Derivatives deals land RBC in legal case

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The U.S. Securities and Exchange Commission is investigating subsidiaries of Royal Bank of Canada for their role in the 2006 sale of nearly $200-million (U.S.) in risky derivatives to five Wisconsin school districts – an investment rendered next-to-worthless after the financial crisis.

The sales saw the school boards, using mostly borrowed money, invest in financial products known as collateralized debt obligations (CDOs), derivatives similar to those that would later became notorious in the near-collapse of the U.S. banking system in 2008.

The deals are already the subject of a civil lawsuit. The bank, and its co-defendant, U.S. brokerage Stifel Nicolaus & Co., were in mediation talks this week in an attempt to settle the three-year-old lawsuit filed by the school boards against Stifel, Royal Bank of Canada Europe Ltd., RBC Capital Markets Corp. and RBC Capital Markets Holdings (USA) Inc.

In the lawsuit filed in 2008, the school boards accuse RBC and Stifel of fraudulently making "illegal" sales of "convoluted and opaque" derivatives, while hiding the risks and the financial products' exposure to dodgy subprime mortgage loans.

RBC and Stifel have denied the allegations, which have not been proven in court, and claim the school boards were made aware of the risks. RBC argues in a statement of defence filed in court that the school boards' losses "were caused by their own carelessness or contributory negligence." A spokesman for RBC declined to comment on the case.

Stifel has disclosed in a U.S. regulatory filing that the SEC told it in April that it could face civil fraud charges over the derivatives deals. In RBC's second-quarter report to shareholders, issued in late May, the bank said that the lawsuit "was subject to regulatory investigation" and that it was "fully co-operating with the regulatory investigation and vigorously defending the lawsuit."

The SEC declined to comment on the investigation.

According to the lawsuit, RBC and Stifel told their clients that the 2006 investments were conservative and low-risk. "There would need to be 15 Enrons before you would be impacted," the school boards say they were told.

Two years later, it wasn't 15 Enrons, but rather the financial meltdown sparked by the collapse of the U.S. housing market. The school boards had been looking for investments to help finance mounting retiree health-benefits liabilities. Instead, they ended up losing almost all of the approximately $45-million they invested directly and the more than $160-million that was borrowed to make the investment.

Mediation between the school districts, RBC and Stifel began in July, but the case is scheduled to be back before a Milwaukee judge later this month if it has not been settled.

A lawyer for the school boards, C.J. Krawczyk, said if the talks fail, his clients plan to keep fighting in court: "While we have participated in the mediation process in good faith, should it fail to produce an acceptable resolution, we look forward to presenting the evidence we have obtained in court."

Dan Callahan, a spokesman for Stifel, e-mailed a statement from the firm denying responsibility for the derivatives' collapse: "We did not create the investment product, but only served as broker in the transactions. The investments when issued by RBC were rated AA- by [Standard & Poor's Corp.] By the time the investments failed, our relationship with the school districts had been over for more than a year."

The school boards' allegations read as a cautionary tale about the excesses that led to the 2008 financial disaster, an era in which even local school boards were being sold complex derivative investments.

The lawsuit is one of several cases to emerge after the financial crisis in which U.S. banks are accused of selling highly complex derivatives dependent on mortgage-backed securities as safe bets to unsuspecting customers, despite knowing the risks. But it has been rare for Canadian banks – who enjoy a reputation for caution and prudence that spared them from the ruin that followed the crisis – to be caught up in such allegations.

In a crossclaim filed against RBC in late June, its co-defendant, Stifel, lays all of the blame for the school boards' losses at the feet of the Canadian bank, accusing it of "undisclosed conflicts and hidden profits" of the kind that were a "significant contributor to the financial crisis" as detailed in the U.S. Senate report on causes of the financial collapse. None of the claims have been proven in court.

Stifel alleges that RBC made "millions of dollars in undisclosed profits" on the school boards' investments. Stifel also accuses the bank of hiding the high risks, and of having the assets managed in the bank's interest, not the investors'.

The crossclaim, calling the derivatives a "Trojan horse," accuses RBC of hiding its profits from credit-rating agency Standard & Poor's in order to preserve the investments' positive rating and conceal its real volatility.

According to its court filing, Stifel says that, based on RBC's internal documents, the bank made profits on the school boards' investments "several times" larger than those it disclosed to Stifel. In all, Stifel alleges that RBC made $14-million, or more than the school boards' expected return, nearly nine times the $1.6-million Stifel says it made on the deals, and enough to have kept the investments from later defaulting.

RBC declined to comment on Stifel's allegations. A spokesman for the bank told The Wall Street Journal in June that Stifel's crossclaim "cannot distract from its central role in these transactions," and that Stifel had conceived of the investment program and persuaded the school boards to take part.

The five Wisconsin school boards – Kenosha Unified School District, Kimberly Area School District, School District of Waukesha, West Allis-West Milwaukee School District and Whitefish Bay School District – claim they were wrongly sold investments that were too complex and risky for them, and that RBC and Stifel should have known they were "beyond the investment knowledge or experience" of the boards.

The school boards were invited to attend an "investment meeting" in July, 2006, put on by Stifel and RBC, and Dublin-based Depfa Bank PLC, at which the boards were assured they would be protected from losses in what the lawsuit describes as a "highly misleading" presentation.

The boards say they asked and were told repeatedly that there was no exposure to subprime mortgage debt. They allege that there was, and that had they known, they would not have made the investment.

According to the lawsuit, the school boards initially put up about $35-million of their own money, and borrowed about $165-million from Depfa, sinking the money into what are known as "synthetic" collateralized debt obligations, or pools made up not only of debt instruments but also of "credit default swaps," another derivative that became infamous after the 2008 crisis. The derivatives and the arrangement were designed by RBC, and, unbeknownst to the investors, the lawsuit alleges, "carried a perpetual risk of collapse."