Regulators Slam Brokerage Firm for Fraudulent Investment Fund

Jack Humphrey, Regulatory journalist
August 10, 2011 /

The Securities and Exchange Commission has charged St. Louis-based brokerage firm and a former senior executive with defrauding five Wisconsin school districts by selling them unsuitably risky and complex investments whose funds came from borrowed money.

In a complaint filed in federal court in Milwaukee, the SEC said that Stifel, Nicolaus & Co. and Senior Vice President David Noack “created a proprietary program to help the school districts fund retiree benefits by investing in notes linked to the performance of synthetic collateralized debt obligations (CDOs).”

Five school districts, including Kenosha Unified School District No. 1, Kimberly Area School District, School District of Waukesha, West Allis-West Milwaukee School District, and School District of Whitefish Bay, established trusts that invested $200 million in three transactions from June to December 2006, funded with borrowed money. The complaint noted that the brokerage firm and Noack sold the school districts an unsuitable product “that did not meet their investment needs.”

It can be noted that among previous SEC enforcement actions related to the offer and sale of CDOs include cases against Goldman Sachs, ICP Asset Management, J.P. Morgan, and Wachovia Capital Markets.

The complaint added that the brokerage firm and Noack misrepresented the risk of the investments and failed to disclose material facts to the school districts, which includes the portfolio in the first transaction performing poorly from the outset, credit rating agencies placing 10 percent of the portfolio on negative watch within 36 days of closing, and certain CDO providers expressing concerns about the risks of Stifel’s proprietary program and declining to participate in it.

“In the end, the investments were a complete failure, but generated significant fees for Stifel and Noack,” the complaint stated.

“Let this be a teaching moment for sellers of complex financial products,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

“The sale of these products to school districts or similar investors must meet well-established standards of suitability and accurate disclosure. Stifel and Noack violated these standards and jeopardized the ability of the school districts to fund operations and provide a quality education to students.”

Elaine Greenberg, Chief of the SEC Division of Enforcement’s Municipal Securities and Public Pensions Unit, added: “Stifel and Noack abused their longstanding relationships of trust with the school districts by fraudulently peddling these inappropriate products to them.

“They were clearly aware that the school districts could ill afford to bear the risk of catastrophic loss if these investments failed.”

Stifel and Noack allegedly violated Section 17(a) of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934. The SEC is seeking permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest, and financial penalties

The SEC alleged that Stifel and Noack assured the school districts that it would take “15 Enrons” — a catastrophic, overnight collapse — for the investments to fail.

They also misrepresented that 30 of the 105 companies in the portfolio would have to default and that 100 of the top 800 companies in the world would have to fail before the school districts would suffer a loss of their principal.

The school districts had no prior experience with investing in CDOs and related instruments and lacked the requisite sophistication and experience to independently evaluate the risks of the investment.

According to the SEC, the brokerage firm knew that the school districts relied on Stifel and Noack’s recommendations that the school districts contribute $37.3 million toward the $200 million investment and borrow the remaining $162.7 million.

The SEC further claimed that the heavy use of leverage and the structure of the synthetic CDOs exposed the school districts to a heightened risk of catastrophic loss.

The investments fell in value in 2007 and 2008 as heavy series of downgrades pounded the CDO portfolios. By 2010, the school districts learned that the second and third investments were a complete loss and that the lender had seized all of the trusts’ assets. The school districts suffered a complete loss of their investment and suffered credit rating downgrades for failing to provide additional funds to the trusts they established.


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