Bid Rigging Lawsuits

On April 24, 2008, the City of Oakland California instituted a class action lawsuit against many of the largest financial firms in the country. The list of those sued reads like a Who’s Who of finance. Bank of America, Wachovia, J.P. Morgan Chase, Bear Stearns, AIG Financial Products Corp., Merrill Lynch, Morgan Stanley, Société Générale and UBS among others were alleged to have conspired to fix the prices of guaranteed investment contracts. A copy of the complaint can be found at: http://www.lieffcabraser.com/pdf/20080400-gic-complaint.pdf

This lawsuit follows right behind another suit against essentially the same parties, but filed by Fairfax County Virginia, City of Chicago, State of Mississippi and others also alleging the financial firms of conspiring to fix the price of derivatives sold to the municipalities.

What appears to be missing from both suits is any allegation that any of the municipalities actually lost money due to the alleged misbehavior of the financial institutions. Sure there are allegations that the institutions conspired to fix the prices of the derivatives, but neither complaint states how this harmed the municipalities. To understand this, you must have an understanding of the IRS arbitrage regulations. The easiest way to understand this is through an example.

Assume that the City of Chicago borrowed funds in the tax exempt market at 1% on $100 million for a year. These suits would have us believe that if the financial institutions had not conspired, the earnings on the investments would have been higher, producing an increase in earnings. In fact, that could not happen.

Assume that the free market yield of the derivatives would have been 3% and that through the conspiracy the actual yield was reduced to 1.5%. Through the operation of the arbitrage regulations, the City of Chicago must pay to the IRS $500,000, the profit it earned by investing for a profit. Now assume the market was not fixed and the City was able to invest at 3%. Now they would get to pay the IRS $1,500,000. In other words, the conspiracy, if it existed, did not harm the municipalities that filed the lawsuits.

One would have to question why file the lawsuit. Is it possible the municipalities are attempting to distance themselves from the financial firms that supported them and rush onto the side of the federal government that has instituted an investigation of the municipal market?