Where are the market crisis cases is a long standing
question. There have been investigations. Some cases have been brought. Some
investigations have been closed. Still, the question remains - where are the
market crisis cases?
The Commission filed a new market crisis case. It may be
among the most significant brought by the agency. SEC v. Stifel, Nicolaus
& Co., Civil Action No 2:11-cv-00755 (E.D. Wis. Filed Aug. 10, 2011) is
the sad tale of five Wisconsin school districts searching for ways to maximize
their limited resources to cover unfunded employee liabilities. To try and
cover them they made investments in supposedly safe securities. In fact they
were highly leveraged, risky, esoteric vehicles. The school districts relied on
a trusted financial adviser and his firm. The adviser unfortunately had little
knowledge of the risky investment he recommended. The firm did know but sold
the securities. Now there are millions in losses.
The defendants are Stifel, Nicolaus & Co., Inc., a
retail and institutional brokerage and investment banking firm based in St.
Louis Missouri, and David Noack, a senior vice president of the firm and
co-head of its Milwaukee office. The investors are five school districts:
School District of West Allis-West Milwaukee; Kenosha School District No. 1;
School District of Waukesha; Kimberly Area School District; and School District
of Whitefish Bay.
Mr. Noack had a long standing working relationship with
the five school districts, according to the complaint. Each considered him its
financial adviser. Each had a pattern of following his advise. Each had
significant unfunded liabilities for post employment benefits for its
employees. Stifel and Mr. Noack were well aware of these unfunded liabilities.
In late 2005 and early 2006 Stifel and Mr. Noack created
what they called the GOAL program to address the unfunded liabilities. The
centerpiece of this program was leveraged investments linked to collateralized
debt obligations. Specifically, the program called for the school districts to
invest largely borrowed funds in notes tied to the performance of synthetic
CDOs comprised of a portfolio of 100 or more credit default swaps on corporate
bonds. In essence the program called for the school districts to insure the
performance of a select group of corporate bonds with public money.
Prior to the creation of the GOAL program Mr. Noack had
no experience with CDOs. By the time of the first investment by one of the
School Districts in mid-2006 he had a general familiarity with the product. The
firm knew that he had limited knowledge of CDOs. It also understood that
products such as those in the GOAL program were typically purchased by
sophisticated investors such as hedge funds. The five school districts, in
contracts, were unsophisticated, risk adverse investors who relied on the firm
and Mr. Noack for investment advise, facts well known to the defendants.
To induce the school districts to invest in the GOAL
program Mr. Noack represented that the investment was "Treasury-like" and
virtually risk free. Pharses such as it would take "15 Enrons" for the
investment go bad before the school districts would lose their money were used
in presentations. Mr. Noack repeatedly assured his clients that the investments
In fact Mr. Noack's claims were false In fact the
investments were high risk and highly leveraged. Of the $200 million ultimately
invested by the school districts only $37.3 million came from their funds. The
other $162.7 million was borrowed. The highly leveraged structure increased the
potential return, but magnified the downside risk - and the fees to the
defendants. That risk was intensified by the fact that portfolio losses of only
5 to 6% would result in investor losses and the fact that there was only a 1%
difference between a complete recovery and complete failure. In any event, even
if the program was a complete success, it would have only covered a small
fraction of the unfunded liabilities of the school districts. Failure in
contract would result in millions of dollars in losses.
The initial investments by the school districts
immediately suffered difficulties. Rather than telling his clients these facts,
Mr. Noack falsely stated that they were performing as expected. He then induced
the five school districts to make additional investments. Ultimately the
program collapsed. The lending bank took all of the investments. The five
school districts lost all of their investments. There were millions of dollars
in losses. The firm kept its fees.
The complaint alleges that the defendants "knowingly or
recklessly recommended an unsuitable product that did not meet the investment
needs of the School Districts." The defendants knew this and, nevertheless,
recommended esoteric products which were only suitable for sophisticated
investors using a series of misrepresentations to sell the securities,
according to the complaint. It alleges violations of Securities Act Section
17(a) and Exchange Act Sections 10(b), 15(c)(1)(A). The case is in litigation.
Program: Current Trends in
FCPA Enforcement, August 17, 2011, Live in Menlo Park, CA, and webcast
nationally. The program link is here.
For more cutting edge commentary on
developing securities issues, visit SEC Actions, a
blog by Thomas Gorman.
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