The U.S. Securities and Exchange Commission sued broker Stifel, Nicolaus & Co. for fraud, claiming it misled five Wisconsin school districts about the risks of complex investments that wiped out $200 million.
Stifel and David Noack, a former executive, masked the risks in persuading the schools to buy notes tied to synthetic collateralized debt obligations, or CDOs, a type of derivative linked to corporate bonds, the SEC said today in a complaint brought against the two in U.S. District Court in Milwaukee.
While the schools lost their entire investment, Stifel and Noack, 48, received “significant fees,” the agency said in a statement. The districts used $37.3 million of their own cash and borrowed $162.7 million to invest in the securities in 2006, trying to produce earnings to help pay retiree health costs. The SEC said the firm and Noack misled officials about the risks of products typically sold to hedge funds, banks and insurers.
“Stifel and Noack abused their longstanding relationships of trust with the school districts by fraudulently peddling these inappropriate products to them,” Elaine Greenberg, head of the SEC’s unit that handles municipal bond cases, said in the statement. “They were clearly aware that the school districts could ill afford to bear the risk of catastrophic loss.”
Stifel Financial Corp. (SF), the broker’s St. Louis-based parent, fell $2.72 a share, or 9.5 percent, to $25.88 at 4:15 p.m. in New York Stock Exchange composite trading after dropping as much as 19 percent, the most in more than 19 years.
Stifel said the notes were rated AA- when they were sold to the districts and faulted RBC Capital Markets, a New York unit of Toronto-based Royal Bank of Canada, for the loss. The bank and its affiliates created the investments, according to the SEC, which didn’t accuse the bank in its complaint.
“Based on what we knew in 2006, the investments were suitable,” Stifel said in a statement. “To allege in 2011 that Stifel should have foreseen the 2008 economic collapse, the structural flaws in derivatives which caused billions of dollars in losses, as well as the misrepresentations and conflicts Stifel believes RBC hid from it and the school districts, is 20/20 hindsight.”
The districts acknowledged in writing that they were “sophisticated” investors who understood the risks of the products and who could withstand losses, Stifel said. AA- is Standard & Poor’s fourth-highest credit rating.
“We take exception to Stifel’s attempt to deflect blame without acknowledging their own, central role in the school districts’ losses,” Kevin Foster, an RBC Capital spokesman, said by e-mail. He said Stifel created the investment program, asked Wall Street banks to participate and sold it to the districts, while representing to RBC that it was suitable.
Ron Kane, a lawyer for Noack, didn’t return telephone calls seeking comment. A call to a telephone number listed in Noack’s name in Hartland, Wisconsin, went unanswered.
The SEC action follows lawsuits by the school districts and a government initiative to crack down on municipal securities fraud. The agency has also brought other cases tied to CDOs, including suing Goldman Sachs Group Inc. last year.
Stifel and Noack persuaded the school districts to invest in the derivatives, providing a kind of insurance on the underlying assets.
Publicly Funded Insurance
“In effect, Stifel and Noack persuaded the school districts essentially to insure the performance of a select group of corporate bonds, and do so with public funds,” the SEC said in its complaint.
The districts -- serving Kenosha, the Kimberly area, Waukesha, West Allis-West Milwaukee, and Whitefish Bay -- were sold the investments as a means to help cover retiree health costs that they hadn’t set aside money to fund, the SEC said.
The investments, in three transactions from June to December 2006, were unsuitable for the districts, which had no experience with CDOs and related instruments, the SEC said. The agency said that Noack also misled district officials about the chances of failure for the investments.
Stifel and Noack knew the districts lacked the sophistication and expertise to evaluate the risks they were taking, relying instead on recommendations from the company and Noack, the SEC said.
Noack also gave “sweeping assurances” as to the safety of the investments, the SEC said. In one instance, Noack and the company said that 100 of the top 800 companies in the world would have to go under before the school districts would lose their principal, according to the complaint. They also told the districts it would take the collapse of “15 Enrons” for the investments to fail, a reference to Enron Corp., the Houston energy trader that went bankrupt in December 2001.
“Let this be a teaching moment for sellers of complex financial products,” Robert Khuzami, director of the SEC’s Enforcement Division, said in the statement. Those who push such investments must meet standards of disclosure and ensure the suitability of the products for the buyer, 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,” he said.
The case is Securities and Exchange Commission v. Stifel Nicolaus & Co Inc., 11-cv-00755 U.S. District Court, Eastern District of Wisconsin (Milwaukee).
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