MEMORANDUM

To: Saqib Bhatti, ReFund America Project at the Roosevelt Institute

From: Ross Wallin
212 755 7876
rwallin@graisellsworth.com
Bradley Miller
212 897 9499
bmiller@graisellsworth.com
Date: October 9, 2014
Re: Potential Claims by Public Issuers of Synthetic Fixed-Rate Debt
As you requested, we have considered potential claims that public entities may have under the
Municipal Securities Rulemaking Boards fair dealing rule, Rule G-17, concerning the interest rate
swaps and related securities transactions that many public issuers entered into as part of complex
municipal securities financings. We cannot advise on any specific financing without closely
reviewing the financing and all related transactions, as well as the representations made by
underwriting banks and others to issuer personnel. In general, however, our research strongly suggests
that underwriters frequently failed to provide the disclosures to public issuers required by the fair
dealing rule, and sometimes misrepresented material risks. If an issuers underwriters did violate the
MSRBs fair dealing rule, the issuer may have a remedy in arbitration before the Financial Industry
Regulatory Authority (FINRA).
In addition, the disclosures required by the MSRB fair dealing rule may be incorporated into the unfair
trade practice statutes or the law of misrepresentation of many states.
Developments in the Municipal Financing Market
Between 2002 and 2008, underwriters pitched to conservative issuers generally averse to interest
rate risk a kind of new innovative financing designed to create synthetic fixed-rate
debt that supposedly would be cheaper for issuers than traditional, natural fixed-rate debt. The new
financings required public entities to issue debt with an interest rate that changed weekly or monthly
and then to enter into an interest rate swap. The swaps required that the issuer pay a fixed rate to the
counterparty, usually the underwriter, and that the counterparty pay a floating rate to the issuer
based on an index, usually Libor. In practice, the counterparty paid the issuer the difference
between the floating rate and the fixed rate if the floating rate exceeded the fixed rate, and the issuer
paid the counterparty the difference if the fixed rate exceeded the floating rate.
Investors in the variable rate debt usually auction rate securities (ARS) or variable-rate

demand obligations (VRDOs) could sell or put their securities on a weekly basis. Investors in
ARS could sell their securities in a weekly auction that usually was managed by one of the
underwriters; investors in VRDOs could sell their securities each week through a remarketing agent
again, usually the underwriter or an affiliate who would sell the VRDOs to other investors. The
VRDOs often had a liquidity provider in the form of a letter of credit or standby bond purchase
agreement.
The interest rate on an issuers variable-rate debt was reset weekly at the level required to clear the
market of the securities that investors offered for resale that week. For ARS, a Dutch auction
set the weekly rate; for VRDOs, the remarketing agent set the rate. Both ARS and VRDOs usually
included an upper limit on the possible interest rate to limit the risks to the issuer. VRDOs
traditionally were capped at a fixed, maximum rate. ARS traditionally were capped to a short-term
index. Later, it became more common for ARS to be capped at a high, fixed rate, which greatly
increased the risk to issuers, but protected the balance sheets of the underwriters.
The complex variable-rate financings were much more profitable for underwriters than routine, fixed-
rate financings. The financings required additional transactions that generated additional fees, but
the real profit for underwriters was from the interest rate swaps. Few public officials or finance officers
knew what a swap should cost, and the swaps were the least discussed, least transparent, and most
profitable transactions for underwriters. The swaps were typically for terms of 20 or 30 years. By
contrast, swaps in the private sector that are designed to hedge similar interest rate exposure are
very rarely for terms of more than seven years, and are most commonly for a term of one year.
Underwriters assured issuers that the interest rate on the securities and on the index upon which the
swaps were based would move in tandem and played down the factors that could cause the rates to
diverge. The market conditions that determined the interest rate for the variable-rate debt were
very different from the market conditions that determined the index rate, however.
A lot can go wrong in complex transactions, and a lot did go wrong. During the financial crisis,
market clearing interest rates shot up for many ARS and VRDOs. In most cases, the interest rates
shot up because investors became concerned about the creditworthiness of liquidity providers and
bond insurers, which resulted in concern that investors might not be able to exercise their puts on
VRDOs or sell their ARS at auction. At the same time, Libor, the index to which the swaps usually
were tied, stopped moving in tandem with the interest rates on ARS or VRDOs. Instead, Libor rates
collapsed late in 2008 and were then held down in an effort to revive the economy. As a result, the
floating payments on the swaps and the issuers variable-rate debt did not offset each other to
produce a synthetic fixed rate as advertised.

