UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7589 / September 29, 1998 ADMINISTRATIVE PROCEEDING File No. 3-9738 ________________________________ : : In the Matter of : : NEWPORT-MESA UNIFIED : SCHOOL DISTRICT, : : Respondent. : : : ________________________________ : ORDER INSTITUTING A PUBLIC ADMINISTRATIVE CEASE-AND-DESIST PROCEEDING PURSUANT TO SECTION 8A OF THE SECURITIES ACT OF 1933, MAKING FINDINGS, AND IMPOSING CEASE-AND-DESIST ORDER I. The Securities and Exchange Commission ("Commission") deems it appropriate that a public administrative cease-and- desist proceeding be and hereby is instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") against Newport-Mesa Unified School District ("Newport-Mesa USD" or the "District"). II. In anticipation of the institution of this proceeding, Newport-Mesa USD has submitted an Offer of Settlement, which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and without admitting or denying the findings contained herein, except that the District admits the jurisdiction of the Commission over it and over the subject matter of this proceeding, Newport-Mesa USD by its Offer of Settlement, consents to the entry of this Order Instituting a Public Administrative Cease-and-Desist Proceeding Pursuant to Section 8A of the Securities Act of 1933, Making Findings, and Imposing Cease-and-Desist Order ("Order") and to the entry of the findings and the cease-and-desist order set forth below. Accordingly, IT IS HEREBY ORDERED that a proceeding pursuant to Section 8A of the Securities Act be, and hereby is, instituted. III. On the basis of this Order and the Offer of Settlement submitted by Newport-Mesa USD, the Commission finds that:[1] A.Summary In 1994, Newport-Mesa USD, a school district located in the County of Orange, California ("Orange County" or the "County"), offered and sold over $45 million in taxable municipal securities through an Official Statement that was materially misleading. These securities were issued for the purpose of earning interest income by investing the proceeds in the Orange County Investment Pools (the "Pools"), with the expectation of earning a higher yield than the interest rate at which they borrowed. The Official Statement for this offering was materially misleading because it failed to disclose: the intended investment in the Pools for profit, the risks of the Pools' investment strategy, and the Pools' declining investment results. Newport-Mesa USD knew of the intended investment in the Pools for profit, certain facts concerning the Pools' investment strategy, and the Pools' investment results. Newport-Mesa USD should have known of the risks of the Pools' investment strategy. In light of such knowledge, Newport-Mesa USD, in authorizing the issuance of securities and approving related disclosure documents, should have known that the Official Statement was materially misleading by omitting to disclose such information. The District thus violated Sections 17(a)(2) and (3) of the Securities Act by offering and selling securities through an Official Statement that was materially misleading. B.The Respondent Newport-Mesa Unified School District operates public schools in and around the cities of Newport Beach and Costa Mesa, California. During the relevant time period, Newport- Mesa USD served over 17,500 students and had an annual budget exceeding $88 million. Newport-Mesa USD conducted the offering that is the subject of this Order. C.Facts 1.The Orange County Investment Pools The Pools operated as an investment fund managed by the Orange County Treasurer-Tax Collector ("County Treasurer" or "Treasurer"), Robert L. Citron ("Citron"), assisted by Matthew L. Raabe ("Raabe"). The Pools consisted of the Commingled Pool, the Bond Pool and certain specific investments, in which the County and various local governments or districts (the "Pool Participants" or the "Participants") deposited public funds. As an Orange County school district, the District was a mandatory Pool Participant because state law required it to deposit its funds with the County Treasurer. As of December 6, 1994 (the date the County and the Pools filed bankruptcy petitions), the Pools held approximately $7.6 billion in Participant deposits, which the Treasurer had leveraged to an investment portfolio with a book value of over $20.6 billion. The Commingled Pool was the principal investment pool and consisted of $6.126 billion in Participant deposits. The proceeds from the subject offering were deposited into the Commingled Pool. a) The Pools' Investment Strategy The Pools' investment policy as stated by the Treasurer's Office to the Pool Participants was, in order of importance: 1) preservation of investment capital; 2) liquidity; and 3) investment yield. Contrary to that policy, the Treasurer caused the Pools to engage in a risky investment strategy. This strategy involved using a high degree of