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SEC says brokerage firm defrauded school districts

Collateralized debt obligations were intended to fund retirees' benefits

Aug. 10, 2011

U.S. securities regulators charged a brokerage firm and its former executive Wednesday with defrauding five Wisconsin school districts when it sold them risky investments as a means to fund retiree benefits, according to a complaint filed in federal court in Milwaukee.

The Securities and Exchange Commission alleges that St. Louis-based Stifel, Nicolaus & Co. and former Senior Vice President David Noack of Hartland misled the districts when they encouraged them to invest in complex financial instruments intended to generate funds needed to cover health insurance and other post-retirement benefits promised to employees.

The instruments, known as synthetic collateralized debt obligations, or CDOs, cost the districts a total of about $200 million in mostly borrowed money. The CDOs became virtually worthless after the economic crash of 2008.

The SEC investigation and subsequent charges, which have drawn national interest, are seen by the districts as validation that they were innocent victims of fraud. The charges may also help the districts in their own lawsuit against Stifel and the Royal Bank of Canada, which manufactured the investments, as they seek to recoup money lost in the deals.

One of the attorneys for the five school districts - Waukesha, West Allis-West Milwaukee, Whitefish Bay, Kimberly and Kenosha - said his clients were the guinea pigs for investments that were likely to be marketed to other districts facing liabilities from non-pension retirement benefits.

"Stifel was starting on what they called a national program, not just for the five districts in Wisconsin, but for every entity that had a trailing benefit problem," attorney Stephen Kravit said. "This was a great new idea: They had invented it themselves, found the lender in DEPFA bank, found the supplier of the CDOs in (the Royal Bank of Canada) and packed it all together in a spread. And they represented it as something as safe as U.S. Treasury bonds."

The deals started in 2006, when a European bank, DEPFA Bank of Ireland, lent about $165 million to trusts established by the districts. The districts also contributed money to the trusts, much of it borrowed. The trusts then invested the money in CDOs put together by the Royal Bank of Canada.

The districts believed they were taking only a small risk by borrowing money at rates lower than the returns they expected from the CDOs.

Warning on risks

The Journal Sentinel started reporting on the districts' involvement with the CDOs in early 2008, warning that if the investments didn't pan out, taxpayers could be on the hook for more debt.

Several experts at the time expressed concern about school districts getting involved with bundled corporate or mortgage bonds that even some of the brightest minds on Wall Street didn't completely understand.

The districts that invested in the CDOs had not hired outside advisers before engaging in the deals, the Journal Sentinel reported.

But Kravit said the five districts had every reason to act on the advice of Noack, whom they trusted because he had advised them in the past on investment matters.

According to the complaint filed by the SEC Wednesday, Stifel and Noack persuaded the districts to invest in the CDOs "through a series of falsehoods and misrepresentations." They misled them about the cost of the investments, the likelihood of defaults and the safety of the principal, the complaint says.

The complaint also says Stifel and Noack assured the districts that it would take "15 Enrons" for the investments to fail, meaning that more than a dozen investment-grade companies would have to collapse before the districts' investments would be vulnerable.

"They represented that there would be breadlines, and that the country would have to suffer an economic collapse greater than the Great Depression, before the School Districts would lose their money," the complaint says.

The complaint also says that unlike their clients, Stifel and Noack profited from the investment instruments through fees they earned.

Stifel released a statement Wednesday saying it was disappointed by the SEC's "misplaced action."

It says that the school districts acknowledged in written statements to Stifel and the Royal Bank of Canada that they were sophisticated and accredited investors, that the investments were suitable for them, that they understood the risk of the investments, and that they could withstand the total loss of the investment.

Stifel also has blamed the Royal Bank of Canada for misleading the firm about the suitability of the investments and not disclosing inherent conflicts.

Stifel filed a cross-claim against the company and attempted to amend it in June with additional information alleging the Royal Bank of Canada hid how much it was going to earn on the CDOs, which made the financial instruments look safer than they really were.

"Based on what we knew in 2006, the investments were suitable," the Stifel statement says. "With what we have uncovered in the meantime, we do not believe the product, created by RBC, was suitable for any investor."

An attorney for Noack, now a managing director in public financing for Robert W. Baird & Co., could not be reached for comment.

The school districts, Stifel, RBC and DEPFA Bank were engaged in talks as recently as last month and seemed headed toward a possible lawsuit settlement.

There will be a hearing in Milwaukee County Circuit Court on Aug. 30 about whether to allow Stifel to file its amended cross-claim against RBC.

Kravit said the school districts are also considering amending their own complaint to reflect "significant additional facts" involving RBC.

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