The mismatch of interest rates and changes in ARS structures resulted in huge financial losses for
public issuers. The interest rate on many ARS and VRDOs rose to the upper limits, often 15 or
even 20 percent, for many months. Libor, in contrast, started 2008 at 4.5 percent and trended
down but generally moved more or less normally for most of 2008. Libor was 3.8 percent in
October 2008. In November, Libor was 0.4 percent. Libor bounced back to 1.1 percent in
December, but then fell to 0.1 percent in January and was never higher than 0.3 in 2009.
1


1
There are many different Libor rates. The rates cited above are the monthly averages of U.S. dollar overnight
rates.



The marketing materials that underwriters provided issuers characterized the risk that interest rates
on the securities would diverge from the index for the swaps as more theoretical than real. The
materials showed that the two rates had moved tightly together for the decade that the financings
were in effect. We expect, however, that the underwriter personnel who structured the transactions, if
not the personnel who worked directly with issuers, understood and had even quantified that risk,
and knew that a dramatic divergence at some point over the term of the transaction was possible and
perhaps likely.

Many issuers have had to refinance or restructure their variable rate debt on highly
disadvantageous terms. Others remain in the swaps, which require significant payments because the
fixed rate the public issuers agreed to pay is much higher than the Libor rate they receive. Moreover,
because the swaps typically are for terms of 20 or 30 years, the termination payments required to get
out of the transactions are often exorbitant. We expect that the terms of the swaps typically required
that the issuer make significant make whole payments in order to exit the swaps. We further
expect that the inability to exit the swaps on reasonable terms significantly increased the cost to
issuers of calling their securities and refinancing. Based on the marketing materials we have seen,
this aspect of synthetic fixed-rate financing was rarely, if ever, explained in adequate detail to
municipal issuers. In fact, underwriters sometimes represented to issuers that issuers could easily
exit the swaps if they wanted to refinance.

Underwriters have represented that the issuers losses, including the payments on the swaps and the
payments required to terminate swaps, were the result of an unforeseeable perfect storm of economic
events. Many issuers accepted those representations, and continued to work with the underwriters to
reduce losses. In fact, underwriters almost certainly knew that synthetic fixed-rate financings
created risks not present in traditional fixed-rate financings, and that the effect of the long-terms
swaps was to place those risks on issuers. Underwriters likely quantified the risk and the value of
change in the optionality of the financings.

Underwriters also represented that synthetic fixed-rate financings were cheaper for issuers than
traditional, or natural fixed-rate financings. That was true only under economic conditions that were
unlikely to prevail for the duration of a 20 or 30 year swap. As explained above, during the financial
crisis, the long term swaps made it exorbitantly expensive for many issuers to call their
securities. That optionality in the jargon of finance had a quantifiable value. The difference in
optionality effectively made these types of financings more expensive than traditional fixed-rate
financings. Underwriters almost certainly knew that any representations to the contrary were false.

Fair Dealing MSRB Rule G-17

Rule G-17 requires that [i]n the conduct of its municipal securities...activities, an underwriter
shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair
practice. The MSRB adopted the Rule pursuant to a statutory requirement to adopt market integrity
rules for municipal finance. The rules as a minimum must:

be designed to prevent fraudulent and manipulative acts and practices,
to promote just and equitable principles of trade, to foster cooperation
and coordination with persons engaged in regulating, clearing, settling,
processing information with respect to, and facilitating transactions in
municipal securities, to remove impediments to and perfect the

mechanism of a free and open market in municipal securities, and, in
general, to protect investors and the public interest ....

15 U.S.C. 78o-4(b)(2)(C).
2


There is a strong argument that underwriters in many transactions did not comply with MSRB Rule G-
17.

In numerous statements over the past 17 years, the MSRB has stated that Rule G-17 obligates
underwriters to deal fairly and not engage in unfair practices with municipal issuers. See
Interpretive Letter, Purchase of New Issue from Issuer (Dec. 1, 1997); Interpretive Notice
Regarding G-17, on Disclosure of Material Facts (Mar. 18, 2002); Reminder Notice on Fair Practice
Duties to Issuers of Municipal Securities (Sept. 29, 2009).
Moreover, the MSRB has emphasized repeatedly that whether or not an underwriter has dealt fairly
with a municipal issuer depends on the facts and circumstances of an underwriting. E.g.,
Interpretive Letter (Dec. 1, 1997).

To comply with Rule G-17, underwriters must explain complex transactions in an understandable
way to issuer personnel and disclose material risks. In addition, they must not encourage a municipal
issuer to enter into transactions that serve the interests of the underwriter but not the issuer. Indeed, it
is hard to imagine how an underwriter could deal fairly with a municipal issuer if the underwriter
failed to satisfy these rudimentary requirements.

