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Failing Grades: School District and Auditor Earn SEC Discipline

The Crosby Independent School District, located in unincorporated Harris County, Texas, about 35 miles north of downtown Houston, dates to the late 19th century.  According to the Texas Education Agency, as of 2016 the District served 5,666 students in seven schools (including a high school).  The student body is diverse, with 16.3 % of the students being African-American, 34.9% Hispanic, 45.9% Caucasian, 0.3% Native American, and 0.4% Asian. As of 2016, the District also had the highest school district tax rate in Harris County.  According to the U. S. Securities and Exchange Commission (“SEC”), the number of students had risen to approximately 6,400 by 2022.

In 2013, the District issued $86.5 million in municipal bonds for capital projects, but those projects were modified by (quoting from the March 16, 2022 enforcement Order of the SEC), “enhancements beyond the original scope of work [which] inflated the total cost of the projects.”

As of August 31, 2016 (then the District’s fiscal year end), the District’s General Fund “lacked sufficient funds to cover the $12 million of unanticipated construction expenses required to complete its capital projects.” This caused the District and its Chief Financial Officer (“CFO”) to pursue two paths to deal with the shortfall. First, the District changed its fiscal year end from August 31 to June 30, which would conceal part of the District’s operating costs in any subsequent year. Payroll expenses comprised a substantial majority of those costs. Teachers earned their salaries over the 10- month school year, but were paid equally over the 12 months of the fiscal year. By changing the fiscal year, the District “cut off” recognition of 1/6 of its operating costs for 2017.

The second path involved the issuance of $20 million of new municipal bonds in January 2018. The District’s Official Statement concerning these bonds contained the District’s 2017 audited financial statements, which failed to report “payroll and construction liabilities totaling $11.7 million.”  Consequently, the SEC was able to conclude that “the disclosures in the [District’s] official statement were false and misleading because they did not include the appropriate payroll and construction liabilities.” Further, the SEC determined that the CFO “had ultimate responsibility over …[the District’s] fiscal year 2017 financial statements.” The Commission also noted that the District’s Board President signed the official statement used to sell the 2018 Bonds.

During the spring of 2018, the District’s cash flow problems continued. In June 2018, the CFO left (according to the SEC Order) “for other employment.”  A new CFO identified the misstatements and informed the District leadership, which in turn disclosed the issues to the District’s Board and to the public. By September 2018, rating agencies had downgraded the 2018 Bonds. On October 8, 2018, the District declared a “financial exigency” that subjected it to oversight by a monitor from the Texas Education Agency. The audit report for the 2018 fiscal year included material restatements of the 2017 numbers and expressed concern about the District’s ability to continue as a going concern.

The District’s Superintendent since 2010 resigned effective June 2018. In October 2018, the District laid off 34 contracted employees, including teachers. It was also forced to convert its pre-kindergarten program from a full day to a half day to save money. The SEC, noting the remedial acts undertaken by the District and its cooperation with the Commission, only ordered the District, in the SEC enforcement action, to cease and desist from future violations. It may be that the damages suffered by the District and its students stemming from the District’s financial and reputational injuries weighed against any civil penalty.

The audit partner of the accounting firm responsible for the audit of the 2017 financial statements was also the subject of an SEC enforcement order dated March 16, 2022, brought under SEC Rule 102(e), which allows the SEC to discipline professionals (attorneys and accountants) who practice before the Commission. The Commission determined that the audit partner had: i) failed to obtain sufficient evidence to support the audit opinion; ii) failed to properly supervise the audit; and iii) failed to exercise professional judgment and to maintain professional skepticism. The audit partner, a 48-year-old accountant, first became a partner (as of 2017) of a national audit firm and became the engagement partner for the District’s audit. She had worked on the District’s audits since 2014. Due to her work on the District’s 2017 audit, she was suspended from appearing before the Commission for three years, with substantial compliance requirements in order to return to practice before the SEC.  The enforcement order notes that in 2020, she left the national accounting firm to become the chief financial officer of a different school district.  So, at the very apex of her career, her professional shortcomings left her with a much-reduced future.

This is not the first time I have written about municipal finance disclosures, especially as they involve school funding. See my September 22, 2020 Blog, “SEC Focus on Municipal Securities: Disclosure and Enforcement – the Peculiar Structure of the Municipal Securities Disclosure Regime” and my March 2, 2021 Blog, “Being Held Accountable: The ‘Education’ of KPMG at the College of New Rochelle.”  There is a tendency to view education finance as “low risk” because there is no profit motive driving efforts to reach particular results. That view is compounded by the notion, especially in public schools like the District, that management of a school system is a task, at least at the board of education level, for “amateurs,” public spirited individuals willing to serve their community. The District’s experience reported here is a cautionary tale for those views. No fund-raising involving the sale of securities to investors is without risk.  Municipal finance, even for local school districts, requires knowledge of the law, experience with finance, and, to cite the SEC enforcement action against the audit partner, “professional skepticism.”

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