CHICAGO — Stifel Nicolaus & Co. and a former senior executive fraudulently misled five Wisconsin school districts by steering them into unsuitably risky and complex investment products to fund their non-pension retirement obligations, the Securities and Exchange Commission charged in a complaint filed Wednesday.

The districts established trusts to begin funding their other post-employment liabilities and in 2006 — on the advice of Stifel and former senior vice president David W. Noack — invested $200 million in three transactions between June and December under a Stifel proprietary program.

The now-worthless 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 sound, the SEC charged.

The districts borrowed $36 million to cover a $37.3 million cash investment to participate in the transactions and their trusts issued a collective $162.7 million of asset-backed notes supported by the districts’ moral obligation.

The SEC alleges that the heavy use of leverage and the structure of the synthetic CDOs exposed the school districts to a heightened risk of catastrophic loss. “Let this be a teaching moment for sellers of complex financial products,” Robert Khuzami, director of the SEC’s Division of Enforcement, said in a statement.

“The sale of these products to school districts or similar investors must meet well-established standards of suitability and accurate disclosure,” he said. “Stifel and Noack violated these standards and jeopardized the ability of the school districts to fund operations and provide a quality education to students.”

While the complaint is not the first from the SEC to focus on the suitability of securities sold to a local government, it does mark the agency’s first pursuit of action involving the suitability of sales of CDO products to municipalities. It’s also the latest in a series of enforcement actions stemming from the offering and sale of CDOs and misconduct related to the financial crisis. CDOs are a type of asset-backed security collateralized by a pool of fixed-income assets such as mortgage-backed securities.

The 44-page complaint alleging violations of federal securities laws was filed in the U.S. District Court for the Eastern District of Wisconsin in Milwaukee. It accuses Stifel and Noack, 48, who worked for Stifel from 2000 to 2007 and was co-head of the firm’s Milwaukee office, of defrauding 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.

The SEC is asking the court to impose civil penalties against the firm and Noack and require them to disgorge ill-gotten gains. It also wants the court to impose permanent injunctions against them to prohibit them from further violating or abiding and abetting violations of the securities laws. Stifel and Noack face three joint counts and each faces one additional count in the complaint.

Stifel expressed its disappointment in the SEC’s action it called “misplaced” and said it would fight the charges. “We will vigorously defend ourselves and believe we will prevail on the merits of the case,” a statement read. Stifel reiterated its position that it spelled out the investments’ risks for the districts in signed statements and defended the investments’ suitability because of their AA-minus rating at the time. Stifel argues it could not have foreseen the 2008 financial crisis that rendered the investments worthless.

Stifel and Noack profited from fees on the transactions, according to the SEC, while the investments eventually collapsed and are now worthless.

Stephen Kravit, an attorney for the school districts, which have filed their own lawsuit against Stifel, Noack, and others, released a statement on his clients’ behalf praising the lawsuit’s filing Wednesday. “The districts are gratified that the SEC has issued fraud charges against Stifel and Noack. The districts are aware that the SEC has dedicated considerable resources to its own investigation. The filing by the SEC of a parallel lawsuit to our case is proof that the districts are following a just path, and that they are ever closer to recovering their losses from this fraud,” the statement read.

The SEC filing Wednesday marks a major development in the saga of the districts’ soured investment strategy, which has played out over the last few years.

Noack was a longtime financial advisor to the district and Stifel served as the placement agency-broker on the transactions. RBC Capital Markets Corp. acted as the arranger for the CDOs. Depfa Bank Plc served as the lender to the districts’ trust on the note sale to fund the investments.

After the subprime real estate market collapsed and the value of 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 in late 2007. The districts were required under the loan agreements with Depfa to cure the default but refused.

The districts in 2008 filed a lawsuit against Stifel, RBC, and others alleging violations of state and federal securities laws. The districts’ decision not to cure the default prompted Depfa in early 2010 to take possession of the remaining assets and demand repayment from the districts. With its lawsuit pending, the districts refused last summer 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. Stifel disclosed this past April that it had received a Wells Notice from the SEC notifying it that it was considering taking enforcement action.

