Daniel J.

Collins
Drinker Biddle &Reath LLP
Dan Collins is an experienced trial attorney, having tried more than 20 cases to verdict in
criminal and civil proceedings in both federal and state court. As a former federal prosecutor,
Dan is well positioned to advise corporate and individual clients in responding to government
and regulatory inquiries, conducting internal investigations, and handling other complex
litigation matters.
Before joining Drinker Biddle, Dan served as an Assistant United States Attorney for the
Northern District of Illinois for 10 years, where he investigated and prosecuted a wide array of
white collar crimes, including commodities and securities fraud, bank fraud, mail and wire fraud,
computer access fraud, health care fraud, export controls and sanctions, public corruption, tax
evasion and money laundering. In particular, Dan developed substantial experience conducting
parallel investigations with the Securities and Exchange Commission (SEC), the Commodity
Futures Trading Commission(CFTC), and other regulators.
Dan held multiple supervisory positions while at the United States Attorney's Office. Most
recently, he was Deputy Chief of the Financial Crimes and Special Prosecution section, where he
oversaw the work of several senior AUSAs in the investigation of more complicated white collar
matters. Before that, Dan served as Acting Chief and Deputy Chief of the General Crimes
Section, where he supervised and trained AUSAs in federal criminal practice and trial advocacy.
James L. Kopecky
Kopecky Schumacher Bleakley Rosenburg PC
Early in his career, Jim represented defendants in commercial disputes, including complex,
federal court multi-district litigation matters. Jim joined the United States Securities and
Exchange Commission ("SEC") in 1999, rising to the level of Branch Chief in the Division of
Enforcement. At the SEC, Jim lead a team of attorneys and staff that investigated and
prosecuted securities fraud, including insider trading, accounting fraud, complicated market
manipulation actions, Ponzi schemes, offering frauds and sales practice actions.
Jim leads his firm's regulatory services practice, and frequently litigates matters on behalf of
individuals, public companies, broker-dealers, and hedge fund managers in both state and federal
courts across the country, as well as arbitrations before the Financial Industry Regulatory
Authority ("FINRA"), the National Futures Association, and the American Arbitration
Association. Jim acts as an independent investigator for investigations under Sarbanes Oxley
and as an independent expert consultant to companies disciplined by Self Regulatory
Organizations. In addition, federal district court judges, upon recommendation from the staff of
the United States Securities and Exchange Commission, have appointed Jim to act as Receiver
on behalf of victims of securities fraud. Jim also acts as a Hearing Officer for the Illinois
Securities Department, presiding over and making recommendations regarding actions against
broker-dealers, investment advisers and individuals.

77779967.2

ANALYSIS OF POTENTIAL LEGAL CHALLENGES TO

THE CITY OF CHICAGO'S INTEREST RATE SWAP TRANSACTIONS

I.

EXECUTIVE SUMMARY

We were asked to independently review the City of Chicago's interest rate swap
agreements to determine whether there is any evidence that the agreements were procured by
fraud and to determine whether there are any grounds for the City to challenge those agreements
based on fraud, misrepresentations, omissions, or unfair dealing through arbitration or in court.
To complete our review, we analyzed the transaction documents for these swap agreements,
communications between the City and its swap counterparties, and other documents relating to
the City's swap transactions. In total, we reviewed approximately 50 boxes of hard copy
documents, and analyzed thousands of pages of electronic documents. We also interviewed nine
current and former City employees (including current and former Chief Financial Officers,
Comptrollers, and Deputy Comptrollers) who were responsible for negotiating, executing, and
managing the swap agreements.
Our investigation found no evidence that would support a claim that the City's swap
agreements were procured by fraud or that any of the City's swap counterparties made any
material misrepresentations or omissions of fact. Nor did we find evidence to support a claim
that the City's swap counterparties failed to deal fairly with the City when negotiating and
executing the swap agreements.
An essential element of any cause of action for fraud is a material misrepresentation or an
omission of material fact. We found no evidence that any of the City's swap counterparties
misrepresented or omitted material facts relating to the transactions. Nor were any of the
individuals we interviewed aware of any material misrepresentation or omission. All of the
individuals we interviewed, including those responsible for negotiating and executing the swap
transactions, were well informed and aware of the various risks associated with swaps. None of
them believed that any swap counterparty engaged in fraudulent conduct, and several stated their
belief that the City benefitted from the swaps. Further, we found no documents authored or
presented by counterparties or underwriters, or other communications, that attempted to misstate
the risks associated with swaps.
Our investigation disclosed a number of facts that would make it challenging, if not
impossible, to claim that the City's counterparties did not deal fairly with the City or that the
City did not understand the risks associated with swap transactions. The City employed a
talented, experienced, and knowledgeable debt management team as well as outside advisors and
outside counsel to advise on these transactions. The City and its counsel and professional
advisors negotiated and documented each of the swap transactions. Moreover, in the swap
transaction documentation itself, the City makes a number of representations regarding its
knowledge and sophistication and acknowledges the limited, non-fiduciary role played by the
swap counterparty. Finally, and perhaps most telling, the City not only acknowledged, but also
publicly disclosed the risks associated with swap agreements in its Comprehensive Annual
Financial Reports(CAFRs)going back to 2004, and in its Interest Rate Swap Policy,
implemented in 2004 and first posted online in 2006.

The City also would have an extremely difficult time establishing that it relied on a
representation made by any swap counterparty, which is a required element of a securities fraud
claim. In addition to the disclosures in the City's CAFRs,the City's 2006 SWAP Policy, and the
City's experienced and knowledgeable debt management team each of which alone creates an
obstacle to establish reliance the International Swap Dealers Association, Inc.(ISDA)Master
Agreements, which governed all ofthe City's swap agreements; contained a "non-reliance"
clause, in which the City stated that it had made its own decision to enter into each transaction
using its own judgment and relying upon the advice of its own advisors. The City affirmatively
acknowledged that it was not relying on any representation by a swap counterparty and that the
counterparty was not acting as the City's fiduciary or as the City's advisor with respect to the
transaction.
As part of our investigation, we also reviewed the various assertions in two recent letters
from three unions urging the City to file arbitration before the Financial Industry Regulatory
Authority (FINR.A)"to seek a refund of sums [that the City] expended on fraudulent interest rate
swaps," as well as a legal memorandum from a New York law firm that, while acknowledging
that it "cannot advise on any specific financing without closely reviewing the financing and all
related transactions, as well as representations made by underwriting banks and others to issuer
personnel," nevertheless speculates as to what such a review might show and the remedies an
issuer "may have" if an underwriter did violate the fair dealing rules. Not only did we find no
evidence that the City was misled, defrauded, or dealt with unfairly, but the relevant documents
we reviewed and the testimony of the witnesses we interviewed affirmatively refute any such
claim and establish that the City was fully aware of the risks of such transactions. Our review
showed that the City used swaps as a strategy to reduce the costs of its debt and hedge the
interest rate and other risks associated with that debt. Accordingly, even if FINRA arbitration
were legally available (which, as we explain below, it is not), filing a claim alleging fraud or
unfair dealing would be meritless, and could serve to damage the City's credibility in its current
and future dealings with financial institutions and its ability to finance the City's needs going
forwaxd.
II.

BACKGROUND
A.

Interest Rate Swaps

The Municipal Securities Rulemaking Board(MSRB)defines an "Interest Rate Swap

Contract or Agreement" as:
A specific derivative contract entered into by an issuer or obligor with a
swap provider to exchange periodic interest payments. Typically, one
party agrees to make payments to the other based upon a fixed rate of
interest in exchange for payments based upon a variable rate. The swap
contract may provide that the issuer will pay to the swap counter-party a
fixed rate of interest in exchange for the counter-party making variable
payments equal to the amount payable on the variable rate debt.
MSRB, Glossary of Terms, available at http://www.msrb.org/ l~oss_ar ~~aspx (last visited October
28, 2014). The MSRB also defines a "Floating-to-Fixed Rate Swap" as:

