The current system of regulating municipal securities, including Mello Roos and Marks Roos bonds, is "inadequate" and "encourages non-compliance", according to a new report a state task force. Noting the alarming rate of defaults among land-based securities, the report recommends creation of a new municipal bond law-enforcement division within the state's department of justice. The findings and recommendations have been praised by both government officials and some industry observers, although at least one prominent bond counsel objected strongly to what he described as the negative portrayal of bond professionals in the report. As if to underscore the urgency of the report, a grand jury in July returned a criminal indictment of the city attorney of the City of Waterford relating to his activities as a bond disclosure counsel in several Marks-Roos deals, while an allegation has been made that $70 million of the city's Marks Roos bonds may be illegal. The "Report of the Interagency Municipal Securities Task Force" was issued by the California Debt and Investment Advisory Commission - the result a two-year investigation conducted by a task force appointed by State Treasurer Matt Fong, in response to the rising rate of defaults on land-based bonds. (The default rate in 1997 for land-based bonds exceeded $200 million, nearly three times the level of the previous year.) According to the report, the default rate for Mello-Roos bonds alone is at least 5%, which is "extremely high relative to the capital market or any sector of the municipal market." The "key question facing state policy makers," the report goes on to say, "is whether the regulatory framework for municipal securities has kept pace with the changes described above and affords adequate protections for investors and issuers. Ill-advised borrowing decisions have already brought certain small communities through the state to the brink of bankruptcy and put at risk the delivery of essential public services." Part of the blame lies with the bond industry, according to the report: "In these cases (of default), municipal bond industry professionals actively promoted fraudulent transactions to earn high fees. In other cases, professionals are opening flaunting both the letter and intent of the law." Among the task force's findings: o The lack of enforcement of state bond laws encourages non-compliance; o The concern that land-based bond defaults may pose serious risks to local agencies who issue them; and o The fact that underwriters and bond traders are targeting "unsophisticated" investors, "through mass advertising, and other techniques, as customers for some of the most speculative municipal securities in the market today," according to the report. The central recommendation of the task-force report is the creation of a Municipal Bond Law Enforcement program to remedy the lack of enforcement of the state's existing municipal-bond laws. Specifically, the task force recommends that the legislature "direct the Department of Justice to initiate a program to review municipal bond offerings, focusing primarily on Marks-Roos bond and other types of debt with a high potential for abuse. Peter W. Schaafsma, executive director of the debt advisory commission, says response so far to the task-force report has been positive. "We have received several letters from investors who like the idea" of a bond law-enforcement program, he said. One government official who said he is "enthusiastic about those recommendations" was Sen. Quentin Kopp, I-San Francisco, a leader in Marks-Roos reform. In May, Governor Pete Wilson signed into a law sponsored by Kopp, SB 147, which requires projects financed by Marks-Roos bonds to be located in the jurisdiction of at least one of the local agencies that are issuing the bonds. (Marks-Roos bonds are issued by joint-powers authorities). The bill was intended to correct a perceived abuse of Marks-Roos bonds, in which of local municipalities using their bonding authority to finance speculative real estate projects that are hundreds of miles away. "I am particularly desirous for a specific unit in the Department of Justice to monitor municipal bond transactions, such as those issued by the Pacific Genesis firm in San Francisco," said Kopp, referring to the bond underwriter that has been associated with several issues that either defaulted or drew on reserves in the cities of Wasco, Waterford, and elsewhere. (Pacific Genesis officials said in interviews that all those defaults have been cured.) He described the practice of issuing Marks-Roos bonds by some cities as an indication of "greed and desperation by local officials." Local agencies are often able to generate a high "administrative fee" for issuing for re-financing the bonds, which is seen as an incentive for those agencies to issue land-based securities. Kopp complained about the practice of underwriters who "pay (cities) a fee to borrow their name" for the purpose of issuing securities, describing it as an "invidious practice." Kopp said that he would be willing to sponsor legislation to create the proposed bond law-enforcement program, but would be unable to do so, because of he will soon leave the Senate under term-limits.. A different response, however, came from some bond lawyers, according to Schaafsma. "I have heard from some of the bond lawyers that they dislike the report, but support the recommendation," he said. One lawyer who was incensed by the report is Roger Davis, who heads the municipal bond practice group in the San Francisco office of Orrick Herrington & Sutcliffe. He criticized the fact that the report suggests there are widespread problems in the issuance of Marks Roos bonds, when in actuality the problems are "all coming from a single firm," which he did not name. He also was critical of the report's correlation of bond failure and a lack of due care by bond professionals. Most of the Mello-Roos defaults, he observed, were the result of the real estate recession of the early 1990s, not substandard underwriting or legal work. The report, he concluded, is "an insult to the entire bond profession." Notwithstanding that rebuke, alleged mishandling of Marks-Roos bonds is creating legal problems for at least one lawyer. Waterford City Attorney William E. Gnass surrendered to a Stanislaus County Judge on July 20 to answer charges of 11 separate violations of the California Government Code. He pled innocent to all charges. Since 1996, the city has issued $76 million in Marks Roos bonds. Gnass was both disclosure counsel and city attorney at the time the deals were executed. In 1996, a Stanislaus County grand jury investigation concluded that Gnass had properly disclosed his dual role at the time of the transactions. Separately, in late June, State Attorney General Dan Lungren issued a formal opinion that nearly $70 million of Marks-Roos bonds issued by the City of San Joaquin in Fresno County are technically illegal, because they were issued by an illegal agency - that is, an agency that does not exist in the eyes of the law. Specifically, Lungren ruled on two questions: (1) Can a joint-powers agency, such as one that issues Marks-Roos bonds, legally consist a city and a non-profit public benefit corporation created by that city? And (2) Can a joint powers agency consisting of those two entities impose development fees on property outside their geographic boundaries, for the purpose of paying off the bonds? Lungren's opinion on both questions was no. About $62 million of the San Joaquin bond proceeds went to finance the River Ranch project in Madera County. Contacts: Roger Davis, partner, Orrick Herrington & Sutcliffe, (415) 392-1122. Peter Schaafsma, executive director, California Debt and Investment Advisory Commission (916) 654-7440. Sen. Quentin Kopp, (916) 445-0503