WASHINGTON — The secret whistleblower responsible for federal investigations and lawsuits accusing banks and broker-dealers of fraud and collusion in the remarketing of variable rate demand obligations will likely be forced to go public because of a recent ruling by Massachusetts’ highest court.
The Massachusetts Supreme Judicial Court ruled in August, in Phone Recovery Services, LLC v. Verizon of New England, Inc., that a whistleblower suit can’t be filed under the state’s False Claims Act by a limited liability company.
The latest whistleblower suit to be made public alleging fraud and collusion against banks and broker-dealers remarketing VRDOs was filed in Massachusetts. In that suit, similar to one filed in Illinois that was made public in April — the plaintiff is Edelweiss Fund LLC, a Delaware-registered limited liability company incorporated on April 29, 2014, specifically to pursue the litigation.
The complaints in both cases say Edelweiss’ principal has more than 20 years of experience advising municipalities and other clients on issuing securities, particularly VRDOs and other types of municipal bonds. But they don’t identify the principal and little public information about that individual or Edelweiss exists.
Now, because of the high court’s ruling in August, the VRDO suit in Massachusetts will have to be amended to name the person hiding behind Edelweiss.
The suit filed by Edelweiss on behalf of Massachusetts, accuses four banks and dealers — JPMorgan Chase & Co., Citigroup Inc., Merrill Lynch & Co. and Morgan Stanley Smith Barney — of using a “robo-resetting” scheme under which VRDO rates are mechanically reset en masse without any consideration to the characteristics of the bonds, the associated market conditions, or investor demand. The defendants allegedly never disclosed the use of this device or scheme to issuers of investors, according to the suit.
The four banks and dealers were also sued in Illinois, along with four others. They would not comment on the allegations.
Both suits claim the charges against the four banks and dealers are supported by a forensic analysis of interest rates and other market data that Edelweiss conducted from April 1, 2009, through November 14, 2013.
Also, in both suits, Edelweiss’ consulting expert is Michael Lissack, the former Smith Barney banker who helped the government win hundreds of millions of dollars — and reaped tens of millions of dollars himself in the process — from filing whistleblower lawsuits against Wall Street and other firms in 1995 over charges that they engaged in yield-burning.
The Securities and Exchange Commission is conducting a sweep of bank and broker-dealer VRDO remarketing practices and the Justice Department is conducting an antitrust investigation, sources have said.
The suit in Massachusetts alleges that since April 2009, Merrill Lynch was remarketing agent (RMA) for roughly 141 VRDOs issued by the state, which had a collective value at issuance of about $3.6 billion. JPMorgan was RMA for about 63 VRDOs issued by the state, with a total value at issuance of $3.7 billion, according to the suit.
Morgan Stanley was RMA for roughly 22 VRDOs issued by the state, valued at issuance at about $2.4 billion while Citigroup was RMA for 16 VRDOs issued by the state and valued at issuance at roughly $2.1 billion, the suit alleges.
The four defendants used the robo-resetting device to collectively impose “artificially high interest rates” on VRDOs in the state, which was “the exact opposite of what Massachusetts hire[d] them to accomplish,” the suit says.
The high rates caused VRDO investors, typically tax-exempt money market funds, to hold onto the bonds rather than redeem them from the remarketers at face value plus interest, it says.
As a result, according to the suit, the remarketers made millions of dollars of remarketing fees each year without having to provide remarketing services. In addition, some of the banks also collected fees from issuers for serving as liquidity providers for the VRDOs, when such services were rarely, if ever, needed, according to the suit.
Because of the alleged fraudulent rate-setting activity, the suit alleges, Massachusetts, since at least April 2009, has paid more than $100 million in overcharges by paying: fees for remarketing services never provided; inflated and collectively set VRDO interest rates and; excessive fees for letters of credit that were rarely, if ever, called upon.
The complaint gives several examples of alleged collusion in robo-resetting. One is the Federal Reserve’s decision on Dec. 15, 2015, to raise the target for the federal funds rate by 25 basis points.
“Commercial paper rates, for example, responded by moving in the beginning of December from single digit rates to those [of] around 30-35 basis points,” the suit says. The “defendants … however, did not react at all for several months, and then in March suddenly and in unison drove the interest rates on the VRDOs they managed well past commercial paper rates. The delayed response cannot be explained absent collusion among defendants and other large RMA banks.”
Another example given is when Moody’s Investors Service’s telegraphed, and then actually, downgraded of Bank of America from a tier 1 to a tier 2 rating in 2012.
“The Bank of America downgrade should have caused tax-exempt money market funds to see many of their VRDOs backed by Bank of America,” the suit says. “But that did not happen.”
In April 2012, the Edelweiss principal was told by “a senior Bank of America banker [that] the defendant RMAs had gotten together during this and agreed it was best to keep investing in Bank of America-based VRDOs irrespective of ratings detail,” the suit says.
The suit seeks treble damages and penalties.