An agreement whereby an issuer synthetically converts variable rate debt

to fixed rate debt through an interest rate swap or similar agreement. In
this process, the issuer makes payments to the counterparty at a fixed rate
according to the terms of the swap and the counterparty makes payments
on a variable rate or rates according to the terms of the swap, which may
be equivalent to the rates payable to bondholders under the bond contract.
Id. In a floating-to-fixed rate swap, payments made by one counterparty typically are based on a
floating rate of interest, such as the London Interbank Offered Rate(LIBOR)or the Securities
Industry and Financial Markets Association(SIFMA)Municipal Swap Index, while payments
made by the other counterparty are based on a fixed rate of interest.
Historically, municipalities have used interest rate swaps in connection with the issuance
of bonds. A swap agreement typically involves two counterparties: the municipality and a bank.
When a municipality issues a variable, or floating, rate bond, it may enter into a contract with a
bank counterparty to "swap" the floating (variable) rate of interest for a fixed rate of interest in
order to, among other benefits, reduce interest rate risk. The swap changes the risk profile of the
debt by essentially converting the floating rate debt issue into a fixed rate debt, referred to as a
synthetic fixed rate.
The municipality pays the fixed rate on the swaps, plus the difference between the
floating rate on the bonds and the floating rate on the swaps, plus support costs. If interest rates
rise after the swap is executed such that the mark-to-market value ofthe swap rises for the
municipality, the municipality may exercise the option to terminate the agreement and receive a
termination payment. Conversely, if interest rates fall after execution of the swap agreement and
the counterparty exercises its option to terminate the agreement, the municipality will pay a
termination payment. Termination payments take place only when the agreement is terminated
before its expiration date. Where an agreement expires on the date agreed upon, no termination
payment is made by either side.
Corporations, nonprofit organizations, and units of state and local government have used
interest rate swaps widely for decades. For example, the cities or city agencies of Miami,
Baltimore, Philadelphia, Los Angeles, Houston, New York City, Albuquerque, and Pittsburgh all
have used interest rate swaps as far back as the 1990s. So have the states and/or state borrowing
agencies of Massachusetts, Indiana, New York, Connecticut, Texas, North Carolina, Michigan,
Wisconsin, Oregon, Kentucky, and Illinois. Locally, the City of Chicago, Chicago Public
Schools, Chicago Transit Authority, State of Illinois, Regional Transportation Authority, and
Illinois Tollway all have used interest rate swaps.
Many municipalities have issued variable rate bonds instead of fixed rate bonds, and then
entered into afloating-to-fixed rate swap to manage the interest rate risk of the variable rate
bonds and to lower costs. When a municipality issues a variable rate bond and then enters into a
swap agreement, the synthetically-created fixed rate that results typically is less than the interest
rate that would have been paid had the municipality simply issued a fixed rate bond. Over the
term of the bond, the municipality may benefit from costs savings that result from each payment

of the lower interest rate. These costs savings are realized over time, and can be substantial
depending on the term of the bond and subsequent changes in interest rates.
The City of Chicago entered into its first interest rate swap agreement more than 20 years
ago. The City Council of Chicago, by way of the City's ordinance process, grants the CFO or
Comptroller the authority to enter into such swaps. If the CFO or Comptroller wishes to enter
into a swap for which the ordinance authorizing the issuance of the underlying bonds did not
authorize a swap transaction, then authority must be granted through the passage of a new
ordinance. In each instance that we reviewed, the City properly obtained authorization by
ordinance from the City Council.
Typically, the City entered into interest rate swaps in connection with an underlying
variable rate demand obligation bond offering. Often, at the same time, the City also issued
fixed rate bonds. The City used the combination of fixed rate and variable rate offerings as a risk
management tool. The City used interest rate swaps in connection with the variable rate
offerings to synthetically convert floating rates to fixed rates to reduce interest rate risks. These
swaps resulted in synthetically fixed costs (or "financing costs") that were lower than the
comparable level of fixed rates available in the primary municipal bond market at the time.
In addition to the floating-to-fixed rate swap agreements, the City also has entered into
swaps to convert the basis upon which the interest rates were calculated, called "basis swaps."
The City has entered into these basis swaps in exchange for substantial upfront payments to the
City. Certain basis swaps did not extend for the entire life ofthe underlying variable rate debt.
The City later extended some basis swaps to more closely match the maturity of the underlying
variable rate bonds, or altered the duration of the swap to further manage risk. The swaps
converted the interest basis, for example,from SIFMA to LIBOR. The City used these basis
swaps to obtain funds from counterparties and as tools to further manage the City's risk
exposure:
The City entered into its swap agreements through either a competitive or negotiated
process. In a competitive process, the City or its financial advisor issued a swap bid form and
term sheet to multiple financial institutions setting forth the general specifications and terms of
the anticipated swap transaction. For example, the form and term sheet often explained that
while counterparties were obligated to post collateral in connection with the swap, the City
would not be required to post collateral. In a negotiated process, the City negotiated directly
with one, or multiple, potential counterparties. The advisor's role in a negotiated process was to
ensure that the pricing received by the City was fair and consistent with prevailing market
conditions. The advisor also negotiated swap related credit terms, analyzed risk versus reward,
and made specific recommendations.
B.

City's Comprehensive Annual Financial Reports

The City's accounting policies are based upon accounting principles prescribed by the
Governmental Accounting Standards Board (GASB). In 2008, the GASB issued GASB
Statement No. 53, titled Accounting and Financial Reportingfor Derivative Instruments, which
required that the City's financial reports include specific disclosures on derivatives, including the
various risks associated with swap transactions. These risks include the following:

G~

Credit risk the possibility that the swap counterparty will not make good on its
promise to pay the local government;
2.

Interest rate risk the risk that changes in the interest rate could reduce the value
ofthe swap agreement;

3.

Basis risk the possibility that the local government could have to pay higher
amounts because of differences in the indexes upon which the swap agreements
are based; and

4.

Termination risk the possibility that a swap agreement may end earlier than
expected and thus potentially require the local government to make a significant
termination payment.

Although GASB 53 went into effect in June 2009, the City had been making these
disclosures publicly since 2004. The City, in fact, has included a detailed statement of the risks
associated with its swap agreements in every CAFR since the 2003 fiscal year (published in
2004). Although first publicly disclosed in 2004, our interviews revealed that the City officials
who negotiated and executed the swap agreements on its behalf were aware of the risks much
earlier, including at the time that the City executed its existing swap transactions. In the CAFRs,
the City disclosed:(1) credit risk (e.g., counterparty risk);(2)interest rate risk;(3) basis risk
(including risks tied to changes in marginal tax rates, tax-exempt status of bonds, and supply and
demand for variable rate bonds);(4)tax risk; and (5) termination risk (including risks tied to
ratings downgrades, covenant violations, bankruptcy, payment default and other events of
default). The CAFRs also highlighted any material changes to the swap agreements (including
counterparty downgrades) and/or terminations.
Accordingly, every year for more than 10 years the City has been disclosing the very
September and October union letters allege the City's swap counterparties may have
the
risks
misrepresented, failed to disclose, or downplayed. The City's disclosures affirmatively
explained the risk of interest rate movements, the risk that a credit event affecting the credit
ratings of the City would occur, and the risk that a swap could be terminated as a result of certain
events, including a ratings downgrade ofthe City. The City's disclosures demonstrate its
knowledge and understanding of the various risks that could impact its swaps transactions.
C.

Interest Rate Swap Policy

The City also disclosed the various risks associated with swap transactions in its Interest
Rate Swap Policy, which first was implemented in 2004 and later published in 2006. The
Interest Rate Swap Policy(2006 Swap Policy) established guidelines for execution and
management of the City's interest rate swaps, identified eleven separate and specific risk factors
that the City would examine before entering into a swap agreement, and proposed ways to
mitigate each ofthese risks:
Wa s to Miti ate Risk

T e of Risk

Descri tion of Risk

Basis risk

The City and its financial advisors will

Basis risk refers to the mismatch
review historical trading differentials
payments
between the variable rate
between the variable rate bonds and the
received on a swa contract and

Descri tion of Risk

the interest payment actually owed
on the bonds. The two significant
components driving this risk are
credit and SIFMA/LIBOR ratios.

Tax risk

The risk of a change in U.S. tax

law such that the federal tax
exemption on municipal debt is
eliminated or its value is reduced.
The City is negatively impacted by
reductions in tax rates.
The risk that a counterparty will
not perform pursuant to the
contract's terms thus exposing the
City to the risk of unwinding the
swap and/or a termination
a ment.
The risk that the swap could be
terminated as a result of certain
events including a ratings
downgrade for the issuer or swap
counterparty, covenant violation,
bankruptcy, payment default or
other defined events of default.
The City may be exposed to
rollover risk if the swap terminates
early or if the term of the swap is
shorter than that ofthe bonds.
The inability to continue or renew
a liquidity facility.

Counterparty risk

Termination risk

Rollover risk

Liquidity risk

Ratings Risk

The risk that the City's credit

rating would be adversely affected
by entering into a swap
transaction.

Risk of
Restructuring
Flexibility

For City purposes, swaps make the

underlying bonds non-callable
because the City will not have a
swap without an underlying bond.
This factor not only eliminates the
opportunity to refund these bonds
for savings, but also eliminates the
abili to restructure this debt.
Risk that the swap amortization
schedule will not match the
amortization schedule of the

Amortization
Risk

Wa s to Miti ate Risk

index. The City will seek to minimize basis
risk by structuring swaps with small
deviations between cash inflows and
outflows. The City will not seek to
maximize upfront benefit by structuring
swa s with undul hi h basis risk embedded.
The City and its counsel will review the tax
events in proposed swap agreements. The
City will evaluate the impact of potential
changes in tax law on LIBOR indexed
swaps.
The City will monitor exposure levels,
ratings thresholds, and collateralization
requirements on a portfolio-wide basis. The
City will often require two counterparties on
swaps to mitigate counterparty risk.
The City will compute its Counterparly
mark-to-market exposure. The City always
retains the right to terminate swaps at market
rates. The City does not allow counterparties
to terminate unilaterally, except in the event
of a weakening of the City's credit or if other
termination events have occurred.
The City will determine, in accordance with
its Debt Policy, its capital structure in light
of a swap terminating early. The City will
also evaluate enterin into another swa
The City will evaluate the expected
availability of liquidity support for swapped
and unhed ed variable rate debt.
The City will continue an open dialogue with
the rating agencies so that all the benefits and
risks of a swap are understood. In addition,
the City will seek confirmation that the swap
will not adversely affect the underlying
credit ratin s.
The City and its financial advisors will
evaluate the benefits of a swap in relation to
the lost benefit of future savings and
restructuring opportunities.
.

