Some of the biggest names in the financial industry face a proposed class action over an alleged years-long price-fixing conspiracy to set and reset the interest rates of Variable Rate Demand Obligations (VRDOs) issued by public entities in California.
Barclays, Goldman Sachs, JP Morgan, Morgan Stanley, Bank of America, Merrill Lynch, Citi Bank, the Royal Bank of Canada, Wells Fargo and a stable of the companies’ subsidiaries are alleged in the 71-page lawsuit to have engaged in a scheme whereby they convinced cash-strapped public entities in California to issue highly specialized bond instruments that, in a properly functioning market, would provide the entities with the benefit of long-term financing at lower short-term interest rates.
The defendants, the complaint alleges, conspired to then manipulate those rates in order to protect themselves from losses and “preserve the integrity of their own books.” Put another way, the defendants’ scheme, the lawsuit says, was “rigged to benefit Wall Street at the expense of multiple California City Halls and Main Streets,” in particular by “repeatedly, surreptitiously, and illegally conspiring to manipulate the rates of VRDOs” in violation of federal and California antitrust laws.
The case alleges the defendants, listed at the bottom of this post, reaped as a result of the apparent scheme unlawful profits in the form of fees paid in exchange for “doing little more than nothing.” Moreover, the defendants were paid, among other improper profits, fees for serving as providers for letters of credit that would not be drawn down to the same extent had they not “illegally colluded to keep VRDO rates high,” according to the suit.
According to the lawsuit, VRDOs are long-term debt instruments that cities, municipalities, political subdivisions and other governmental entities, such as the plaintiff, the Board of Directors of the San Diego Association of Governments, issue to raise funds, typically to finance projects, capital investment or operations. Most VRDOs, as with other municipal debt instruments, are tax-exempt for investors, which makes the instruments “particularly attractive investments,” the case relays. Unlike other long-term debt instruments, however, the interest rate of VRDOs reset periodically, typically weekly and more commonly on Tuesdays or Wednesdays, the suit says.
Although VRDOs are long term as far as the issuing entity is concerned, the weekly interest rate reset and an inherent “put” feature allow and cause investors to treat VRDOs as low-risk, short-term, highly secure, liquid securities, the lawsuit continues. More specifically, the “put” feature allows a VRDO holder to “put” the instrument back to the issuer or liquidity provider, or essentially sell the VRDO back at “par value” plus accrued interest, according to the case. Issuers and investors theoretically benefit from structuring VRDOs in such a way that issuers can raise cash and keep it for the long term, while paying only short-term interest rates, while investors receive in exchange a security that is highly liquid and secure, not to mention tax-exempt, per the suit.
The plaintiff and proposed class members contract with and hire financial institutions such as the defendants to manage the issuance, sale, repurchase and resetting of the interest rates for VRDOs, the lawsuit explains. Banks tasked with these jobs are called “remarketing agents” (RMAs), and their duties include finding initial VRDO buyers, managing the weekly rate resets, and finding new VRDO purchasers when the VRDOs are tendered, or “put,” back by an investor, the case states. Per the complaint, RMAs receive substantial fees from VRDO issuers, and are contractually obligated to set the interest rate for each VRDO issuance as low as it can go to allow the bonds to trade at par.
“This is exactly how each of the Defendants marketed themselves to Plaintiff and the Class: you get the financing you need; we do the rest,” the suit alleges.
The case explains that because the majority of VRDOs are purchased by money market mutual funds (MMFs)—funds that hold only highly liquid, short-term investments—and because many of the same institutions that act as RMAs also own MMFs that invest in VRDOs, there exists an obvious conflict of interest that leads proposed class members to receive the short end of the stick. From the complaint:
“These financial institutions play both sides of the VRDO market. The conflict of interest is obvious: on the one hand, issuers, including Plaintiff, hope to pay the lowest interest rate possible to minimize their interest expense, and RMAs promise to help them so that they pay the lowest interest rates possible; on the other hand, investors (MMFs) hope to receive the highest interest rate possible. Unfortunately for the issuers, RMAs—who tend to be affiliates of MMFs—have the right to unilaterally set the interest rates that MMFs receive. Until the U.S. Department of Justice began investigating the RMAs, including Defendants, for their collusive and illegal conduct, RMAs colluded to artificially inflate those rates at the expense of the issuers.”
