Aug. 1 (Bloomberg) -- Bank of America Corp. and BNP Paribas were sued by a California university that alleges the banks conspired to overcharge the school for $84.2 million of interest-rate derivatives.

Biola University, a Christian college founded in 1908 as the Bible Institute of Los Angeles, said it was misled by Bank of America and BNP Paribas into believing that it paid a fair price for four derivatives it bought in 2002 and 2004. The contracts were tied to tax-exempt bonds the college sold, according to a lawsuit the university filed yesterday in U.S. District Court in Los Angeles.

Bank of America, the second-biggest U.S. bank, is among more than a dozen banks, brokers and insurance companies that have been subpoenaed by the U.S. Justice Department in the widest-ever criminal probe of the municipal market.

``If the facts are as the plaintiff alleges, it would seem to be the type of pattern that Justice is reported to be investigating,'' said Christopher ``Kit'' Taylor, former executive director of the Municipal Securities Rulemaking Board, the tax-exempt market's regulator.

The government is investigating anti-competitive practices in the business of selling investments and unregulated derivatives to states, local governments and other tax-exempt borrowers that have $2.4 trillion of debt outstanding.

Damages Sought

Bank of America, which in January agreed to cooperate with the Justice Department in exchange for amnesty, declined to comment on the suit, said Shirley Norton, a spokeswoman for the Charlotte, North Carolina-based company. Kerrie McHugh, a spokeswoman for Paris-based BNP Paribas, France's biggest bank, also declined to comment. Richard W. Chisholm, a Bank of America employee also named in the suit, didn't return a phone call seeking comment.

``The charges involve a very serious case of fraud by some very large financial institutions against a small nonprofit educational institution,'' said Sylvia Scott, a partner with Freeman, Freeman & Smiley LLP in Los Angeles, which is representing Biola.

The university is seeking $25 million or more in compensatory and punitive damages, said Scott, a former prosecutor with the U.S. Securities and Exchange Commission, NASD and Justice Department.

David Koontz, the university's finance director, wasn't available for comment, said Chelsea Shelby, an employee in his office. She referred questions on the matter to the university's lawyer.

Concerns Raised

The SEC's top municipal bond official, Martha Haines, raised concerns earlier this year that some borrowers may be using derivatives without understanding what they have committed to on the advice of bankers who profit from the deals. Derivatives are financial contracts whose value is determined by another security, such as a municipal bond, index or commodity.

Biola said it purchased the financial instruments on the advice of Bank of America, a bank it had worked with for more than two decades.

Biola, located in La Mirada, describes its mission as ``biblically-centered education, scholarship and service -- equipping men and women in mind and character to impact the world for the Lord Jesus Christ.'' The school has 5,700 students and offers undergraduate degrees as well as graduate degrees in theology, education, psychology, business, professional studies and intercultural studies.

Swap Agreements

The lawsuit centers on the university's purchase of a ``synthetic fixed-rate'' derivative, a product used by borrowers seeking to lower their interest bill. A borrower sells bonds that carry a variable rate. It then agrees to pay a bank a fixed rate on the amount it borrowed and receive a floating rate in return.

The university agreed to do the swaps when it sold bonds in deals managed by Bank of America in 2002 and 2004. In 2002, it sold $59.6 million of variable-rate bonds and purchased derivatives from BNP Paribas. The bonds were sold through the California Statewide Communities Development Authority, an agency that sells bonds on behalf of tax-exempt borrowers in the state.

The university agreed to pay 5.34 percent on $24.6 million of the bonds, and 5.1 percent on $35 million of bonds, in exchange for floating rates through 2032. The fixed rates were excessive, according to the lawsuit, even though BNP Paribas certified they were in line with market prices at the time.

Secret Deal

Then, without the university's knowledge, Bank of America engaged in a transaction that enabled it to share the profit earned by BNP Paribas, the lawsuit alleges. In a transaction mirroring BNP Paribas's swap with the university, BNP Paribas agreed to pay Bank of America the fixed-rate payments it would receive from the university in exchange for the floating-rate payments it owed. BNP Paribas also received an upfront payment of $2.58 million from Bank of America.

``These `upfront fees,' which were in actuality kickbacks, were funded by excessive profits extracted from Biola on the swap transactions, and possibly the excessive underwriting fees the Bank of America defendants charged Biola on the related bond issuances,'' the suit claims.

Under the arrangement, BNP Paribas kept the risk that the university would fail to make its payments, though the suit claims that payments are far more than what would be appropriate to compensate the bank for that risk. The suit also claims Bank of America made payments to others who had no role in the transaction, without disclosing their identities.

Payments Made

In 2002, Bank of America fired an employee in its municipal derivatives department after he told his manager that he paid a total of $182,393 to CDR Financial Products, a Beverly Hills, California-based broker, and two rival banks on transactions in which they played no role, according to records from the NASD and North Carolina's state court in Mecklenburg County. The payments were reported in a Bloomberg article on Oct. 4, 2006.

The agreement between Bank of America and BNP Paribas came to light when the Internal Revenue Service probed the transaction and determined it ran afoul of tax laws. That allowed BNP Paribas to reduce the size of the floating-rate payment it made to the university, resulting in losses to the college of more than $246,000, the suit alleges.

Biola claims in the suit that it was also overcharged for two swaps totaling $24.6 million in 2004 that didn't involve any side deals. Bank of America provided one swap and BNP Paribas the other.

``These are complex products,'' said Taylor. ``People need to understand them fully, because there are risks associated with using those products.''

Task Force

The IRS has set up a task force to examine potential overpricing payments for derivatives. It has also uncovered kickbacks between banks that handle the investment of municipal bond proceeds and brokers ``in multiple examinations,'' according to a June 28 letter to U.S. Senator Charles Grassley, by former IRS commissioner Kevin Brown on tax-exempt compliance issues.

The city of Atlanta disclosed in 2005 that the IRS was probing whether a behind-the-scenes swap between Bank of America and CDR Financial Products diverted money that should have gone to the federal government.

May Settlement

Biola University isn't the first borrower in the tax-exempt debt market to allege price gouging on interest-rate swaps.

In May, Rice Financial Products Co., a New York-based investment bank and derivatives broker agreed to settle allegations that it defrauded a Los Angeles-area water agency on two interest rate swaps the agency entered into in 2001 and 2003. The West Basin Municipal Water District alleged Rice earned profits of 500 percent to 1,500 percent above similar derivative transactions. Rice didn't admit wrongdoing.

Bloomberg News reported in an August 2005 article that Jefferson County, Alabama, paid fees of $100 million to JPMorgan Chase & Co. and other banks on 11 interest rate swaps, about two times the fees collected by banks for similar deals. Jefferson County's transactions are under investigation by the SEC.

The case is Biola University Inc. v. Bank of America Corporation, Banc of America Securities LLC, Bank of America N.A., Richard W. Chisholm, BNP Paribas, U.S. District court for the Central District of California (Los Angeles) CV-07-4917.

To contact the reporter on this story: Martin Z. Braun in New York at Mbraun6@bloomberg.net; William Selway in San Francisco at wselway@bloomberg.net.

Last Updated: August 1, 2007 13:30 EDT