T e of Risk

The City matches the amortization schedules

of bonds and swaps. The City and its
financial advisors: will continue to assess the

Descri tion of Risk

bonds. Amortization mismatches
could also result in terminations of
portions of the swap prior to
maturity and under unfavorable
conditions to the City.

Wa s to Miti ate Risk

City's overall bond portfolio to determine the
best practice in each particular instance.

Interest Rate Risk

Risk that movement of interest

rates over time could affect the
value of an outstandin instrument.
Risk that a credit event could
occur that would affect the credit
ratings of the City or of one of its
counter arties.

The absolute level of interest rates and their

effect on the market will be taken into
account before the Ci enters into a swa
The City will monitor the ratings of its
counterparties and insurers.

Credit Risk

e of Risk

Similar to the City's risk disclosures in its CAFRs,the City's 2006 Swap Policy
demonstrates the City's knowledge and understanding of the risks associated with swap
transactions. It also adopts certain policies and procedures to address and minimize these risks,
and prohibits the City from entering into swaps that were viewed as too risky or lacking in
transparency.
D.

The Interest Rate Swap Agreements

e.,

The 2006 Swap Policy also sets forth that the City's contractual relationships with its
swap counterparties be governed, to the extent possible, by the terms and conditions set forth in
the International Swap Dealers Association, Inc.(ISDA)Master Agreement. The typical City
swap transaction also included the following additional documents: a Schedule to the Master
Agreement, Credit Support Annex, Swap Confirmation, legal opinions, and fairness opinions.
The ISDA Master Agreement, along with the Schedule and Confirmation, identify the swap
counterparties (i. the City and a bank), and specify the particular interest rates being swapped,
payment terms, and the other material terms of the transaction.

(i.e.,

The ISDA Master Agreements, as set forth in the Schedules thereto, contain a "nonreliance" clause pursuant to which the City agrees that it has made its own decision to enter into
each transaction using its own judgment and relying upon advice from advisors of its choosing.
The City also affirmatively acknowledges that it is not relying on any communication or
representations) by the swap counterparty, and that the swap counterparty
recommendation
is not recommending the transaction. In addition, each Transaction Confirmation contains the
following additional representations by the City:
[the City's] counsel, accountants and tax advisors are familiar with this
Transaction ...and relying on the advice of such professionals and advisors the
[City] has made an independent analysis and decision regarding this Transaction;
and

[the City] has determined the economic risks and merits, as well as legal, tax, and
accounting characterizations and consequences ...and is capable of assuming
such risks, without relying on the advice of[counterparty bank].
The City also acknowledges through the ISDA Master Agreement that the counterparty bank is
not acting as the City's fiduciary or as the City's advisor with respect to the transaction.
In addition to the "non-reliance" clauses, the ISDA Master Agreements, as set forth in the
Schedules thereto, contain exclusive dispute resolution clauses requiring the parties to submit
any legal claims or disputes to the exclusive jurisdiction ofthe Courts of the State of Illinois or
the United States District Court for the Northern District of Illinois.
The ISDA Master Agreement also provides that the City may terminate the interest rate
swaps at any time for market value, or upon the occurrence of certain events. While the City
maintains an unlimited right of early termination, the bank counterparties' termination rights are
limited. The swap agreements also establish certain early termination events. The City's swap
agreements contain credit ratings thresholds that require both the City and its counterparties to
maintain certain credit ratings. An early termination event is triggered if the credit rating of the
City or a counterparty is downgraded below such agreed upon threshold. Once triggered, the
other counterparty has the right to terminate the swap. Upon termination, one party may owe the
other a termination payment.
E.

Existing Swap Transactions

As of the date of this report, the City remains involved in swap agreements relating to
nine bond deals. The City ceased issuing new variable rate demand bonds in 2007. The last
swap made in connection with the issuance of an underlying bond was executed in 2008. Each
of these deals involved the issuance of variable rate demand bonds. The City remains involved
in 16 swaps that were entered into in connection with one of these nine underlying variable rate
demand bonds ("underlying swaps"), and in nine swaps entered into after the underlying bond
deals to convert the basis upon which the interest rates were calculated ("basis swaps"). The
City recently has renegotiated the terms of certain of its swap agreements to (1)reduce the credit
rating thresholds that allow the City's counterparties to terminate the swaps if the City
experiences further downgrades in its credit rating, and (2) modify the maturity of the swap
agreements. See City of Chicago Reoffering Circular for its General Obligation Variable Rate
Demand Bonds Project and Refunding Series 2003B, September 2014.
The following chart shows the City's existing swap agreements, the underlying offerings
to which each swap agreement relates, the swap counterparties on each transaction, whether the
swap relates to the underlying bond transaction ("U")or was a basis swap ("B"), the notional
amount ofthe swap, and its trade and effective dates:

$202,500,000 Genera! Obligation

Variable Rate Demand Bonds, Project
and Refunding Series 2003B
[8/7/2003]

Swap Counterparty

Lehman Brothers
Special Financing Inc.
(Counterparty is now
Wells Fargo Bank,
National Association)

Bond Senior
Manager

William Blair
Company, LLC
&

Bond Issue Name(Par Amount)

Issue Dated

Bear Steams
Financial Projects Inc.
(Counterparty is now
JPMorgan Chase
Bank, N.A.)
The Bank of
New York Mellon
PNC Bank,
National Association
PNC Bank,
National Association
$222,790,000 General Obligation
Variable Rate Demand Bonds, Project
and Refunding Series 2005D
[8/17/2005]

Goldman Sachs
Bank USA

Loop Capital
Markets, LLC

Loop Financial
Products III LLC
(Counterparty is now
Bank of Montreal)
Loop Financial
Products III LLC
(Counterparty is now
Deutsche Bank AG,
New York Branch)
RFPC Capital
Services, LLC
(Counterparty is now
The Bank ofNew
York Mellon)
Jeffries Funding LLC
(Counterparty is now
Deutsche Bank AG,
New York Branch)
PNC Bank,
National Association
$200,000,000 General Obligation
Variable Rate Demand Bonds, Refunding
Series 2007EFG
[11/8/2007]

Loop Financial
Products III LLC
(Counterparty is now
Deutsche Bank AG,
New York Branch)
Morgan Stanley
Capital Services Inc.
Wells Fargo Bank,
N.A.
Wells Fargo Bank,
N.A.

Loop Capital
Markets, LLC

U/B

Notional
Amount

Trade Date

Effective
Date

$]51,875,000

8/6/2003

8/7/2003

$50,625,000

8/6/2003

8/7/2003

$144,570,000

1/30/2013

11/1/2014

$48,195,000

1/30/2013

3/1/2014

$144,570,000

2/9/2012

3/1/2014

$155,953,000

8/2/2005

8/17/2005

$66,837,000

8/2/2005

8/17/2005

$61,395,000

12/17/2010

1/1/2014

$100,000,000

12/16/2010
(Amended
4/30/2014)

1/1/2014

$61,395,000

12/17/2010

1/1/2014

$207,880,000

2/9/2012

1/1/2031

$150,000,000

10/24/2007

11/8/2007

$50,000,000

10/24/2007

11/8/2007

$100,000,000

1 1/30/2010

1/1/2014

$100,000,000

12/2/2010

1/1/2014

$332,230,000 Second Lien Wastewater

Variable Rate Revenue Refunding
Bonds, Series 2004A (refunded by
$332,230,000 Second Lien Wastewater
Variable Rate Revenue Refunding
Bonds, Series 2008C on 10/16/2008;
.1PMorgan was sole underwriter; swaps
remained in place)
[7/29/2004]

Lehman Brothers
Special Financing Inc.
(Counterparty is now
Deutsche Bank AG,
New York Branch

Lehman Brothers,
Inc.

JPMorgan Chase Bank

Bank of America,
N.A.
$500,000,000 Second Lien Water
Revenue Project and Refunding Bonds,
Series 2004
[8/24/2004]

UBS AG,
Stamford Branch

Morgan Stanley &

Co. Incorporated

Royal Bank of Canada

$100,000,000 Second Lien Water
Revenue Project Bonds, Series 2000
[12/22/1999]
$116,595,000 Sales Tax Revenue
Refunding Bonds, Variable Rate Series
2002
[6/27/2002]
$152,150,000 Chicago Midway Airport
Second Lien Revenue Refunding Bonds,
Series 2004CD (Auction Rate Securitiesy
[12J14/2004]

$232,560,000

7/22/2004

7/29/2004

$49,835,000

7/22/2004

7/29/2004

$49,835,000

7/22/2004

7/29/2004

$300,000,000

7/29/2004

8/5/2004

$200,000,000

7/29/2004

8/5/2004

4/10/2008

4/16/2008

UBS AG,
Stamford Branch

Morgan Stanley &

Co. Incorporated

$100,000,000

JPMorgan Chase Bank

Siebert Brandford
Shank & Co., LC

$I 16,595,000

6/21/2002

6/27/2002

$91,290,000

12/9/2004

12/14/2004

$60,860,000

12/9/2004

12/14/2004

$44,900,000

8/5/1999

9/1/1999

The Goldman Sachs

Group, Inc.

J.P. Morgan Chase

Securities, Inc.

JPMorgan Chase
Bank, N.A.
(Counterparty is now
Wells Fargo Bank,
N.A.)
$44,900,000 Senior Lien Ta~c Increment
Allocation Bonds(Near North
Redevelopment Project), Series 1999A
[8/5/1999]

Bank of America N.A.

