Locke Lord QuickStudy: SEC Action Against School District is Reminder of Importance of Role of Auditors

In a settled administrative enforcement action,¹ the SEC charged the Montebello Unified School District in California and two of its officials with violating the anti-fraud provisions of the federal securities laws in connection with the December 2016 sale of $100 million of general obligation bonds. The action against one of the officials is continuing in federal court.

The alleged violations were due to the failure of the School District to disclose that its auditors had raised concerns about reported fraud and internal control problems at the District. The auditors, having been informed by a District accounting official about possible fraud and accounting improprieties, asked the District for information about these charges and indicated it could not complete the fiscal year 2016 audit without satisfying itself regarding the charges.According to the SEC, instead of providing the information, the District terminated the auditor and used the fiscal year 2015 audited financial statements in the official statement for the bonds without disclosing the situation. The SEC states that by doing so without disclosing the auditor’s concerns, the District gave the impression that the audit firm was still its auditor and that the fiscal year 2016 audited financial statements would be available shortly. The SEC found that the disclosure failures violated Rule 10b-5 and Section 17(a)(3) of the Securities Act.

This SEC enforcement action sends a strong message to issuers to be candid and forthcoming with their auditors.  It also provides a message to municipal underwriters to inquire, as part of their diligence efforts, about any issues raised by the auditor and, if necessary, to follow up as appropriate.  Moreover, the problems underlying the charges reported to the auditors remind issuers that they should pay attention to their internal controls and their disclosure controls and procedures in order to ensure the reliability of their financial statements and the adequacy of their disclosures.