CHICAGO — RBC Capital Markets LLC will pay $30.4 million to settle charges
"RBC failed Securities 101 when it sold complex derivatives that were unsuitable to five school districts without fully informing them of the risks," Robert Khuzami, director of the SEC's Division of Enforcement, said in a statement. RBC does not agree nor deny the allegations in the order filed Tuesday.
The SEC's announcement comes a month after it took its first enforcement action in the saga involving the five districts and their attempts to partially fund their non-pension retiree health care obligations by investing in complex and now worthless synthetic collateralized debt obligations.
The SEC filed a complaint in federal court last month charging Stifel Nicolaus & Co. and a former senior executive of fraudulently misleading the five districts by steering them into the complex investments. The districts established trusts to begin funding their other post-employment liabilities and in 2006, on the advice of Stifel, invested $200 million.
They borrowed $36 million to cover a $37.3 million cash investment to participate in the three transactions and their OPEB trusts issued a collective $162.7 million of asset-backed notes supported by the districts' moral obligation.
The investment products were linked to the performance of synthetic collateralized debt obligations that included non-investment-grade credits, information concealed from the districts, which were told the investments were in more sound credits.
The difference between the earnings from the investment and the costs of borrowing were to be used to reduce the unfunded retiree benefits but the value of the trusts dwindled after the subprime real estate market collapsed and the value of the structured securities fell.
The market's ongoing woes and the recession further cut into the value of the trusts, triggering a default in late 2007. The districts' refusal to honor the moral obligation pledge to cure the default with note holder Depfa Bank resulted in a round of downgrades. The districts filed a lawsuit in state courts in 2008 against Stifel and RBC.
RBC was selected to supply the product after a request for proposals process. It put together and sold the CDOs to the districts' trusts despite its own concerns over the suitability of the product for unsophisticated investors like the school districts. RBC Capital's marketing materials also failed to adequately explain the risks associated with the investments, the SEC charged.
The commission accused the firm of violating various federal securities laws, including rules prohibiting any person, in the offer or sale of any security, from obtaining money or property by means of any untrue statement of material fact or any omission to state a material fact.
In a statement from RBC issued after the SEC's announcement, the firm stuck with its position that Stifel was at fault.
"We did not know that Stifel was misrepresenting the products' risks to its clients and would not have participated in the transaction had we had full knowledge of Stifel's communication with its client. We are very pleased to resolve this matter and are heartened by the fact that the school districts will be the beneficiary of the settlement," the statement read.
While Stifel is fighting the SEC's charges, RBC agreed to settle the matter without admitting or denying the commission's findings laid out in an 11-page order filed Tuesday. Under the sanctions, the firm is censured and directed to cease and desist from committing or causing any violations and any future violations of various securities laws.
RBC agreed to pay disgorgement of $6.6 million, prejudgment interest of $1.8 million, and a penalty of $22 million. The funds will go to 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 to compensate for losses.
An attorney for the districts welcomed news of the settlement and praised the SEC for its probe. "The SEC's action confirms what we have alleged: the duties to assess investor suitability and to provide adequate risk disclosures are sacrosanct. They cannot be contracted around or pushed off on to an unsophisticated investor, as RBC and Stifel attempted to do here," said Stephen Kravit of Kravit Hovel & Krawczyk.
The payment does not release the firm of any liability in the districts' case but Kravit said, "It is a substantial down payment on the districts' attempt to get all of their money back." The districts' lawsuit is pending and mediation has taken place between the districts and the firms. If no settlement is reached, a trial could take place as soon as next year.
Stifel and RBC have attacked each other in court filing and statements. Stifel charges in court filing that RBC hid its true profits, concealed the products' risks, and misrepresented its ability to provide daily pricing of the CDOs.
Those attacks continued Tuesday. Stifel issued a statement saying of the SEC action: "Importantly, the SEC found not only that RBC was aware of those risks but that RBC disguised the risks in the marketing materials provided to the school districts and Stifel. We continue to believe that if RBC's product was as represented, it would have been suitable for the districts," the statement read.
RBC countered, calling Stifel's attempt to direct the blame at RBC "meritless" and an effort aimed to divert attention from Stifel's "central" role in the transactions and responsibility to its clients, the districts.
The districts' decision not to cure defaults when the value of the investment fell prompted Depfa in early 2010 to take possession of the remaining assets and demand repayment. With its lawsuit pending, the districts refused last year to honor their moral obligation. The strain of the investment losses and the decision to renege on the moral obligation pledge led to downgrades, though the districts' ratings remain in solid investment-grade territory.
The SEC order notes that traditional buyers of such CDOs from RBC tended to be hedge funds, pension funds, banks, and insurers with significant fixed-income assets, not entities like the districts that had limited knowledge and had traditionally invested in cash-equivalent holdings.
The order lays out how most of RBC's internal discussions over suitability issues appeared geared towards insulating RBC from liability. "There was little discussion about whether the CDO investments were in fact suitable for the school districts and little desire … to find the answer to that question," the order says. RBC eventually left it up to Stifel to convey the risks.
