Warning that the outcome of the case will impact the bond insurance industry overall, Financial Security Assurance Inc. has asked a federal appeals court to overturn a lower court's dismissal of the securities fraud and other charges it filed against underwriter Stephens Inc. and an engineering firm over alleged false claims they made in documents for some now-defaulted solid-waste bonds that FSA insured.
"The case presents important issues of federal securities law policy and questions impacting the rights, costs, and risks to financial guaranty insurers and the bond industry as a whole," the New York City-based insurer said in the appeals brief it filed late last week with the U.S. Court of Appeals for the Eleventh Circuit in Atlanta.
FSA complained that the U.S. District Court in Atlanta erred in concluding in September 2001 and August 2004 rulings that the insurer had no "standing" in the case and that Stephens, which is based in Little Rock, Ark., and Hayes, James and Associates Inc., an engineering firm in Georgia, had no duty to disclose certain information to it. The insurance company said the lower court failed to understand FSA's financial guaranty policy and the role that insurance companies play in the municipal bond market..
"Full and honest disclosure of material facts and risks is essential to the smooth and efficient operation of the securities industry in general, and the municipal bond market in particular," FSA told the appeals court. "No less than the actual purchasers of those securities, issuers of financial guaranty insurance are entitled to, and expect, accurate disclosure in the materials which are prepared and distributed to them by bond underwriters seeking to induce the issuance of such insurance."
FSA said its policy expressly states that it will become the owner of bonds if the bonds default and it is required to make payments to the bondholders. As a result, FSA is in effect a "purchaser" of the bonds under the Securities Exchange Act of 1934 and case law and is owed the same complete and accurate disclosures as bondholders, the insurer said.
The case revolves around $69.6 million of bonds issued in November 1998 by the Crisp County Solid Waste Management Authority to finance the completion of a disposal and recycling facility in Cordele, Ga. The facility never operated as expected, was experiencing serious operational and revenue problems only a few weeks after the bonds were issued, and was shutdown in less than a year. The bonds defaulted in 2000, leaving FSA faced with paying bondholders a total of about $21.6 million, some of which it has already paid out.
FSA claimed that it only insured the bonds after relying on Stephens' request for proposals for credit enhancement, the official statement for the bonds, letters from the engineering firm, and other documents that contained information about the facility's operational capabilities and projected revenue. The key information in those documents later proved to be false and misleading, the insurer claimed.
Although one of FSA's analysts visited the plant and ultimately recommended the company insure the bonds, FSA claimed that Stephens and Hayes James, concealed the plant's operational and revenue problems from it. FSA said it was directed to run all of its questions and other communications through the Stephens bankers assigned to the deal and told not to contact the authority directly.
In particular, FSA claimed it was never told that Chris Cannon, the president of TransWaste, which was to be the major waste hauler involved in the project, had repeatedly complained that the facility was not operating as planned and that the bond issue was premature. In addition, the insurer said it was not told that Cannon renegotiated his contract with the authority to reduce his tipping fees and to defer an 800-ton-per-day guarantee of waste that was to be delivered to the plant, lessening the revenue that would be received for debt service.
Stephens argued that it had no duty to disclose information to FSA and said that if the insurer had conducted its own due diligence, or even exercised reasonable care, it would have discovered all of the information that it claimed was concealed from it.
The lower court judge agreed and granted Stephens' pre-trial motion for summary judgment in September 2001, dismissing FSA's federal securities fraud charges against the underwriter. Then on Aug. 23, 2004, the court dismissed without a trial the remaining charges against Stephens and Hayes James.
In his Aug. 23 ruling, Judge J. Owen Forrester said: "Taken to its extreme, FSA's position seems to be that it has no obligation to investigate any bond transaction offered up by an underwriter for FSA to insure. While this might be a business model that bond insurers would prefer, it does not reflect the manner in which Georgia law considers the due diligence obligations of sophisticated parties."
FSA challenged Forrester's statement in its brief, telling the appeals court: "The evidence presented to the district court demonstrated that, in the municipal bond industry, a bond insurer's 'due diligence' generally includes 'analyzing the information provided to them by the underwriter, which often includes the due diligence conducted by the underwriter' and ... does not include duplicating the bond underwriter's own due diligence."
"Bond underwriters understand that 'the bond insurers rely on the information provided to them [by the underwriter] in determining whether to issue insurance on a proposed transaction,' " FSA said.
Stephens is scheduled to file to a response to FSA's appeals brief by May 2.