Mesirow Financial,
Inc.

The chart demonstrates that of the City's 25 existing swap agreements, it entered into 21
of them after it publicly acknowledged its understanding of the risks presented by swap
transactions in the City's CAFR for fiscal year 2003 (published on June 18, 2004). Further, as
mentioned above, although the City first publicized its understanding of the risks in 2004, the
City officials who were involved in negotiating and executing these swap agreements told us that
they were well aware of the risks presented by swap transactions long before the City's public
acknowledgement and, more specifically, at the time they entered into agreements on the City's
behalf in 1999, 2002, and 2003(two swaps in 2003).

~ On April 16, 2008, the City refunded a portion of the Series 2004 Water bonds, at which time (a)the swap with
UBS AG, Stamford Branch relating to the Series 2004 water bonds was amended to lower the notional amount to
$200,000,000, as amortized; and (b)the City entered into a new swap with a notional amount of$100,000,000
related to the Series 2000 Water bonds (reflected in the chart above).

10

Our interviews also confirmed that these City officials entered into variable rate demand
bonds and related interest rate swap agreements in an effort to save the City money versus
issuing comparable fixed rate debt, and as an overall debt risk management tool. In each case, it
cost the City less to issue variable rate demand bonds at the time of issuance than it did to issue
fixed rate debt. The City then entered into an interest rate swap to establish a synthetic fixed
rate, lock in market conditions at the time, and hedge against interest rate risk.
The performance of the City's swaps is and has been a function of various factors. Two
factors are of particular importance for future performance: the City's credit rating and the
support costs associated with the issuance of the underlying variable rate debt. As described
above, the City's swap agreements generally contain provisions that permit, but do not require,
the swap counterparty to terminate the agreement if the City's credit rating falls below a
specified threshold level. Under current market rate conditions, if the City's ratings were
reduced below threshold levels and its counterparties exercised their rights to terminate the
swaps, the City would be liable for termination payments. The probability that this risk could
occur, at least as to some of the City's swaps, has increased in the last two years due to
downgrades in the City's credit rating, as discussed in greater detail in the City's recent
reoffering circular for the General Obligation Variable Rate Demand Bonds, Project Refunding
Series 2003B,issued on September 25, 2014. In particular, in the last 18 months the City has
experienced three credit downgrades:(1)on July 17, 2013, Moody's reduced the ratings on the
City's general obligation bonds from "Aa3" to "A3,"(2)on March 4, 2014, Moody's reduced the
ratings of the City's general obligation bonds from "A3" to "Baal", and (3)on November 8,
2013, Fitch reduced the rating on the City's general obligation bonds from "AA-" to "A-".
These downgrades did not bring the City's credit rating below the thresholds in the agreements,
and did not trigger counterparties' options to terminate. The credit downgrades, however, have
caused the support costs, i.e., the letter of credit fees, associated with the underlying variable rate
debt to increase.
F.

The Union Letters, the Roosevelt Institute Blog Post, and the Grais &
Ellsworth Legal Memorandum

On September 15, 2014, the City received a letter from three union leaders urging the
City to "immediately file for arbitration to seek a refund of sums expended on fraudulent interest
rate swaps that are costing the City of Chicago and the Chicago Public School System over a
hundred million dollars every year, and to date, have resulted in a loss of over $800 million
dollars." (September Letter). The September Letter did not identify a specific "fraudulent" swap
agreement, did not explain how the swap agreements were "fraudulent," did not identify a
material misrepresentation or omission of fact related to any particular swap agreement, and did
not provide any basis, or underlying facts, for the alleged $800 million "loss."
Rather than pointing to specific facts relating to the City's swap agreements, the
September Letter referenced purported efforts by other cities to "get out of such borrowing
deals" and to "review[][their] options for recouping losses on [their] interest rate swaps." The
September Letter also referenced a recent American Arbitration Association award entered in
favor of Baldwin County Sewer Service, LLC(BCSS), a private sewer utility headquartered in
Summerdale, Alabama, based on a bank's specific misrepresentation that the rate tied to BCSS's
variable rate demand note was a LIBOR rate when it, in fact, was not, and the bank's failure to
11

disclose "basis risk." The September Letter reasoned that because the BCSS will recoup its
losses, the City has "a chance to recoup [its unidentified] swap losses too."
The assertions of the September Letter closely resembled those of a blog post written by
Saqib Bhatti of the Roosevelt Institute. In the blog, Mr. Bhatti asserts that "[a]s a rule, bankers
highlighted the upside and minimized the potential downside in pitching these deals. This was in
violation of MSRB Rule G-17." The blog argues that cities can "potentially win back hundreds
of millions of dollars from Wall Street," and suggests that they pursue legal claims by filing for
arbitration with FINRA. Other than the assertion that banks acted "as a rule," the blog provided
no facts specific to the City's swap agreements or swap counterparties, did not identify any
particular misrepresentation or omission, and did not address the fact that the City had
acknowledged publicly its understanding ofthe risks for more than 10 years.
On September 18, 2014, the City requested from the union leaders facts supporting their
allegations offraud and losses related to the City's swap agreements. The City has not received
a response to this request. Instead, on October 9, 2014, the union leaders sent the City a second
letter (October Letter) again urging the City to file an arbitration claim under MSRB's Rule G-17
to challenge the "financial industry's questionable practices that were pervasive with municipal
swap deals including the widespread failure to adequately disclose risks and that have
resulted in states, cities, and school districts across the country getting stuck in these grossly
unfair arrangements." The October Letter, like the September Letter, provides no facts specific
to the City's swap agreements, the City's swap counterparties, or the alleged "failure to
adequately disclose risks" associated with the City's swap agreements. The October letter,
however, disclosed the union leaders' purported legal basis for filing a fraud or unfair dealing
claim against the City's swap counterparties: a memorandum from the law firm Grais &
Ellsworth LLP to Saqib Bhatti titled "Potential Claims by Public Issuers ofSynthetic Fixed-Rate
Debt," dated October 9, 2014. As discussed in further detail below, the Grais &Ellsworth LLP
memorandum likewise provides no facts or allegations specific to the City, the City's swap
agreements, or the City's counterparties. To date, the City has received no additional
information from the unions relating to their allegations offraud or losses related to the City's
interest rate swaps.

12

III.

THE INVESTIGATION
A.

Scope of Review

The City retained Drinker Biddle and Kopecky Schumacher to conduct an independent
analysis of potential challenges to the City's existing interest rate swap agreements based on
fraud, misrepresentations, omissions, or unfair dealing through arbitration or the courts. The
review also analyzed the allegations set forth in the September 15, 2014 and October 9, 2014
letters and the Grais &Ellsworth Memorandum,to determine whether the City has'any viable
claim that the swap counterparties defrauded or failed to deal fairly with the City.
B.

Documents Reviewed

We requested, received, and reviewed approximately 50 boxes of hard-copy documents

and thousands of pages of electronic documents relating to the City's swap transactions. We
requested information from multiple sources, including the City, and the current and former
employees identified below. In addition to the materials we specifically requested, we
encouraged the City and witnesses to furnish any other documents or information that might be
relevant to this review. All of our requests for information were met. We also reviewed the
hundreds of documents relating to the City's bond offerings and swap agreements available
through the City of Chicago's website and the Municipal Securities Rulemaking Board's
website.
Our review included the documents relating to the City's existing swap transactions: the
Interest Rate Swap Confirmations, Amendments to Interest Rate Swap Confirmations, ISDA
Master Agreements, Schedules to the Master Agreements, and Credit Support Annexes. We also
reviewed, to the extent these materials existed, communications between the City and its swap
counterparties.
C.

Witness Interviews

In addition to the analysis of records described above, we interviewed nine individuals.

These interviews are summarized briefly below. The purpose of these interviews included
identifying the key individuals involved in the negotiation, execution, and management of the
City's interest rate swap agreements, understanding the City's policies and procedures for using
interest rate swaps, understanding the representations made to the City by its counterparties (and
potential counterparties) prior to and following the execution of the swap agreements,
determining the City's understanding of its swap agreements and the various risks and benefits
associated with these agreements, understanding the City's experience and expertise in entering
into complex financial arrangements, determining the City's debt management goals and
objectives, and identifying any misrepresentations or omissions of fact related to the City's swap
agreements.
If the City were to file a claim against one or more of its swap counterparties, anumber
of these individuals likely would be called as witnesses. Each individual displayed a high level
of knowledge and understanding of the swap transactions. None believe that the City was
defrauded. In addition, the swap transaction documents themselves acknowledge the limited,