Stifel and RBC have filed cross-claims in the districts’ suit before Milwaukee County Circuit Court Judge William Brash. Stifel’s most recent filing 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.

RBC has countered that Stifel’s claims are an attempt to deflect blame and disclosed its estimated profits which did not come to fruition. “The SEC lays it all out well in its suit — from Stifel’s conceiving the investment program, branding it, marketing it to their long-standing school district clients, arranging financing for it, designing the investment parameters, to sending our RFPs to a number of Wall Street firms including us, and representing to us in writing that Stifel had judged it suitable in light of the school districts’ objectives,” an RBC statement Wednesday read.

The SEC declined comment on whether RBC is a target. “The investigation is continuing and we may bring additional action against others,” said Elaine Greenberg, chief of the SEC Division of Enforcement’s Municipal Securities and Public Pensions Unit.

A central piece of the SEC’s complaint is the sweeping assurances offered by Stifel and Noack to school finance officials and school board members — unfamiliar with such sophisticated investment products — and their contrast to the investments’ true nature. Greenberg said it was Stifel’s responsibility to offer suitable products for the districts based on their “risk tolerance and investment objectives.” The nature of the investments violated both, the suit says.

Noack referenced the collapse of Enron Corp. in assuring school officials that it would take “15 Enrons” for the investment to fail and that the country would have to suffer an economic collapse greater than the Great Depression for them to lose their investment, the complaint says. The districts were told the investments were “Treasury like” in AAA and AA corporate securities and not subprime mortgages. The portfolio on the first transaction began to struggle soon after the transaction’s closing, but Noack and Stifel withheld information on its faltering performance.

“Stifel and Noack induced the school districts to invest in complex financial instruments through a series of falsehoods and misrepresentations,” the complaint charges. “Stifel and Noack knew that the school districts were risk-averse, and they knew that the preservation of capital was of paramount importance. They materially misled the school districts about the risks of the investments, the likelihood of defaults, and the safety of their principal.”

Stifel and Noack created the Government OPEB Asset and Liability Program, or GOAL, as a business opportunity in late 2005 to early 2006, to create trusts for the districts to generate funds to pay OPEB liabilities. The centerpiece would be CDOs. An internal working group included Stifel’s chief executive officer and members of Stifel’s Alternative Spread Products trading desk. The complaint alleges that Noack reported to Stifel’s CEO, Ron Kraszewski, who is not named, who played a significant role in key decisions.

Noack knew little about CDO investments. On June 1, 2006 — shortly before the first investment by one of the school districts — Stifel’s head of fixed income sent an e-mail to Stifel’s CEO. He wrote: “I do want you to consider the fact that Dave [Noack] was (and to a certain extent, still is) relatively ignorant about the nuances of CDOs,” according to the lawsuit.

An internal dispute about how to allocate fees between Noack and other Stifel employees prompted Stifel employees with expertise in CDOs to become less involved in the GOAL program, yet Noack “forged ahead,” the complaint alleges.

Because the investments were funded with mostly leveraged funds, the borrowing costs drove up the need to invest in assets with higher yields to capture financial benefits for the districts’ trusts, increasing the risk. RBC was selected as the CDO arranger because it offered CDO tranches with relatively higher yields, according to the complaint. Stifel and Noack ignored warnings from CDO arrangers about the dangers of high-leverage investments.

The complaint alleges that RBC refused to sell directly to the districts as it did not want to be on the hook for suitability issues. After the first transaction, Noack and Stifel asked other firms if they were interested in participating in future investments. One said his firm only sold such investments to qualified institutional buyers and another expressed concerns because of the high leveraging to fund the investment.

The complaint raises questions over the value of the GOAL program even if it had performed as promised. With a collective $600 million in OPEB liabilities, the investment scheme at its best would generate only $10 million of net income for the districts over its seven-year term.

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