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Wisconsin Districts in Mediation With Firms

AUG 4, 2011 6:49pm ET
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CHICAGO — Lawyers for five Wisconsin school districts trying to recoup their ill-fated $200 million investment in collateralized debt obligations to fund their non-pension retiree health liabilities are engaged in formal mediation talks with the financial firms they blame for their losses.

The talks, led by a professional mediator, began in mid-July and will conclude on Monday, according to a lawyer for the school districts who said it remains unclear whether the parties can resolve the issue and put an end to ongoing litigation.

The districts accuse the firms of fraudulently misleading them over the safety of the 2006 investments in synthetic CDOs involving credit-default swaps made by the districts’ trusts set up to fund their unfunded other-post employment benefits.

“If mediation is unsuccessful, we are confident in going forward with the litigation. The evidence shows the districts were defrauded,” said one of the districts’ attorneys, Stephen Kravit of Milwaukee-based Kravit, Hovel & Krawczyk SC.

The next hearing in the districts’ 2008 lawsuit against Stifel Nicolaus & Co., RBC Capital Markets Corp. and others is scheduled for Aug. 16. Absent a settlement, the case could go to trial next year.

Stifel last spring disclosed that it had received a Wells Notice from the Securities and Exchange Commission, indicating it is considering filing a civil or administrative enforcement against the firm for possible violations of securities laws relating to its role in the deals.

The SEC declined to comment on the status of the probe Thursday.

The districts contend the firms violated state securities laws by either knowingly or negligently misrepresenting details of the transactions. The suit further alleges that the firms violated Wisconsin’s trade and fraud statutes because of their statements about the safety of the transactions and their compliance with state laws.

Stifel, which was the placement agency-broker, and RBC, which was the arranger for the CDOs, have filed cross-claims.

One of the matters before Milwaukee County Circuit Court Judge William Brash later this month is Stifel’s request that the court accept its amended counterclaim in which it accuses RBC of providing misleading information about the transactions and their fees. If properly disclosed, Stifel argues that the transactions would not have occurred.

Stifel has long taken the position that the districts knew of the investment perils, producing documents signed by district officials outlining those risks. In its amended cross-claim filing, Stifel now takes aim at RBC, charging that it hid its true profits, concealed the products’ risks and misrepresented its ability to provide daily pricing of the CDOs.

“We did not create the investment product, but only served as broker in the transactions,” Stifel said in a statement. “The investments when issued by RBC were rated AA-minus by S&P. By the time the investments failed, our relationship with the school districts had been over for more than a year.”

RBC declined to comment.

Stifel asserts that RBC’s alleged behavior on the three transactions mirrors that of other banks that contributed to the 2008 financial crisis, based on a congressional probe known as the “Levin Report.”

“RBC selected credits for the reference portfolio that had a market price reflecting a higher level of risk than the then-existing ratings for those credits,” the filing reads. “Furthermore, regardless of the rating, on information and belief, the OPEB trusts would not have purchased the synthetic CDOs from RBC had the OPEB trusts known of RBC’s true, undisclosed profits and its material, undisclosed conflict of interest.”

On a $60 million deal, RBC reported earning a commission of $3.6 million, several times more than it represented in documents submitted as part of a competitive selection process for the CDO provider. “RBC intentionally misrepresented its profit because, on information and belief, it knew that if its true profit had been disclosed, Standard & Poor’s may not have assigned the investments a AA rating, and the OPEB trusts likely would not have made the investments,” Stifel’s filing reads.

“Shockingly, RBC’s estimated profits exceeded the expected investment return to the OPEB trust over the life of the investments. The filing also charges that RBC’s inability to provide accurate daily pricing of the investment prevented officials from acting earlier as its value dwindled. Stifel believes claims against it should be dismissed or its liability limited to the districts’ initial contribution of $37.5 million.”

Beginning in 2006, the school districts invested $200 million in total — $165 million from the issuance of asset-backed notes by trusts to fund their other post-employment benefits, and $35 million in cash — to help cover their collective $432 million of unfunded OPEB liabilities. They followed the advice of their long-standing banker, David Noack, who was with Stifel at the time, and who was referred to in the lawsuit as a “trusted financial adviser.”

The districts put their moral obligation pledge behind the trust notes that were held by Depfa Bank PLC.

In their lawsuit, the districts argue that they believed they were investing in highly rated securities that were not exposed to subprime or other market risks. They were not told the underlying assets backing the CDOs included subprime mortgages. They expected to benefit financially by capturing the spread between the low rate they paid on the notes and the higher rate of return expected on the CDO investments.

When the subprime real estate market collapsed and the value of other structured securities fell, the value of the trusts dwindled. The market’s ongoing woes and the recession further cut into the value of the trusts, triggering a default by the districts in late 2007. The districts were required under the loan agreements to cure the default but they did not, and last year noteholder Depfa demanded repayment.

The Kenosha Unified School District, the Kimberly Area School District, the Waukesha School District, the West Allis/West Milwaukee School District, and the Whitefish Bay School District refused to make good on their moral obligation pledge.

The districts want to resolve the litigation before handing over their own funds to repay Depfa. After the district’s declined to repay the notes issued on behalf of their trusts, Moody’s Investors Service downgraded them, though the ratings remain solidly in investment-grade territory.

The Wall Street Journal reported in late June that the SEC’s probe was expanded to include whether the securities were suitable for sale to the districts. The SEC has declined any comment on details of its probe.

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