13

non-fiduciary role of the banks (the counterparties), and make affirmative representations
regarding the City's understanding of the transactions. As we discuss in greater detail below in
the Analysis Section, the knowledge, experience, sophistication and anticipated testimony of
current and former members ofthe City's debt management team, along with the written
representations made in the swap agreements and the risk disclosures in the CAFRs and 2006
Swap Policy, would make proving (or even allegYng in good faith) a fraudulent misrepresentation
or omission claim extremely challenging.
Lois Scott(Chief Financial Officer)
Lois Scott is the Chief Financial Officer for the City. In that role, she is responsible for
the long-term financial strategy for the City, including debt management, investor outreach and
disclosure, interest rate risk management, and analysis of pension liability and funding issues.
Before joining the City in 2011, Ms. Scott was co-founder and President of the firm Scott Balice
Strategies, LLC, which became one of the largest public finance advisory firms in the country
and specialized in public finance. Ms. Scott earned her bachelor's degree and M.B.A. at Cornell
University.
Ms. Scott currently oversees the issuance of the City's bonds and notes and oversees the
City's debt management team. Ms. Scott explained that one of her primary responsibilities is to
regularly and proactively monitor the City's outstanding bonds and swap deals for any
opportunity to produce savings and reduce risks. To that end, Ms. Scott and her staff consult
regularly with financial advisors to manage the City's debt portfolio. That ongoing review has
resulted in the City entering into five basis-swap deals in which the City renegotiated the terms
of its pre-existing swap agreements. The City also has(1)terminated two swaps;(2)
renegotiated the terms of certain of its swap agreements to lower the credit rating levels that
could trigger termination payments to counteract the City's recent credit downgrades, and (3)
renegotiated the maturity of certain of the City's swap agreements to reduce its counterparty
exposure. According to Ms. Scott, the City remains committed to mitigating the risks associated
with its swaps and generating costs savings(where possible) on those swaps.
Ms. Scott believes that the City had in the past, and currently has in place, a sophisticated
and experienced financial and debt management team that understands the risks associated with
swaps, including the credit rating, interest, termination, and counterparty risks. Ms. Scott was
not aware of any misrepresentations or omissions of material fact related to the City's swap
agreements. She believed that the City was well informed about the risk factors associated with
the swaps (referencing the City's 2006 Swap Policy and the risk disclosures in its CAFRs).
2.

Jeremy Fine(De~ut~ptroller)

Jeremy Fine joined the City in 2003 as an assistant comptroller in the debt management
group and became Deputy Comptroller in 2007. Mr. Fine currently reports directly to Lois Scott,
the City's CFO, and Comptroller Dan Widawsky. Prior to joining the City, Mr. Fine worked in
public finance, and concentrated on municipal underwriting at LaSalle Bank. Mr. Fine earned an
undergraduate degree from the United States Military Academy(West Point) and a Masters in
Business Administration (Finance)from the University of Notre Dame.

14

According to Mr. Fine, the City entered into swap agreements through two methods:(1)
competitive bid agreements (in which the City solicited simultaneous bids from several financial
institutions at one time), and (2) negotiated agreements. The majority ofthe City's swaps were
procured through a competitive bid process. If the City elected to use a "negotiated"
procurement process, the City obtained athird-party opinion regarding the value ofthe swap
priced on a negotiated basis. Mr. Fine explained that underwriters on the underlying bond deals
typically would contact the City about entering into swap agreements. The City generally
retained a financial advisor to advise on the underlying bond offering and to assess the swap bids
or negotiate the terms of the swap agreement on behalf of the City, and issue an opinion on the
fairness ofthe proposed swap agreement.
Mr. Fine believes the City's debt management team was well informed about the risk
factors associated with swap agreements. Before entering into a swap agreement, the City
analyzed the terms of the proposed agreement, the historical performance of LIBOR and SIFMA
(and other interest rate indexes), the impact of the swap agreements on the availability and cost
of liquidity support for other City variable rate programs, the call option value, the counterparty
risk, the City's exposure to variable rates of interest, and other factors relating to the City's debt
portfolio. Mr. Fine explained that the City has disclosed publicly in its CAFR (since 2004)and
in its 2006 Swap Policy the risk factors that it considered and the means used to mitigate those
risks before entering into a swap transaction.
Mr. Fine could not recall any instance in which a swap counterparty or the City's swap
advisor failed to disclose a material fact, misrepresented a material fact, failed to explain the
product or the terms of the swap, or withheld any information requested by the City (or the
City's financial advisors). While Mr. Fine believes that counterparty disclosures relating to the
swap agreements have increased over the years, he does not believe or have reason to believe
that any information or risk factors were misstated or withheld from the City before it entered
into the swap agreements. Nor was Mr. Fine aware of any fraudulent or reckless conduct by the
swap counterparties. Mr. Fine believes that the City's swaps benefitted taxpayers and that the
City obtained the best deals it could based on the market conditions existing at the time it entered
into the swap agreements.
Michele Curran (Assistant Comptroller)
Michele Curran became an Assistant Comptroller in 2007. Prior to that, she was
employed by the City as a research analyst starting in 2000. Ms. Curran earned an undergraduate
degree (B.S. Finance)from the University of Illinois at Chicago and a Masters in Business
Administration from DePaul University (Finance). Ms. Curran currently reports directly to
Deputy Comptroller Jeremy Fine and CFO Lois Scott.
Ms. Curran has been involved in the City's swap agreements since 2003, and has played
an active role in the procurement and administration of the agreements since 2007. Ms. Curran
explained that the City was well informed about the risks associated with swap agreements. The
City worked with sophisticated financial advisors who specialized in swap deals. These advisors
would analyze swap terms sheets, attend meetings with financial service companies that
proposed financing structures (including swaps), negotiate the terms of the swap agreements,
identify and communicate risk factors to the City, and issue opinions regarding the fairness ofthe

15

proposed transactions. The City also understood the impact that various risk factors could have
on the performance of the swap agreements. This included the risk that the interest due under a
variable-rate agreement could fall below the synthetic fixed rate payment paid to the bank
counterparties.
Ms. Curran believes that the City got the best deal that it could based on market
conditions at the time it entered into the swap agreements. Ms. Curran was not aware of any
fraudulent conduct, material misrepresentations of fact, or material omissions of fact related to
the City's swaps.
4.

Brian King(former Deputy Comptroller)

Brian King served as Deputy Comptroller from 1999 to 2006. Currently, Mr. King is a
Managing Director of Public Finance at Mesirow Financial. Mr. King has over 20 years of
public finance experience. Mr. King earned his bachelor's degree from Knox College and a
Masters of Management from Northwestern University.
As Deputy Comptroller, Mr. King worked on all of the City's swap agreements from
1999 through 2006. Mr. King explained that the majority of the City's swaps were procured
through competitive bid processes. For those swaps procured through negotiation, Mr. King
believed that the counterparties dealt with the City in good faith. Mr. King explained that swap
counterparties had an incentive to deal with the City in good faith because the banks wanted to
conduct future business with the City. According to Mr. King, the City would not do business
with a counterparty it believed to be dishonest.
Mr. King believed that the City was well informed about the risks associated with swap
agreements. Among its employees and financial advisors, the City frequently discussed
counterparty risks, credit risks, basis risks, tax risks, and termination risks. Mr. King believed
that the City got the best deal it could based on market conditions at the time it entered into the
swap agreements. Mr. King was not aware of any fraudulent conduct, material
misrepresentations of fact, or material omissions offact related to the City's swaps.
5.

Dana Levenson (former CFO)

Dana Levenson served as Chief Financial Officer from approximately September 2004 to
March 2007. Mr. Levenson graduated from Brown University in 1979 and obtained a Master's
in Business Administration from New York University. Prior to joining the City, Mr. Levenson
worked in investment banking for more than 25 years, performing numerous corporate and
municipal debt financings and interest rate swaps.
Mr. Levenson believed that the debt management team at the City during his tenure was
both experienced and knowledgeable. Further, because of his own experience, he was involved
in the City's bond issuances, including variable rate demand obligations and interest rate swaps.
He and the debt management team understood the risks of such transactions. Indeed, he
participated in identifying and drafting the risks associated with the swap transactions for the
City's CAFRs and the City's 2006 Interest Rate Swap Policy. Mr. Levenson noted that at the
time of these transactions, the City's credit rating was at a 20-year high, but further noted that he

16

fully understood that downgrades in the City's credit ratings could impact the cost of capital.
While he did not expect that risk to be realized, he understood this risk at the time the City
entered into the swap agreements. Mr. Levenson did not believe that any actual or potential
counterparties misrepresented that risk to the City, and he believed that the rest of the City's debt
management team likewise understood that risk.
During Mr. Levenson's tenure, the City used financial advisors and swap advisors to
consult on the transactions. He did not believe that any of these advisors, bond underwriters or
swap counterparties downplayed or tried to minimize the risks of the transactions. Mr. Levenson
was not aware of any misrepresentation or omission made in connection with any of the City's
swap transactions.
6.

Tariq Malhance (former Comptroller

Tariq Malhance started at the City in 1981 as an Accountant for the City Comptroller's
Office. In 2002, he became the Comptroller and remained in this position until December 2005.
Mr. Malhance holds a Bachelor of Science and a Masters in Business Administration from
Roosevelt University, an M.A. in Economics from the University of Illinois at Chicago, and
finished the coursework for a Ph.D. in Public Policy Analysis at the University of Illinois at
Chicago. Currently, Mr. Malhance serves in the Public Finance Group at Hilliard Lyons.
In his roles at the City, Mr. Malhance oversaw the issuance of debt, including debt
transactions with interest rate swaps. Mr. Malhance currently has little recollection of the details
of any specific swap transaction. He did remember the termination of an interest rate swap with
Bear Stearns that resulted in a profit to the City. According to Mr. Malhance, Bear Stearns paid
the City a substantial termination fee. He explained his knowledge and understanding of swap
transactions, and used the example of the Bears Stearns swap as a situation that turned a profit
for the City. Mr. Malhance stated that the City consistently tried to keep its cost of capital low,
and used a combination offixed and variable rate debt in an effort to do so.
The City used financial advisors and swap advisors to assist it. Mr. Malhance does not
believe that a bank counterparty or underwriter misled the City, or that the City did not
understand the risks involved in the transactions. He is not awaxe of any misrepresentation or
omission made in connection with any of the City's swap transactions.
7.

