Several Wisconsin School Districts May Sue Firms Over OPEB CDOs

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CHICAGO - Five southeastern Wisconsin school districts are weighing litigation against financial firms they believe misrepresented the safety of a complex investment transaction that involved collateralized debt obligations and a credit default swap to help fund a portion of their other post-employment benefit liabilities.

The districts' boards - who believe their $200 million investment has lost as much as $120 million of its value - are expected to vote at upcoming meetings on whether to file a lawsuit in connection with the transaction from two years ago, according to a joint statement from the group of districts that joined together to commission a legal review of the deal and determine whether the five were defrauded.

The report compiled by the districts' legal advisers names Stifel, Nicolaus & Co. and former Stifel banker David W. Noack and the Royal Bank of Canada Europe Ltd. as participants in the complex transaction that the districts contend was misrepresented to them. RBC served as the counterparty on the swap and Stifel served as the broker and placement agent, but no additional information on the swap has been provided by school officials.

The districts are considering authorizing the filing of a lawsuit seeking rescission, actual and exemplary damages, and costs and fees, according to the joint statement, although it does not specifically say who would be sued. Noack declined to comment. Stifel countered the allegation by providing documents they claim show the districts were aware of the investment risk. RBC could not immediately be reached for comment.

The districts consist of the Waukesha School District, the Whitefish Bay School District, the West Allis-West Milwaukee School District, the Kenosha Unified School District, and the Kimberly Area School District.

The investigation is now complete and the districts believe the evidence shows they were duped because of several inconsistencies between "how the investment had been described, what was promised and what the investment ultimately came to be," a statement from Whitefish Bay reads. "Consequently, the school districts involved are planning to initiate legal action against those responsible for actions related to the investment."

The districts have been questioned in local published reports for their failure to hire an independent financial adviser to assess the proposed investment scheme. Noack, now a managing director with Robert W. Baird & Co., pitched the transactions to the boards.

The districts entered into the transaction as each sought an affordable solution to fund a portion of their growing accrued unfunded liabilities for their other post-employment benefits that combined totaled $430 million, according to an attorney for the districts.

Most issued some form of taxable debt - backed by either a general obligation pledge or a moral obligation pledge - totaling about $160 million to put towards the transaction that they were told was being used to invest in double-A to triple-A rated debt that would earn higher returns and help fund OPEB trusts to cover retiree health care costs.

The play on arbitrage - borrowing at a lower cost and investing with the hope of earning higher returns - is a gamble, but the districts contend the investment transactions were posed as low risk because they were allegedly investing in a double-A/triple-A rated corporate debt portfolio. The districts since have learned that the collateralized debt obligations they invested in included more risky triple-B rated securities, including subprime mortgages, despite assurances that they would not be investing in subprime debt, the districts contend.

The districts also believed that the investments would pay the total amount promised if the corporate debt obligations were held to maturity in five years. But they have since learned there is no such guarantee that the value of the investment will be recovered.

"It looks like misrepresentations were made to induce us to follow the firms' investment advice. We believed them and we relied on them," said Kimberly district superintendant Bob Mayfield.

The school districts fear that the latest valuation shows their investments may have lost as much as $120 million.

"Our lawyers and their expert, Dr. Craig McCann of the Securities Litigation and Consulting Group,concluded that these transactions were opaque and believed to be deliberately so," Shawn Yde, director of business services of the Whitefish Bay district, said in a statement. "There were no documents signed by the districts or even presented to the districts prior to closing that disclosed the true risk of the deal. There is no way the districts knew or could have known that they were being victimized."

Because the value of the investments has fallen dramatically over the last year, the districts have in some cases been asked to post additional funds as collateral in order to avoid a default. Some the districts have found themselves paying more to cover their original debt than they are receiving from their investment.

Stifel strongly countered some of the districts' assertions. The firm provided copies of acknowledgment letters signed by the districts that did at least generically discuss the investment risks.

"There can be no guaranty" the investment goals will be achieved, according to the document, which also warned that their value might fluctuate. It further warns that a double-A level rating from a rating agency "does not mean that no loss can occur ... on the contrary, there is a risk of loss of principal." The letter also notes that potential investors should have sufficient expertise or advice to weigh the risks and benefits.

Stifel also provided a copy of a letter sent to Kenosha schools in 2007 after the district sought to replace the firm with Baird as its placement agent. In the letter, Stifel reiterates the risks of the investment and outlines its role solely as a placement agent and not as an adviser. It also notes the Government Finance Officers Association's recommendation that governmental units use an independent financial adviser to assess the risks and benefits in managing trust investments

The districts are being represented by the Houston firm Shepherd, Smith, Edwards & Kantas LLP and Milwaukee-based Kravit, Hovel & Krawczyk SC.

In the case of Whitefish Bay, officials assert that even with the investment losses, the OPEB trust, set up four years ago, retains assets of about $5 million and they expect future assets of $21 million from life insurance policies that would cover future costs. The district will continue to make annual pay-as-you-go contributions to fully fund the trust.

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