leverage by obtaining funds through reverse repurchase agreements on a short-term basis (less than 180 days), and investing in securities with a longer maturity (generally two to five years), many of which were derivative securities known as inverse floaters. The Pools' investment return was to result principally from the interest received on the securities in the Pools. Leverage enabled the Pools to purchase more securities to generate increased interest income. This strategy was profitable as long as the Pools were able to maintain a positive spread between the long-term interest rate received on the securities and the short-term interest rate paid on the funds obtained through reverse repurchase agreements. b)The Pools' Portfolio During 1993 and 1994, the Treasurer, using reverse repurchase agreements, leveraged the Participants' deposits to amounts ranging from 158% to over 292%. The Treasurer then typically invested the Participants' deposits and the funds obtained through reverse repurchase agreements in debt securities issued by the United States Treasury or United States government sponsored enterprises. Many of the Pools' securities were derivative securities, comprising from 27.6% to 42.2% of the Pools' portfolio and from 31% to 53% of the Commingled Pool's portfolio. In particular, the Pools were heavily invested in derivative instruments known as inverse floaters which paid interest rates inversely related to the prevailing market interest rate. Inverse floaters are negatively affected by a rise in interest rates. c)The Rise in Interest Rates During 1994 and its Effect on the Pools The composition of the Pools' portfolio made it highly sensitive to interest rate changes. As interest rates rose, the market value of the Pools' securities fell, and the interest received on the Pools' inverse floaters also dropped. Thus, the Treasurer's investment strategy was profitable so long as interest rates, including the cost of borrowing through reverse repurchase agreements, remained low and the market value of the Pools' securities remained stable. Indeed, the Treasurer's 1992-93 Financial Statement for the Pools stated that the investment strategy was "predicated on interest rates to continue to remain low for a minimum of the next three years." During 1993, interest rates remained low and relatively stable. Due to the low interest rates and the Pools' investment strategy, the Pools earned a relatively high yield of approximately 8% during 1993. Beginning in February 1994, interest rates began to rise. This rise in interest rates caused the Pools' yield to decrease, the reverse repurchase costs to increase, the Pools' interest income on inverse floaters to decrease, and the market value of the Pools' debt securities to decline. Month-end reports generated by the Treasurer reflected that the securities marked-to-market experienced a sharp drop in value, ranging from over $26 million in January 1994 (or .45% loss in value), to over $443 million in June 1994 (or 5.24% loss in value). The rising interest rates and the declining value of the Pools' securities caused the Pools to suffer corresponding losses through collateral calls and reductions in the amounts loaned under reverse repurchase agreements. From January through June 1994, the Pools suffered collateral calls and reductions in loan amounts totaling over $873 million. 2. Orange County's Bankruptcy On December 6, 1994, Orange County and the Pools each filed a petition for Chapter 9 bankruptcy. The petitions followed the County's public disclosure on December 1, 1994, that the Pools had suffered a "paper" loss of approximately $1.5 billion on an investment portfolio of $20.6 billion. Between mid-December 1994 and January 20, 1995, the County liquidated the Pools' securities portfolio. Ultimately, the Pools realized a loss of about $1.7 billion on Participants' deposits of $7.6 billion, a loss of approximately 22.3%.[2] 3. The Municipal Securities Offering In 1994, Newport-Mesa USD conducted a taxable note offering.[3] The purpose of this offering was to invest the proceeds in the Pools for profit. Newport-Mesa USD issued its taxable notes simultaneously with three other Orange County school districts, Irvine Unified School District, North Orange County Community College District, and the Orange County Board of Education (collectively, the "Four Districts").[4] The Four Districts issued a total of $200 million in taxable notes on June 14, 1994, the proceeds of which were deposited directly into the Commingled Pool.[5] Newport-Mesa USD issued $46.96 million of this total amount. 4. Misleading Disclosure Regarding Investment of the Proceeds The Official Statement for the subject offering contained misleading disclosure.