Steve Lux (former Comptroller

Steve Lux served the City in various positions from 1996 to 2011. He graduated from the
University of Illinois with a Bachelor of Science in Accounting in 1986 and is a Certified Public
Accountant. He joined Touche Ross, where he spent 9 years as an auditor, with the City as a
client. In 1996, he joined the City as a deputy comptroller for general accounting. He became
the City's Comptroller in 2006 and left the City in July 2011. He later became the Chief
Financial Officer at the Chicago Park District, a position that he continues to hold.
In his role at the City, Mr. Lux was involved with running historical data and calculating
financial projections to be included in the offering documents for the City's bond issuances,
including variable rate demand obligations with interest rate swaps. He believed that the City

17

fully understood the risks involved in these transactions, and he was involved in preparing
disclosures of those risks. Mr. Lux confirmed that at the time of entering into the swap
agreements, he understood the risk that the City's credit ratings could be downgraded, although
he did not believe that the downgrades would happen to the extent that they have. He believed
that the use of interest rate swaps saved the City substantial capital costs as compared to issuing
conventional, fixed-rate debt at the time, that the swaps are still working in the City's favor
today, and that the swaps may ultimately save additional taxpayer funds. Finally, Mr. Lux stated
that the City retained sophisticated counsel and advisors on the transactions, and he did not
believe the swap counterparties or broker-dealers and advisors misled the City. Mr. Lux is not
aware of any misrepresentations or omissions made in connection with any of the City's swap
transactions.
8.

Paul Volpeformer CFO)

Paul Volpe graduated from Northeastern University with a Liberal Arts degree in 1991.
After graduation, he worked in retail banking until joining the Finance Division of the City's
Aviation Department in 1995. He worked on many debt-related transactions while with the
Aviation Department, and moved to the City's budget office in June 2005, where he became the
City's budget director. In June 2007, Mr. Volpe became the City's Chief Financial Officer, and
served as CFO until he was named former Mayor Daley's Chief of Staff in December 2008. He
is now the Village Manager ofthe Village of Elmwood Park, Illinois.
Mr. Volpe did not have any specific recollection of any particular bond or swap
transaction. He stated, however, that the City used interest rate swaps in an effort to save on the
cost of capital and mitigate the risks of variable rate bond issues. Mr. Volpe reported that the
City generally retained lawyers and outside advisors and had an experienced, knowledgeable
team within the City to review and negotiate transactions. If anyone detected a
misrepresentation or omission, he believed it would have been voiced. He further believed that
given the number of banks involved and the number of presentations the City attended, if any
one bank attempted to misrepresent a material fact, the City would have recognized it or
identified it as a red flag, or a competing bank would have discovered it and brought it to the
City's attention.
Mr. Volpe believed that the City understood the risks involved in swap transactions.
While he did not personally believe that the City's credit rating would be downgraded, he
understood and was advised of the risk of such a downgrade and the impact it would have under
the swap agreements at the time the City entered into these transactions. In that regard, he stated
that he knew more about the City's credit worthiness than the swap counterparties and brokerdealers. Mr. Volpe was not aware of any misrepresentations or omissions made in connection
with any of the City's swap transactions.
9.

Walter Knorr(former CFO)

Walter Knorr graduated from Wittenberg University in 1971 and became a Certified
Public Accountant at Arthur Young &Company in the audit department. He joined the City in
1982 as Assistant Deputy Controller, and remained with the City, rising to Comptroller/CFO,

18

before he left the City in 2002. Mr. Knorr went on to work for Citibank and is currently the Vice
President, Chief Financial Officer, and Comptroller for the University of Illinois.
Mr. Knorr stated that the City took a conservative approach to interest rate swap
transactions. In the mid-1990s, banks began to present swaps as risk management tools. Mr.
Knorr did not want the City to be one of the first municipalities to enter into such transactions
and, therefore, the City monitored the swap market prior to entering into swaps on its own
behalf. Mr. Knorr also remembered sitting through a number of presentations that discussed the
risks associated with swap transactions, including interest rate risk, credit risk, the risk of a
counterparty's credit rating suffering a downgrade, and basis risk. He does not believe any
counterparty downplayed risks or tried to mislead the City by misrepresenting or omitting a
material fact. Nor is he aware of any facts that support a fraud or other claim by the City against
its counterparties relating to the swap transactions entered into during his time at the City.
IV.

ANALYSIS

We have concluded that the City does not have a good faith legal basis upon which to
allege unfair or fraudulent conduct by the bank counterparties to the City's swap transactions.
We analyzed the City's existing swap transactions under the federal securities laws, the Illinois
securities laws, and FINRA arbitration rules.
A.

Fraud Based Claims - An Examination of the City's Swap Deals Uncovered

No Evidence of a Material Misrepresentation or Omission of Fact
1.

Federal Securities Laws Claims

We found no evidence that would support a good faith claim against the City's
counterparties for a violation of the federal securities laws. Section 10(b) of the Securities
Exchange Act makes it unlawful for any person to "use or employ, in connection with the
purchase or sale of any security ... any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Commission may prescribe as necessary or
appropriate in the public interest or for the protection of investors." 15 U.S.C. 78j(b). SEC
Rule l Ob-5 implements this provision by making it unlawful, among other things, to "make any
untrue statement of a material fact or to omit to state a material fact necessary in order to make
the statements made, in light of the circumstances under which they were made, not misleading."
17 CFR 240.1Ob-5(b). The United States Supreme Court has recognized an implied private
cause of action from the text and purpose of 10(b). See Tellabs, Inc. v. Makor Issues &Rights,
Ltd., 551 U.S. 308, 318 (2007).
For the City to prevail on a claim that a counterparty made a material misrepresentation
or omission in violation of 10(b) and Rule lOb-5, it must allege and prove "(1) a material
misrepresentation or omission by the defendant;(2)scienter;(3)a connection between the
misrepresentation or omission and the purchase or sale of a security;(4)reliance upon the
misrepresentation or omission;(5)economic loss; and (6)loss causation." Stoneridge
Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 157(2008).

19

A misrepresentation or omission is "material" when there is "a substantial likelihood that

the disclosure ofthe omitted fact would have been viewed by the reasonable investor as having
significantly altered the `total mix' of information made available." Basic Inc. v. Levinson, 485
U.S. 224, 231-32(1988). The City also must establish that the swap counterparty acted with "a
mental state embracing intent to deceive, manipulate, or defraud." Tellabs, 551 U.S. at 319, n. 3.
A complaint adequately pleads fraudulent intent "only if a reasonable person would deem the
inference of scienter cogent and at least as compelling as any opposing inference one could draw
from the facts alleged." Id. at 324.
Accordingly, the critical element of any cause of action for securities fraud, or any fraud
claim for that matter, is "a material misrepresentation or omission." Here, we found no evidence
of a misrepresentation or omission by the City's counterparties on any of the swap agreements.
Nor was any individual involved in the transactions on behalf ofthe City aware of a
misrepresentation or omission. All of the individuals we interviewed, including the individuals
responsible for negotiating and executing the City's swap agreements, were well informed and
aware of the various risks associated with swaps. No one was aware of any fraudulent or
reckless conduct by a swap counterparty, and several individuals volunteered their belief that the
swaps have benefitted the City. Indeed, all agreed that the City obtained the best possible deal
that it could have made based on market conditions at the time it entered into the swap
agreements.
Further, we found no documents or communications to the City authored by
counterparties or underwriters that attempted to misstate the risks associated with the swap
agreements. Moreover, the City would be hard pressed to claim that it did not understand those
risks. The City employed a talented, experienced, and knowledgeable debt management team as
well as outside advisors and outside counsel to advise on the transactions. In some instances, the
City reviewed multiple presentations from multiple investment banks prior to entering into swap
transactions. The City and its advisors negotiated and documented the swap transactions. In the
swap transaction agreements, the City made a number of representations regarding its knowledge
and sophistication and acknowledged the limited, non-fiduciary role played by the swap
counterparty. The interviews and review of documents make clear that the City knowingly and
strategically used the swap transactions as a risk management tool, and swaps constituted only a
portion ofthe City's debt portfolio. Finally, the City published the risks associated with swap
agreements in its CAFRs and its 2006 Swap Policy.
It would be virtually impossible for the City to argue now that a counterparty made a
material misrepresentation or omission given the City's representations to the counterparties, its
understanding of the risks in these swap transactions, and its use of advisors and outside counsel
to assist.
These same facts would undermine any claim by the City that it relied on a
misrepresentation made by one ofthe City's swap counterparties. Reliance is an essential
element required to establish a 10(b) and Rule l Ob-5 violation. Stoneridge Investment
Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 157(2008). In addition to the disclosures
in the City's CAFRs and the City's 2006 Swap Policy, and the City's experienced debt
management teameach of which alone would create an obstacle in establishing reliancethe
ISDA Master Agreements that governed all of the City's swap agreements contained a "non-

