflict-of-interest charges.
– Staff writer Daniel Strumpf contributed to this report.