According to a recent article in the Atlanta Journal Constitution, “at least a dozen local governments and other institutions that used derivative deals called swaps to try to lower the cost of bond issues have ended up owing as much as $394 million in fees to the Wall Street investment banks that set up the deals’.” AJC, 5/30/10, “Paying a Price for Risky Schemes.” That article looked at how much money a small number of governmental and institutional investors in Georgia have paid to buy their way out of interest rate swaps in the wake of the financial crisis, but it is likely that this is a nationwide phenomenon. The article raised a number of questions?including whether it was appropriate for taxpayer money to be invested in securities with such a high level of risk?but it did not raise the question of whether there are legal remedies that would allow government officials and others to recover the financial losses resulting from such investments.
Interest swaps are complex derivative securities that were purchased by public bond issuers to help lower interest costs paid on their bond debt. Rather than paying a fixed interest rate of 4% on a bond sold to finance a hospital or other project, a municipality would issue a variable rate bond with a rate that would rise and fall with market conditions. Many of those variable rate bonds were auction rate securities, meaning that the rate was determined by periodic auctions held by Wall Street firms every 7 to 35 days. At any given time, variable rates are generally lower than fixed rates because the rate has the ability to go up with the market while a fixed rate remains the same throughout the life of the bond?typically for 20 to 30 years?and because the auction process allowed holders of auction rate securities to liquidate at weekly to monthly intervals without tying up their money long-term. After issuing a variable rate bond, the municipality or other institution would then hedge against the risk of high interest rates by purchasing a “swap,” which is an agreement under which the bond issuer makes a fixed interest payment to an investment bank in return for a variable rate payment made by the bank to cover the bond cost. In essence, the municipality is taking a chance on future interest rates by issuing a variable rate bond, and it is insuring against the risk of higher rates by swapping payments with an investment bank that is hopefully able to absorb that risk.
In theory, the variable swap payments should offset the variable bond payments, leaving the city with a fixed debt payment to the bank at a lower rate. But events of the financial crisis caused interest rate swaps and other derivatives to go sour. The auction rate securities market froze up completely in February 2008, resulting in the illiquidity of many variable rate bonds and preventing interest rates from being reset. The auction failures triggered fail rates in the offering documents that caused many rates to be reset under formulas tied to LIBOR or other benchmarks?which meant that many bond issuers either had to refinance their bonds or be stuck with higher interest payments. It didn’t help that some of the Wall Street firms involved in the swap deals went under?notably Lehman Brothers, which was a party to many swaps. And because there was an overall decline in market interest rates as the crisis deepened, the value of the swaps increased dramatically ? as did the costs of getting of getting out of them. Out of the $394 million in losses incurred by the institutions named in the AJC article, approximately $100 million was paid to Wall Street firms just to cancel swap deals that had gone bad?meaning that the same firms who got paid to set up these swaps were also paid to let investors out of them.
Between the costs of refinancing, the fees paid to cancel sour swap agreements, and the losses absorbed by continuing to making payments on bad swaps that could not be exited, municipal bond insurers in metro Atlanta alone have been spent hundreds of millions of dollars as a result of an investment vehicle that was intended to save them money. Like any investor, a municipality is entitled to full disclosure of the risks of any investment recommended by a securities broker-dealer or investment adviser. Had local government officials been advised of the risk that the payments they received on interest rate swaps might not cover their variable rate bond payments?or that such risk was increasing due to developments in the market in the months leading up to the financial crisis?would they have agreed to assume the risk? It is unlikely, but that is a question that must be asked on a case-by-case basis in determining whether an investor has legal recourse to recover its losses.
In addition to the duty to disclose material risks, a broker-dealer or investment adviser has a legal duty to recommend only those investments that are suitable?both from a general market standpoint as well as in the context of the investment objectives and risk tolerance of the specific client in question. It is hard to imagine that it would be a suitable investment for a municipal government or other steward of public funds to risk tens of millions of dollars just to shave a few basis points off its bond interest payments. The suitability of these swaps is even more questionable in situations where there is a fiduciary relationship between the municipality and the broker or adviser, which can either be created by contract or by circumstances giving rise to a relationship of confidence and trust, that imposes upon the broker/adviser a duty to act in the client’s best interest. Considering that municipalities are run by elected officials who are typically not financially sophisticated?and are certainly not sophisticated securities investors when it comes to understanding complex derivatives?it is natural that they would be forced to rely upon the expertise of financial professionals, whom they reasonably expect will act in accordance with the highest professional standards.
According to Page Perry partner Craig T. Jones, “it would behoove all of the institutions named in the AJC article?as well as any others who have suffered substantial losses from interest rate swaps or other derivatives?to conduct a full assessment of their legal options. If swaps were recommended or sold by brokers, advisers or investment bankers who gained financially from these transactions, then legal counsel should take a close look at the representations that were made?as well as the facts that were not disclosed?in the negotiations leading up to these investments.” Page Perry focuses its practice on the representation of individual and institutional investors, many of whom have brought claims relating to losses from derivatives and other complex securities in the wake of the financial crisis.