Another benefit reaped by RMAs as a result of inflated VRDO rates is the reduced likelihood that investors would ever exercise their “put” option and force the RMAs to find new buyers for the VRDOs, the case says. Throughout all of it, the RMAs continue to collect fees for their role as remarketers, “even though their unlawful actions dramatically reduced the likelihood of the RMAs ever having to actually remarket the VRDOs,” the lawsuit claims.
The suit goes on to allege the defendants found “one additional method to extract bogus fees from issuers” in the form of backstop letters. Per the lawsuit, most VRDO issuances require a backstop letter of credit to provide liquidity to investors in the event an investor puts a VRDO back to the entity providing liquidity and the RMA is unable to find a new buyer.
The complaint relays that “[t]he same financial institutions that served as RMAs, and that owned MMFs, also frequently served as providers of letters of credit to VRDO issuers.” Being the provider of these letters has given financial institutions another benefit from the artificial inflation of VRDO interest rates, namely the lower likelihood that investors would put the VRDOs back, meaning the lower likelihood of the letters of credit being drawn down to repurchase the VRDOs as the liquidity provider of last resort, according to the complaint.
“The financial institutions would still collect fees from providing these letters of credit, even though they illegally took actions to reduce the likelihood that the letters of credit would ever be drawn down,” the suit reads.
As a result of the foregoing, the defendants improperly profited by way of receiving fees for acting as RMAs when, in fact, they did little more than nothing for proposed class members’ benefit. Moreover, the defendants received fees for serving as providers of letters of credit that would not have been drawn down to the same extent absent their apparent collusion over keeping VRDO interest rates high, the case claims. Further still, the defendants were able to provide their MMF affiliates with securities paying inflated interest rates that the lawsuit says were “higher than short-term, municipal securities should have paid,” and leveraged these relationships to obtain significant fees by selling VRDO issuers highly profitable derivative products, the lawsuit charges.
More from the complaint:
“An economic analysis confirms that Defendants were engaged in a conspiracy to artificially inflate VRDO interest rates. The analysis clearly shows that the conspiracy began in 2008 and ended in 2016 at nearly the exact same time that the U.S. Department of Justice began investigating Defendants for their unlawful VRDO practices. During that period, VRDO rates were about equal with the rates of seven-day taxable commercial paper even though the former are tax-exempt. Such a relationship defies economic logic.”
In all, the defendants’ conduct has caused the plaintiff and proposed class members to not receive the services for which they paid and pay higher interest rates than they should have, the suit claims. Additionally, the defendants’ actions, according to the complaint, have caused less money to be available to “a multitude” of California public entities to finance their projects, initiatives and operations.
“Absent their illegal collusion, Defendants would have competed with one another to set the lowest possible rates on each VRDO, and the most competitive of them would have earned more business,” the suit reads. “Unfortunately, however, Defendants elected to conspire to eliminate competition to the benefit of the cartel they had formed—a flagrant violation of federal and California antitrust laws and other applicable law.”
Named as defendants in the proposed class action are Bank of America Corporation; Bank of America, N.A.; Banc of America Securities LLC; Merrill Lynch; Pierce, Fenner & Smith Incorporated; Barclays Bank Plc; Barclays Capital Inc.; Citigroup Inc.; Citibank, N.A.; Citigroup Global Markets Inc.; Citigroup Global Markets Limited; Goldman Sachs & Co. LLC; JPMorgan Chase Bank, N.A.; J.P. Morgan Securities LLC; Morgan Stanley; Morgan Stanley Smith Barney LLC; Morgan Stanley & Co. LLC; Morgan Stanley Capital Group Inc.; the Royal Bank of Canada; RBC Capital Markets, LLC; Wells Fargo Bank, N.A.; Wachovia Bank, N.A.; Wells Fargo Funds Management, LLC; and Wells Fargo Securities LLC.
The suit looks to represent a proposed class of all persons and entities in or based in California that paid interest charges or fees related to VRDOs for which the defendants either served as an RMA or letters of credit provider, or both, from February 1, 2008 to June 30, 2016.
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