Winning the Battle Only to Lose the War?

Many incredible and interesting stories have emerged from the economic turmoil of the past few years. One story that has intrigued me since I first read about it in late 2008 is that of five Wisconsin school districts that invested in collateralized debt obligations (CDOs) on a leveraged basis and lost approximately $200 million. The story underscores the confusion surrounding CDOs and the almost blind faith with which investors made investment decisions prior to the crisis. (For one of my prior posts on this story, see here.) For example, the school districts apparently thought they were investing in corporate bonds and did not understand the insurance-like nature of their investment in synthetic CDOs. As the school districts later discovered, however, they actually invested in a pool of credit default swaps that insured against defaults on certain bonds. (For helpful diagrams of synthetic CDOs, see here and click “Profits in Crisis” link in this New York Times article.)

Given the nature of synthetic CDOs, the school districts would make money (from premiums paid by credit risk protection buyers) as long as the underlying bonds were performing. If those bonds defaulted, however, the school districts’ investment would be used to pay the credit risk protection buyers, leaving the districts with nothing. We of course all know what happened, and like many investors who lost everything, the crisis left the school districts in a liquidity crunch, facing budget cuts and looking for answers. As one of the districts’ teachers explained, “I am really worried. . . . If millions of dollars are gone, what happens to my retirement? Or the construction paper and pencils and supplies we need to teach?” (See here.)

The Wisconsin school districts sued Stifel Nicolaus & Co. and Royal Bank of Canada for, among other things, alleged fraud and misrepresentation in connection with the districts’ investments. According to the districts’ complaint, “[T]hey were told that ‘15 Enrons’ would need to happen before the districts would be affected, none of the CDO’s had sub-prime debt, and the investments were ‘safe’ and ‘conservative.’”  (See here.)  At the end of last month, Milwaukee County Circuit Judge William W. Brash III denied Stifel’s and Royal Bank of Canada’s motions to dismiss on all counts. But as one of Stifel’s lawyers noted after the ruling, now the districts have the difficult and expensive task of proving their allegations. (This sentiment was echoed by Stifel’s CEO in an interview on CNBC last week, see here (comments come at end of interview).) Indeed, the litigation has already been very costly for the districts (see here).

So what does this small victory mean for the districts? Do they really have viable claims against Stifel and Royal Bank of Canada, or is this simply a human reaction by the judge to public empathy for the districts? Perhaps it is similar to some of the judicial reaction to the Enron and WorldCom scandals, where courts appeared to lower entry barriers for litigants even though the ultimate standards for liability remained the same. (For a discussion of that reaction, see here.) And if that is the case, at what cost does this victory come? It will be interesting to watch the resolution of this and other crisis-related lawsuits to see if litigants achieve any meaningful relief.

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