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Stanford Professor Stung by Bond Fund Wins $2.2 Million

A First Republic Bank unit was ordered to pay a retired Stanford University professor and his wife $2.18 million after arbitrators found the firm gave them only a “fleeting and slapdash” explanation of a municipal bond fund that imploded during the credit crisis in 2008.

Eight months after Elliott and Rhoda Levinthal entrusted $3 million to a leveraged investment vehicle called TW Tax Advantaged Fund LLC, it collapsed, an American Arbitration Association panel wrote in a July 2 ruling. Evidence shows workers at First Republic didn’t try to fully grasp risks in the fund they designed, the panel found. The firm also inadequately trained a saleswoman who dealt with the Levinthals, and didn’t ensure they understood the investment.

The education offered to the Levinthals “was fleeting and slapdash,” arbitrators wrote. “An investment in a highly complex and concededly risky product like the fund, sold in this fashion, is by definition unsuitable” for someone with their experience and objectives.

Greg Berardi, a spokesman for the San Francisco-based company, declined to comment. Bank of America Corp. acquired First Republic Bank while buying Merrill Lynch & Co. last year, and sold it last week to an investor group that included founder James H. Herbert II.

Elliott Levinthal, 88, is a professor emeritus of mechanical engineering at Stanford. He and his wife endowed Levinthal Hall, a lecture hall at the Stanford Humanities Center.

Compensatory Damages

The panel ordered First Republic Securities to pay the couple and their trust $2.1 million in compensatory damages, plus $78,153 in fees and expenses.

About 35 retail mutual funds marketed as leveraged municipal arbitrage strategies have failed in recent years, said Craig McCann of the Securities and Litigation Consulting Group Inc., a Virginia consulting firm that testified for the Levinthals in the arbitration. Brokerage firms sold the funds as “higher-yielding alternatives to conventional municipal bond portfolios with little, if any risk,” he said in a 2009 report.

Funds using the strategy contended that the market had historically mispriced the yield on municipal bonds compared with taxable bonds. Exploiting that difference to create a profit relied on hedging long-term municipal bond positions with taxable, shorter-term interest-rate swaps. When long-term municipal bond yields rose in 2007 and 2008 faster than short- term rates declined, the strategy failed and portfolios of many funds were liquidated, according to the report written by McCann and four colleagues.

Less Liquid

The strategy ignored more than 30 years of research showing that municipal-bond yields tend to be higher on a tax-equivalent basis because most such bonds are callable and less liquid than corporate bonds, which also are mostly non-callable, the report said.

The Levinthal case is probably the largest individual award related to the municipal arbitrage strategy, McCann said in an interview. Citigroup said in March 2008 it would provide $1 billion to bail out six of its leveraged municipal bond funds, sold under the names ASTA and MAT.

“First Republic Investment Management created and managed the fund, and it was sold through First Republic, but we learned that they had never run a fund like this before,” said Cary Lapidus, a San Francisco lawyer who represented the Levinthals. The fund was only sold to clients of First Republic, which caters to high-net-worth customers at 57 offices in five states, he said.

While the Levinthals received written materials that explained the fund’s risks, those disclosures didn’t fulfill First Republic’s obligations, arbitrators said.

“An investor may put his or her head in the sand, but only after the professional has done everything within reason to bring to the investor a full, fair and balanced understanding,” the panel wrote.

To contact the reporter on this story: David Mildenberg in Charlotte at dmildenberg@bloomberg.net.

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