In 2012, the MSRB issued an Interpretive Notice that focused specifically on the types of
transactions described in this memorandum. See Interpretive Notice Concerning the Application of
MSRB Rule G-17 to Underwriters of Municipal Securities (Aug. 2, 2012). That Interpretive Notice,
like many before it, reiterates the long-standing requirement that underwriters deal fairly with
municipal issuers. In addition, it highlights the obligation of underwriters to explain complex
transactions and the risks associated with them to municipal issuers. Specifically, it notes that
underwriters must disclose material financial risks, such as market, credit, operational, and
liquidity risks in a fair and balanced manner based on principles of fair dealing and good faith.
Id. MSRB Guidance concerning the Interpretative Notice states also that underwriters should not treat
their communications with issuers as merely a sales pitch without regulatory consequence. See
Guidance on Implementation of Interpretive Notice Concerning the Application of MSRB Rule G-
17 to Underwriters of Municipal Securities (July 18, 2012).

An underwriter is not exempt from the fair dealing rule because the issuer is relatively sophisticated.
The level of disclosure required may vary, the Guidance states, according to the issuers
knowledge or experience with the proposed financing structure or similar structure, capability of
evaluating the risks of the recommended financing, and financial ability to bear the risks of the
recommended financing, in each case based on the reasonable belief of the underwriter. Issuer
personnel may not be well positioned to fully understand the implications of the financings in its
entirety if the financing is structured in a unique, atypical, or otherwise complex manner,
although the same personnel may be very sophisticated with respect to financings with which they
have experience.


2
This statue was amended by the Dodd-Frank Act. This is the version of the statute that was in effect between 2002
and 2010.

We believe that it is appropriate to read the 2012 Interpretive Notice largely as expounding on the
long-standing obligations of underwriters under the Rule. Guidance on the Interpretive Notice states
specifically that, [a]lthough many of the specific elements identified by the Notice are fully
articulated by the MSRB for the first time, all of them arise from the fundamental duty of fairness to
the issuer that the MSRB has already required under Rule G-17 for some time. Guidance (July 18,
2012).
3


The various Interpretative Notices of the MSRB also are consistent with the requirements of the
common law of fraud and misrepresentation. In a recent arbitration, an Alabama private utility, Baldwin
County Sewer Service, prevailed in a claim against Regions Bank related to a similar financing.
4
There,
the bank advised the private utility that variable-rate bonds in combination with an interest rate
swap based on Libor would create a synthetic fixed rate for the utility that would be cheaper than
natural fixed-rate debt. In fact, the arbitrators found, the bank recommended the transaction
because it was more profitable for the bank than the usual interest-bearing direct loans. Rather
than moving in tandem, interest rates on the debt went dramatically higher while Libor went
dramatically lower.

The arbitrators noted that the transaction documents were thousands of pages and filled with
language that the arbitrators described as arcane, rather obtuse, and esoteric. The general
counsel for the utility admitted his confusion in interpreting the language that described how the
interest rate on the debt was determined. The arbitrators were not troubled by the boilerplate statements
in the documents in which the utility acknowledged that it had read and understood all of the terms
of the agreements and had not relied on any representations by the bank. The arbitrators
concluded that the utility reasonably relied on the banks representations given the relative
sophistication and bargaining power of the parties, and granted the utility rescission of the swaps
under the Alabama common law of misrepresentation.

Claims and Remedies for Violation of Rule G-17

There is no express private right of action in court for violation of MSRB rules, and a handful of
lower court decisions have held that there is no implied private right of action. See, e.g., Charter
House, Inc. v. First Tennessee Bank, 693 F. Supp. 593, 598 (M.D. Tenn. 1988). The authorizing
statute does empower the MSRB to provide for the arbitration of claims, disputes, and
controversies relating to transactions in municipal securities and advice concerning municipal
finance products. 15 U.S.C. 78o-4(b)(2)(D). MSRB Rule G-35 requires underwriters to submit to
FINRA arbitration.

In FINRA arbitration, arbitrators can award relief that may not be available in litigation. They are
limited only by the broad concepts of equity and justice and have a plethora of remedies, both
legal and equitable, to choose from in structuring a remedy. ReliaStar Life Ins. Co. of N.Y. v.
EMC Natl Life Co., 564 F.3d 81, 86 (2d Cir. 2009) (internal quotations and citations omitted). In the
past, FINRA arbitration panels have granted relief for violation of MSRB rules. See, e.g., Lozes v.
E*TRADE Securities, LLC, Dkt. No. 09-02855, 2010 WL 1994643 (July 21, 2010) (Foster,

3
The 2012 Interpretive Notice did provide new guidance on the manner and timing of certain disclosures. See
Guidance (July 18, 2012).
4
The arbitration ruling is available at
http://www.al.com/business/index.ssf/2014/05/regions_to_pay_10_million_for.html#Arbitration ruling.