[6] In the section entitled "Purpose of Issue," this document described the purpose of the offering as providing funds to meet the District's current fiscal year expenditures, including current expenses, capital expenditures, investment and reinvestment and the discharge of other obligations or indebtedness of the issuer. In addition, a separate section of the Official Statement, entitled "Security for the Notes and Available Sources of Repayment," represented that the offering proceeds would be deposited into a repayment account. A third section, "Deposit and Investment of Repayment Fund," stated that the repayment account would be invested as permitted by state law. This disclosure was materially misleading because it failed to disclose the issuer's intention to invest the note proceeds into the Pools for profit. Instead, the Official Statement merely recited general language of the applicable state borrowing statute, listing a series of permissible uses of the offering proceeds. This language is typically used in tax and revenue anticipation note ("TRAN") offering disclosure documents; its use in the taxable note Official Statement may have created the misleading impression that the subject offering was a TRAN offering. This characterization is material because the source of repayment, and therefore the risks of repayment, differ for these transactions. Repayment accounts for TRAN offerings are funded by the issuer's anticipated taxes and revenues. In contrast, the repayment account for the subject offering was funded by the note proceeds themselves, which were invested in the Pools. Whereas in TRAN offerings the risks relate to whether the issuer will receive sufficient taxes and anticipated revenues, in the subject offering, the source of repayment is subject to the risks of the underlying investment, which in this case were the risks of investing in the Pools. Despite the importance of this information, the Official Statement failed to disclose both the intended investment in the Pools and the risks of that investment. Specifically, the Official Statement failed to disclose that the Pools' investment strategy: 1) was predicated upon the assumption that prevailing interest rates would remain at relatively low levels; 2) involved a high degree of leverage through the use of reverse repurchase agreements; 3) involved a substantial investment in derivative securities, including inverse floaters, that are negatively affected by a rise in interest rates; 4) was very sensitive to changes in the prevailing interest rate because of the combined effect of the derivative securities and leverage; and 5) as a result, the investment strategy was speculative and risky. The Official Statement also failed to disclose the risks of the investment strategy. In particular, the Official Statement failed to disclose that rising interest rates would have a substantial negative impact on the Pools in several respects: 1) the Pools' cost of borrowing on the substantial reverse repurchase position would increase; 2) the interest income on the Pools' substantial investment in inverse floaters would decrease; 3) the Pools' securities would decline in market value; 4) as the value of the securities fell, the Pools would suffer collateral calls and reductions in loan amounts on the reverse repurchase agreements; 5) as a result of the above effects of a rise in interest rates, the Pools' earnings would decrease; and 6) the Pools would suffer losses of principal at certain interest rate levels. In addition, the Official Statement omitted to disclose certain material information concerning the Pools' investment results. In particular, the Official Statement omitted to disclose that as a result of rising interest rates in 1994: 1) the Pools' cost of borrowing had increased while the income earned from inverse floaters had decreased; 2) the Pools had suffered market losses in the overall value of the portfolio; and 3) the Pools had suffered losses on the reverse repurchase transactions through collateral calls and reductions in loan amounts, which in turn, had a negative impact on liquidity. 5. Conduct of Newport-Mesa USD In connection with this offering, the District was represented by senior officials who, among other things, were responsible for debt issuance. These officials met with the various financing participants and reviewed and approved the Official Statement to be submitted to the approving body of the District. Before the offer and sale of the securities, the District Board voted to approve the Official Statement and issue the notes. Before the offering, Newport-Mesa USD knew that the purpose of the offering was to invest the proceeds in the Pools. Also, in September 1993, the District received the Treasurer's 1992-93 Financial Statement. In this report, the Treasurer stated that the Pools' investment strategy involved the use of leverage of approximately two to one and structured or floating rate securities, including inverse floaters, and was predicated on interest rates remaining low over the next three