Role of swaps in VRDO lawsuits expanding

The role of swaps in two lawsuits alleging fraud in the variable-rate market is expanding following recent court orders in New York and Illinois, with the potential to raise the stakes in cases where alleged damages already total hundreds of millions of dollars.

The latest developments follow earlier court rulings in July, when a New York judge initially granted the request of the accused banks, which include most of the largest banks doing business in the U.S., to seek swap-related discovery. That same New York judge, Andrew Borrok, ruled Sept. 19 that the banks cannot limit the scope of discovery sought by Edelweiss Fund, the litigant entity created by municipal advisor John Rosenberg in order to pursue multiple lawsuits related to the variable-rate demand obligation market.

"The relator has legitimate allegations that the defendants manipulated both the fixed and variable sides of the market," Borrok ruled. "The ramifications of those allegations not only infect the individual transactions at issue, but all commercial decisions made by relator in picking fixed versus variable — including a decision to switch from one to the other. The relator is entitled to show the entire market was rigged and that any decision they made or could have made exposed them to damage. Discovery can not be used to narrow relator's potential damage theories."

The term "relator" in this context refers not only to Rosenberg but also to New York because such whistleblower lawsuits are considered to be on behalf of the state even if the state did not itself bring the suit. Rosenberg stands to potentially win millions of dollars for himself if his suits recover anywhere near the amount of damages alleged in the complaints.

The VRDO cases — which Rosenberg filed in several states including New York, Illinois, and California — stem from the Minnesota-based muni advisor's claims to have discovered a "robo-resetting" scheme in which the banks "bucketed" large groups of VRDOs and set their rates en masse, without regard to the characteristics of the securities.

Rosenberg's lawsuits argue this behavior is a violation of the agreements binding those banks to remarket the securities at the lowest rates possible and cost municipal issuers nationwide billions of dollars. In court filings, the banks have denied the allegations.

The banks, which in New York sought and won discovery of swap-related materials from municipal issuers that the banks described as "narrowly-tailored," had argued the court should reject Rosenberg's more broad request for materials related to swaps because he was using it as a "fishing expedition" to create new theories of damages unrelated to the accusations already under litigation.

"The court should reject relator's transparent efforts to dramatically and improperly expand the scope of this case," the financial firms said in a joint filing prior to Borrok's ruling.

Rosenberg's lawyers have told the court that including swaps in the case increases the damage calculation because issuers pay termination fees to get out of swaps. The banks have rejected this notion in their own filings, arguing that termination fees are not tied to any alleged inflation of the variable rates and are therefore not relevant.

Damages alleged in New York already approach $400 million.

In Illinois, a Cook County judge on Sept. 19 granted Rosenberg's motion to compel discovery concerning VRDO swaps, a similar development as in New York. Damages alleged in Illinois surpass $300 million.