Sheppard, Hunter, Arbs.)

The MSRB rules do not set forth a specific method for calculating damages for a violation of
Rule G-17. Just as courts look to a suitable existing tort action or a new cause of action
analogous to an existing tort action to fashion a remedy for violation of legislative provisions for
which there is no express remedy, we expect that arbitrators would look to analogous tort actions
for a remedy. See, e.g., Restatement (Second) of Torts 874A (Tort Liability for Violation of
Legislative Provision); State ex inf. Ashcroft v. Kansas City Firefighters Local No. 42, 672
S.W.2d 99, 109-16 (Mo. Ct. App. 1984); K.J. ex rel. Lowry v. Division of Youth and Family
Servs., 363 F. Supp. 2d 728, 740-45 (D.N.J. 2005); Brown v. State, 89 N.Y.2d 172, 187-92 (N.Y.
1996).

The most analogous tort actions for violation of Rule G-17 are for fraud and
misrepresentation. See Guidance (August 2, 2012) (describing Rule G-17 as including an anti-
fraud provision). There are a number of potential remedies for fraudulent inducement of a contract:
the amount actually lost, in the form of out-of-pocket damages or lost profits (the latter of which
would not be applicable here); benefit-of-the-bargain damages; and rescission.

Of these remedies, rescission would likely be the most favorable for an issuer.
5
An award of
rescission on an issuers swaps would require that the counterparties on the swaps return to the
issuer all payments, including any termination payments, and to cancel outstanding swaps
without additional payment. Rescission may not be available, however, since a party seeking to
rescind a contract typically must seek rescission promptly after discovery of any alleged fraud. See,
e.g., Merritt v. Craig, 130 Md. App. 350, 365-66 (Md. Ct. Spec. App. 2000) (A plaintiff seeking
rescission must demonstrate that he [or she] acted promptly after discovery of the ground for
rescission, otherwise the right to rescind is waived.) (internal quotations and citations omitted).

Benefit-of-the-bargain damages would also likely result in a very substantial award. This measure of
damages would put the issuer in the same financial position that it would have been in had the
underwriters representations been true. See Dynacorp Ltd. v. Aramtel Ltd., 208 Md. App. 403, 492-
93 (Md. Ct. Spec. App. 2012). We likely would propose to calculate this measure of damages by
comparing the difference in the cost to the issuer of the synthetic fixed-rate financing to the cost
of a natural fixed-rate financing, taking into account the differences in the opportunity to refinance.
Out-of-pocket damages likely would be the least favorable measure of damages for an issuer, but
could still be considerable. Out-of-pocket damages would include termination payments on the
swaps.

If any issuer decides to pursue a claim in arbitration for violation of the MSRB fair dealing rule, it
must act quickly. FINRA Rule 12206 provides that [n]o claim shall be eligible for submission to
arbitration...where six years have elapsed from the occurrence or event giving rise to the claim.
FINRA arbitrators appear to have some flexibility to determine the last occurrence or event that
gave rise to the claim, usually the loss suffered by the claimant; to find a continuing occurrence or
event; or to find that the eligibility period did not begin until the claimant discovered the wrong.
The market for auction rate securities collapsed early in 2008, more than six years ago. Much of the

5
In the Baldwin County Sever Authority arbitration, the arbitrators concluded that the Alabama common law of
misrepresentation gave the sewer authority a choice of remedies, and awarded rescission. The arbitrators said that
the sewer authority could have chosen an award of damages instead.


losses suffered by issuers occurred less than six years ago, however, especially the effect of long-term
swaps on the ability to refinance. Certainly many issuers did not discover any wrong or suffer any
loss until the collapse of Libor less than six years ago. But any further delay increases the possibility
that claims will not be eligible for arbitration.

Possible State Law Claims

There is no cause of action in court for violation of the MSRB fair dealing rule. We expect,
however, that many states would look to the disclosure requirements of the rule and related
guidance when assessing claims for misrepresentation or violation of state unfair trade practices
acts. Many states do not apply the statute of limitations to claims by government entities, or have a
longer statute of limitations for those claims. In addition, the law of most states provides that a cause
of action does not accrue for purposes of the statute of limitations until the plaintiff suffers a loss
and discovers, or with reasonable diligence could have discovered, that the loss was the result of
the defendants wrong. Many states consider also whether there was relationship of trust and
confidence between the parties in determining whether the plaintiff was on notice of a possible
claim.

In short, there may be claims for misrepresentation or for unfair trade practices in many states for
conduct that violates MSRB Rule G-17.

To discuss this further, please contact:

Ross Wallin (212) 755-7876 rwallin@graisellsworth.com
Brad Miller (212) 897-9499 bmiller@graisellsworth.com