20

reliance" clause, in which the City stated that it had made its own decision to enter into each
transaction using its own judgment and the advice of its advisors. The City affirmatively
acknowledged that it was not relying on any representations by a swap counterparty, and that the
counterparty was not acting as the City's fiduciary or as the City's advisor with respect to the
transaction. The ISDA Master Agreements further provided that
[the City] has determined the economic risks and merits, as well as
legal, tax, and accounting characterizations and consequences .. .
and is capable of assuming such risks, without relying on the
advice of[counterparty bank].
Given the "non-reliance" clause in the Master Agreement and the other factors identified above,
we have concluded that the City does not have a basis to establish reliance.
As to the basis swap transactions the City entered into, these transactions were for the
purpose of receiving a substantial up-front payment, or to shorten or lengthen the duration of the
swap. The basis swap transactions served the City's stated purpose. We likewise found no
evidence that the City's swap counterparties misrepresented the risks of these transactions.
Rather, the City strategically negotiated the terms of these swap transactions to manage its debt
portfolio and receive up-front cash payments. The City does not have a credible claim for fraud
or misrepresentation under the federal securities law relating to these basis swap transactions.
One additional fact that would make it extremely difficult for the City to assert a good
faith claim against its swap counterparties for a violation ofthe federal securities laws is that the
City's current and former employees involved in negotiating and executing the swap agreements
are not aware of any misrepresentation or omission made in connection with any ofthe swaps. If
the City were to file a claim against one or more of its counterparties, a number ofthese
individuals likely would be called as witnesses to address that claim. But none will testify that
the counterparties defrauded the City, and none will testify that the counterparties failed to deal
fairly with the City.
Based on our review of the available evidence, we recommend that the City not pursue a
cause of action against any of its counterparties for a violation of the federal securities laws.
2.

Illinois Securities Law of1953 ("Illinois Securities Act")

We also found no evidence that would support a good faith claim against the City's
counterparties for a violation of the Illinois Securities Act. The Illinois Securities Act provides
rescission as a remedy for unlawful conduct in connection with the sale of a security.
Specifically, the Illinois Securities Act provides that "[e]very sale of security made in violation
of the provisions of this Act shall be voidable at the election ofthe purchaser." 815 ILCS
5/13(A). To invoke this provision, the purchaser must give notice of any election to void "within
6 months after the purchaser shall have knowledge that the sale ofthe securities to him or her is
voidable." See 815 ILCS 5/13(B).

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Section 12 ofthe Illinois Securities Act provides:

***

It shall be a violation of the provisions of this Act for any person:

F. To engage in any transaction, practice or course of business in connection

with the sale or purchase of securities which works or tends to work a fraud or
deceit upon the purchaser or seller thereof.
G. To obtain money or property through the sale of securities by means of any
untrue statement of a material fact ....
***
I. To employ any device, scheme or artifice to defraud in connection with the
sale or purchase of any security, directly or indirectly.
815 ILCS 5/12(West 1998).
Because sections 12(F), 12(G), and 12(I) of the Illinois Securities Act are modeled after
sections 17(a)(1) through (a)(3) ofthe federal Securities Act of 1933 (Securities Act)(15 U.S.C.
77q(a)(1)through (a)(3)(2000)), Illinois courts look to federal securities fraud case law in
interpreting those sections. People v. Whitlow, 89 I11.2d 322, 333-34 (1982); Foster v. Alex, 213
Ill. App. 3d 1001, 1005 (5th Dist. 1991). Sections 17(a)(1)through (a)(3) ofthe Securities Act
require nearly the same elements as section 10(b) ofthe Securities Exchange Act(15 U.S.C.
78j(b)(2000)), and Rule lOb-5(17 C.F.R. 240.1Ob-5 (2000)). Moreover,"reasonable
reliance is an element of sections 12(F), 12(G), and 12(I) of the Illinois Securities Law."
Tirapelli v. Advanced Equities, Inc. 351 Ill. App. 3d 450(1st Dist. 2004).
If the City were to attempt to pursue claims under the Illinois Securities Act, it would
face similar hurdles to those relating to the federal securities laws. First, as discussed above, we
have found no evidence of a misrepresentation or omission related to the City's swap
agreements. Second, the City was a sophisticated and knowledgeable market participant that
was advised by professional advisors. Moreover, when the City entered into each ofthe swap
agreements in question, it expressly acknowledged that it had not relied on any representations
made by the counterparty banks. Rather, the City entered into each agreement after its own
review and assessment of the proposed transaction and with the professional input and advice of
outside financial advisors, tax advisors, and counsel. Under these circumstances, it would be
extremely difficult for the City to establish the key element of reliance.
Accordingly, based on our review of the evidence and the facts and circumstances we
recommend that the City not pursue a cause of action against any of its counterparties for a
violation of the Illinois Securities Act.

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3.

Claims Under the Illinois Consumer Fraud and Deceptive Practices Act

The Grais &Ellsworth memorandum also suggests that cities may have "claims under
state unfair trade practices acts." However,the City lacks standing to assert a claim under the
Illinois Consumer Fraud and Deceptive Practices Act(CFA). To state a claim under the CFA,a
"person"(as specifically defined by the CFA)must show:"an unfair or deceptive act or practice
by the defendant; the defendant's intent that plaintiff rely on the deception; the occurrence of the
deception during a course of conduct involving trade or commerce; and actual damage to the
plaintiff proximately caused by the deception." See 815 ILCS 505/1 et seq.; see also Mantis v.
Pekin Mem'l Hosp. Inc., 395 Ill. App. 3d 943, 949 (Ill. App. Ct. 3d Dist. 2009). Under the CFA,
a municipality is not a "person" capable of bringing suit. See 815 Ill. Comp. Stat. 505/1(c);
Board ofEducation ofCiry ofChicago v. A, C and S, Inc., 131 Ill. 2d 428, 469(1989)("[T]he
legislature is aware of how to include a body politic within the definition of `person' or
`corporation,' and we believe that its failure to do so in the Consumer Fraud Act shows an intent
not to include them within the definition of persons who may sue based on the Act.").
Here, because the City is not a "person" eligible to file a claim under the statute, it lacks
standing to assert a claim under the CFA. More importantly, a good faith claim under the CFA
suffers from the same dispositive defects as the other claims discussed above: there is no
evidence of a deceptive act or practice by one of the swap counterparties. There is, therefore, no
good faith basis upon which the City may pursue a claim under the CFA.
4.

Claimsfor Violations ofMSRB and FINRA Rules

The City has no private right of action against any of its swap counterparties under rules
promulgated by the Municipal Securities Rule Making Board (MSRB),or the Financial Industry
Regulatory Authority (FINRA). Congress created the MSRB in 1975, and expanded its mission
with passage of the Dodd-Frank Act in 2010. The MSRB creates rules that securities firms,
banks, and municipal advisors must follow when engaging in municipal securities transactions
and advising investors and state and local governments. The United States Securities and
Exchange Commission (SEC), FINRA,and federal banking regulators enforce MSRB rules,
depending on the status of the entity against whom the rules are being enforced. There is no
express private right of action under the MSRB rules, and courts thus far have rejected attempts
to imply a private right of action. See e.g., Prager v. FMS Bonds, Inc., 2010 WL 2950065 (S.D.
Fla. 2010); Charter House v. First Tennessee Bank,693 F. Supp. 593, 598(M.D. Tenn 1988).
In addition to the enforcement of MSRB Rules, FINRA promulgates its own rules for
member firms, including Rule 2010, which requires members to observe high standards of
commercial honor and equitable principles of trade. Courts also have rejected a private cause of
action for a violation of FINRA rules or regulations. See Salder v. Retail Properties ofAm., Inc.,
No. 12-5882, 2014 WL 2598804, *24(N.D. Ill. June 10, 2014); Richman v. Goldman Sachs
Group, Inc., 868 F. Supp. 2d 261, 275 n. 5 (S.D.N.Y. 2012). Accordingly, the MSRB and
FINRA rules do not create a cause of action the City could pursue in court.

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B.