years. The Treasurer further advised that the County's investment returns were higher than other local investment pools because of the use of reverse repurchase agreements, which added an additional two and one-half percent to the yield. Around June 1993, a community member notified Newport- Mesa USD officials that he believed the Treasurer was being "overly aggressive in certain areas of the investment portfolio" and in using reverse repurchase agreements. The community member informed the District that, because of the "highly risky" reverse repurchase agreements, "it wouldn't take much for the whole thing to come crashing down." In 1994, the Four Districts' offering occurred while the County Treasurer was engaged in the re-election campaign that focused significant attention on the Pools' holdings and risky investment strategy. During two meetings in April 1994, which Raabe also attended, the Four Districts' representatives discussed the upcoming taxable offerings and the campaign allegations. The district representatives questioned Raabe about the Pools, including the Pools' liquidity demands. He told them that within the previous two weeks, the Pools had suffered $140 million in "margin" calls (i.e., collateral calls), but had liquidity of $1 billion. Raabe informed the participants that the Pools' earnings would be lower in 1994 and that the "situation had reversed from a year ago" because interest rates were rising. The Districts' financial adviser predicted that interest rates would probably go up and most of the participants agreed with her assessment, although Raabe believed interest rates would decline in July. The participants discussed the fact that increasing interest rates would decrease their arbitrage earnings, but did not discuss the potential negative effect of an interest rate increase on principal. In April 1994, Newport-Mesa USD became aware that a magazine reporter was planning to do a story on the risks and problems associated with the Pools. Furthermore, in addition to attending the two April 1994 meetings (discussed above), before the 1994 offering, the board and senior administrators of Newport-Mesa USD held additional public and private meetings, some of which were attended by a Rauscher Pierce investment banker. At one of these meetings, Rauscher Pierce's representative noted that the national rating agencies had recently reviewed the Pools without expressing concern about Citron's investments. Even though two board members opposed issuing the 1994 notes based on their evaluation of the risks involved in investing in the Pools and the volatility of interest rates,[7] the issuance was approved without any disclosure in the Official Statement of these debated risks. Raabe also attended a Newport-Mesa USD board meeting in April 1994 to address concerns about the Pools' safety raised by a community member. Raabe told the District officials that the Pools were safe. D.Newport-Mesa USD Violated Sections 17(a)(2) and (3) of the Securities Act in the Offer and Sale of the Taxable Notes Sections 17(a)(2) and (3) of the Securities Act make it unlawful for any person, through the means or instruments of interstate commerce or the mails, in the offer or sale of any security: (2) 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 (3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser. Scienter is not required to prove violations of Sections 17(a)(2) and (3) of the Securities Act. Aaron v. SEC, 446 U.S. 680, 697 (1980). Violations of these sections may be established by a showing of negligence. SEC v. Hughes Capital Corp., 124 F.3d 449, 453-54 (3d Cir. 1997); SEC v. Steadman, 967 F.2d 636, 643 n. 5 (D.C. Cir. 1992). Newport-Mesa USD violated Sections 17(a)(2) and (3) of the Securities Act as the issuer of the securities. See In re CitiSource, Inc. Sec. Litig., 694 F. Supp. 1069, 1072-75 (S.D.N.Y. 1988) (antifraud provisions apply to municipal securities issuers); see also Adoption of Exchange Act Rule 15c2-12, Exchange Act Release No. 26985 n.84, 4 Fed. Sec. L. Rep. (CCH)  25,098 (June 28, 1989) ("(I)ssuers are primarily responsible for the content of their disclosure documents and may be held liable under the federal securities laws for misleading disclosure." (citations omitted)). 1.The Disclosure in the Official Statement Was Materially Misleading The Official Statement for the offering omitted to disclose material information concerning the intended investment of the note proceeds in the Pools for profit, the Pools' investment strategy and the risks of that strategy, material information concerning the risks of the Pools' strategy in a rising interest rate environment, and the Pools' declining investment results. Information is material if there is a substantial likelihood that a reasonable investor in making an investment decision would consider it as having significantly altered the total mix of information made available. See Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). Information concerning the Pools' investment strategy and the risks of that strategy was material to this securities offering. The Pools' investment strategy and the risks of that strategy were directly related to the safety of the funds pledged to repay the securities. 