FINRA Arbitration

Even if the City could assert agood-faith claim grounded in fraud against a swap
counterparty, an arbitration before FINRA, which the September 15, 2014 and October 10, 2014
letters urge the City to "immediately file," is almost certainly unavailable to the City.
FINRA is aself-regulatory organization regulated by the SEC that provides an alternative
dispute resolution forum to its member firms and customers of its member firms. Under FINRA
rules, member firms are required to arbitrate customer disputes before a FINRA appointed
arbitration panel. FINRA member firms also are required to include in their agreements with
customers a provision that allows disputes to be arbitrated. None of the City's swap
counterparties are FINRA member firms. Nor does it appear that in most instances the swap
counterparties could be considered broker-dealers engaging in municipal securities activities or
underwriters subject to an arbitration requirement under Rule G-35 of the MSRB. Rather, the
counterparties are banks that submitted bids to, or negotiated with, the City on the swap
transactions and entered into ISDA Master Agreements for each swap transaction. It is unlikely
that the City could compel these non-FINRA member firms to arbitrate before FINRA.
If a viable cause of action existed, the City might be able to, in some instances, bring
FINRA arbitration claims against the broker-dealer bond managers and underwriters. If the swap
counterparty and senior bond manager, or underwriter, are affiliates of the same investment
bank, the City could argue that the FINRA member sold the interest rate swaps with the
underlying vaxiable rate bonds as a package and that, in doing so, the bond manager or
underwriter misled the City. In many instances, however, the City issued the variable rate bonds
and competitively bid the associated interest rate swap. Consequently, the swap counterparty
and the bond manager or underwriter were not affiliates ofthe same investment bank. These
facts present significant challenges to compelling FINRA arbitration, even under this alternative
theory.
Moreover, the ISDA Master Agreements that the City entered into with the swap
counterparties contain exclusive forum selection clauses. These clauses require the parties to
submit any dispute to the exclusive jurisdiction ofthe courts of the State of Illinois and the
United States District Court in the Northern District of Illinois. Recently, the Second Circuit
held that a "forum selection clause supersedes FINRA rules requiring arbitration." Goldman,
Sachs & Co. v. Golden Empire Sch. Fin. Auth., No. 13-797-CV,2014 WL 4099289, at *6(2d
Cir. Aug. 21, 2014); Citgroup Global Markets, Inc., v. N.C Est. Muni. Power Agency, No. 132247-CV,2014 WL 4099289, at *6(2d Cir. Aug. 21, 2014).
The September 15, 2014 Letter's reference that the City had until only early October to
initiate a FINRA arbitration is likely a reference to FINRA's six-year arbitration eligibility rules.
See FINRA Code of Arbitration, Rule 12206. Under FINRA's dispute resolution rules, the
occurrence or event giving rise to the dispute must have occurred within six years for the claim
to be eligible for submission to arbitration. Here,the City entered into all of the underlying
variable rate bond offerings with connected interest rate swap transactions more than six years
ago. The event or occurrence giving rise to the dispute would be the misrepresentation,
omission, or lack of fair dealing at the time of entering into the underlying variable rate bond
offering and connected swap. Therefore, even if FINRA arbitration were an available forum for
24

the City to file a claim relating to its swap agreements, disputes relating to fraud or unfair dealing
in the inducement of those swap transactions likely would not be eligible for submission to
FINRA arbitration.
C.

The Baldwin County Sewer Service Arbitration, The Roosevelt Institute Blog
Post, and the Grais &Ellsworth LLP Memorandum

It is our understanding that the allegations set forth in the September and October Letters
the City received from union leaders were based on four sources:(1) an Opinion and Award
issued by the American Arbitration Association on March 20, 2014, in the matter captioned In
the Matter ofArbitration between Baldwin County Sewer Service L.L.C. and Regions Bank;(2)a
post by Saqib Bhatti on the Roosevelt Institute blog "Next New Deal", titled Wall Street
Swindled Local Governments, Too. Here's How They Can Get Their Money Back, dated
September 17, 2014;(3)a memorandum from the law firm Grais &Ellsworth LLP, dated August
25, 2014,to Saqib Bhatti; and (4) a memorandum from the law firm Grais & Ellwsorth LLP,
dated October 9, 2014. Because the October 9, 2014 and August 25, 2014 Grais &Ellsworth
memoranda are identical, with the exception of one paragraph that acknowledges that an issuer's
disclosures may vary based upon their knowledge and experience, we refer to both memoranda
collectively as the "Memorandum." The assertions and allegations raised by these materials
were not substantiated by our analysis ofthe City's swap agreements.
The Roosevelt Institute blog post appears to be almost entirely based on the
Memorandum. Our review of Mr. Bhatti's qualifications revealed that he holds an
undergraduate degree in Political Science. He holds no post-graduate degrees, and has no
specialized training in finance, let alone municipal finance. He does not hold a finance,
economics, accounting, or law degree. He completed aone-year fellowship with anot-for-profit
group working with labor unions to review the role municipal finance deals played in the public
budget crisis. Neither his blog post nor the Memorandum provide any detail or any specific
misrepresentations or omissions relevant to the City's swap agreements. In addition, Mr. Bhatti
appeared at the September 24, 2014 meeting of the Chicago Board of Education to urge that the
Board pursue claims against its bank counterparties. The Board of Education asked Mr. Bhatti
for specifics, but he was unable to identify any alleged misrepresentations or omissions.
The Memorandum purports to analyze potential claims by public issuers of synthetic
fixed-rate debt against their swap counterparties. However, in the very first paragraph of the
Memorandum, Grais &Ellsworth acknowledge the limitation of their legal analysis and
recommendations:
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....[IJfan
underwriter did violate the fair dealing rule, the issuer may have a remedy
in arbitration before FINRA.
(emphasis added). The Memorandum then concedes that Grais & Ellworth did not review any
specific financing or swap transaction documents and that it was aware of no specific
underwriter that actually violated the fair dealing rule. Instead, the Memorandum offers the
25

sometimes

suggests

conclusory statement that "[i]n general, however, our [Grais & Ellsworth's] research strongly
that underwriters frequently failed to provide the disclosures to public issuers by the fair
misrepresented material risks." (Emphasis added). No such
dealing rule, and
research has been presented to the City by Grais &Ellsworth or anyone else.
Grais & Ellworth's Memorandum presupposes the most critical and necessary
requirement for a fraud claim: that the underwriters misrepresented material facts to the issuer.
The entire analysis that follows in the Memorandum, and which was subsequently adopted by
the Roosevelt Institute blog post and the September and October Letters, assumes that there were
misrepresentations of material facts related to the City's interest rate swaps. Based on this
assumption, the Memorandum discusses how arbitration could be initiated and claims could be
made against the swap counterparties. The assumption that there were material representations is
a significant one and, based on our investigation, unfounded in the context of the City and its
swap agreements.
Further, the Memorandum cites a 2012 Interpretative Notice relating to MSRB Rule G17, which requires the disclosure of certain risks to issuers of complex municipal securities. The
City, however, has publicly acknowledged its understanding ofthe risks identified in the
Interpretative Guidance for more than ten years, and our interviews revealed that the City
officials responsible for executing the swaps understood those risks long before then. Because
our investigation uncovered no evidence of misrepresentations or omissions on the part of the
City's swap counterparties or underwriters and, in fact, found that the City publicly
acknowledged its understanding of the risks, the Memorandum and the Roosevelt Institute blog
post were not helpful to our analysis.
Reliance on the blog post, the September and October Letters, and the Memorandum to
assert a claim also would be misplaced for another reason: many of the claims and
recommendations in these documents are grounded almost, if not entirely, on a single arbitration
decision involving Baldwin County Sewer Service LLC(BCSS), a private sewer utility
headquartered in Summerdale, Alabama. In this decision, a 2-1 panel found that AmSouth Bank,
while acting both as a creditor and an advisor, misrepresented the rates on variable rate demand
notes sold to BCSS. Specifically, bank employees repeatedly told individuals at BCSS that the
variable rates were "LIBOR rates" when, in fact, they were not. Further, the panel determined
that when the bank later sold swap agreements to BCSS, it failed to disclose the "basis risk"
associated with the swap. The panel rejected the bank's claim that it had disclosed this risk,
noting that the only presentation allegedly made was to a 23-year-old low level temporary
employee at BCSS whose responsibilities included supervising the secretaries, but not finance.
Further, the panel noted that this presentation was three years before the bank even sold a swap
agreement to BCSS.
Because the facts and circumstances in the BCSS arbitration decision are so different
than those relating to the City and its existing swap agreements, that decision offers no support
for the idea that the City should file a fraud or unfair dealing claim against its counterparties.
First, whereas the BCSS arbitration involved a specific misrepresentation saying the rate at
issue was a"LIBOR rate" when it was not our review found no evidence to suggest that any of
the City's bank counterparties misrepresented the terms of the swap agreements. Second, unlike

BCSS,the City has decades of experience in entering swap transactions. The City did not rely
upon its own counterparty as an advisor. Instead, our review ofthe documents and interviews of
individuals involved in executing the City's swap agreements revealed that each transaction was
thoroughly examined, vetted, and negotiated by its own highly sophisticated professionals,
financial advisors, tax advisors, and counsel. In many cases, the City competitively bid the
swaps and received multiple presentations from different banks prior to agreeing on the lowest
interest rate bid. Third, we found no evidence to suggest that bank counterparties misstated the
risks associated with the swaps, including the "basis risk." To the contrary, for more than ten
years, the City has disclosed publicly its understanding of the risks associated with swap
agreements.
Finally, we have not uncovered any support for the allegation in the union leaders'
September and October Letters that the City's interest rate swaps are costing the City and the
Chicago Public Schools over $100 million every year, and have caused losses of over $800
million to date. The October Letter asserts that the City has made net interest swap payments of
approximately $70 million. That the City has made net swap payments, however, does not mean
that the City has suffered damages as a result of fraud or unfair dealing. The notion that net
interest swap payments equate to damages presupposes that such payments are the result of fraud
or unfair dealing and ignores the fact that the City remains obligated to service its debt
(regardless of whether it issued a variable rate or a fixed rate bond).
V.

CONCLUSION

Our investigation found no evidence that would support a good faith claim that the City's
swap agreements were procured by fraud or that any of the City's swap counterparties made any
material misrepresentations or omissions of fact. Nor did the investigation discover any
evidence to support a claim that the City's swap counterparties failed to deal fairly with the City
when negotiating and executing the swap agreements. Indeed, the facts that affirmatively refute
any such claim here are clear and compelling. Filing such a claim not only would be a waste of
the City's money, but could damage the City's credibility, and weaken its position in current and
future bond and other financial dealin~s,at~id transactions.

s L. Kopecky

Daniel J. Co ins

27