2.Newport-Mesa USD Should Have Known That the Official Statements Were Materially Misleading Given Newport-Mesa USD's knowledge regarding the investment purpose of the offerings and facts relating to the Pools' investment strategy, the District should have known that the Official Statement that it authorized was materially misleading as to the matters discussed above. For purposes of the District's violations, the statements and omissions of its representatives may be imputed to the District. See Manor Nursing Ctrs., Inc., 458 F.2d 1082, 1089 n.3 (2d Cir. 1972). The District knew of the intended investment purpose and certain facts regarding the Pools' investment strategy. Newport-Mesa USD should have known of the related risks of the Pools' investment strategy. In light of this knowledge, Newport-Mesa USD, in authorizing the issuance of securities and approving related disclosure documents, should have known that the Official Statement was materially misleading by omitting to disclose such information. E.Conclusion Accordingly, based on the foregoing, the Commission finds that Newport-Mesa USD violated Sections 17(a)(2) and (3) of the Securities Act. IV. Newport-Mesa USD has submitted an Offer of Settlement in which, without admitting or denying the findings herein, it consents to the Commission's entry of this Order, which makes findings, as set forth above, and orders Newport-Mesa USD to cease and desist from committing or causing any violations and any future violations of Sections 17(a)(2) and (3) of the Securities Act. As set forth in the District's Offer of Settlement, Newport-Mesa USD undertakes to cooperate with Commission staff in preparing for and presenting any civil litigation or administrative proceedings concerning the transaction that is the subject of this Order. V. In view of the foregoing, the Commission deems it appropriate to accept the Offer of Settlement submitted by Newport-Mesa USD and impose the cease-and-desist order specified in the Offer of Settlement. Accordingly, IT IS HEREBY ORDERED that, pursuant to Section 8A of the Securities Act: 1. Newport-Mesa USD shall cease and desist from committing or causing any violation and any future violation of Sections 17(a)(2) and (3) of the Securities Act. 2. Newport-Mesa USD shall comply with its undertakings described in Section IV. above. By the Commission. Jonathan G. Katz Secretary **FOOTNOTES** [1]: The findings herein are made pursuant to the Offer of Settlement of the District and are not binding on any other person or entity named as a respondent in this or any other proceeding. [2]: Orange County was charged, in a settled cease-and- desist proceeding, with disclosure violations concerning eight offerings of municipal securities, the Official Statements for which contained false and misleading information about the Pools. See In re County of Orange, California, Securities Act Release No. 33-7260 (Jan. 24, 1996). [3]: Although the national rating agencies downgraded these notes prior to maturity, Newport-Mesa USD paid these notes in full and on time. [4]: These entities are the respondents in a separate proceeding. See In re the City of Anaheim, City of Irvine, Irvine Unified School District, North Orange County Community College District, and Orange County Board of Education, Securities Act Release ______ (______, 1998). [5]: Pursuant to Section 53853 of the California Government Code (West 1983), the notes of each District were issued in the name of and on behalf of the District by the County Board of Supervisors. Each District requested that the County Board of Supervisors authorize the issuance of the taxable notes in its name and on its behalf, which the County Board of Supervisors did without discussion. [6]: In addition to officials at the District, bond counsel, counsel to the underwriter, and the underwriter participated in the preparation of the Official Statement, which Newport-Mesa USD reviewed and approved before issuing the notes. [7]: During the meeting at which the issuance was discussed and voted upon, one of these board members expressed concerns about the direction of interest rates, the sale of a security held by the Pools at a loss of $4.8 million and the Pools' derivative holdings, including inverse floaters. He stated, "My primary concern is that what's happening at our County is very risky with regard to taxpayers' money." The other board member referred to the City of Irvine's decision not to issue taxable notes in May 1994 due to its requirement to earn a specified arbitrage profit.