An illustration of the Interest Rate Swap Scandal in the US: SEC v. JP Morgan

USA securities and exchange commission, case n. 3-13673-2009

Categories: Business Law
Typology: Case Law

Interest Rate Swaps (IRSs) have emerged for having played an important part in the bankruptcies of a number of municipalities in the US during the post-crisis years. In these cases, the derivative contracts were entered into between a bank and a government entity whereby a floating rate of interest was exchanged for a fixed rate on the issuance of a bond. Government entities entered these contracts in order to hedge their exposure to rising interest rates, in connection with loans related to the financing of large public projects.

The bankruptcy of Jefferson County (JC), and the ensuing litigation, provides a useful overview of some relevant legal issues. In the 1990s JC undertook vast rebuilding of its sewage system which had previously caused the pollution of rivers. These works were financed with a bond issue worth $3.2 billion. Upon completion of the work, Jefferson County sought to lower the interest payments on the bond. The investment bank JP Morgan advised JC and recommended firstly, to convert its debt exposure, from fixed interest rates to adjustable (floating) interest rates, and secondly, to hedge the resulting risk of interest rate rises by entering into IRSs. As the global financial crisis exploded, and as the Federal Reserve lowered interest rates, JC found itself owing more interest payments than it was receiving (also because of the number of swaps it had entered simultaneously which amounted to a value greater than the bonds). This led eventually to unsustainable level of debt and to bankruptcy in 2011.

The Securities Exchange Commission (SEC) initiated investigations on the complex swaps agreements arranged by JP Morgan and on the various fees and charges that increased JC’s outstanding debt exposure. Interestingly, the proceedings brought against JP Morgan was preceded by two related actions, one brought against a former local mayor who had accepted illegal payments in relation to the bonds he had negotiated on behalf of JC, and a second one against two former directors of the investment bank involved in the illegal payments scheme that allowed JP Morgan to win business with JC (this involving both the bond offerings and the swaps).

The SEC found that the cost of the illegal payments (essentially bribes) was set off by JP Morgan by charging JC higher interest rates on the IRS. This highlighted the flawed negotiation of the swap agreement because JP Morgan was winning business with JC despite not offering the best deal, which also entailed a breach of the SEC “best execution” rule. The SEC also found in fact that competing deals were dismissed by JP Morgan by making payments to rival Wall Street banks. The complex swaps were in other words used to divert public money (represented in this case by the above-market rates and higher fees, incorporated into the swap) into JP Morgan’s pockets. The SEC also alleged in the action the defendant’s violations for making untrue statements of material facts and omissions of facts that contributed to mislead Jefferson County to purchasing the swaps (violations of section 17(a)(2) and (3) of the Securities Act 1933).

Further to the proceedings initiated by the SEC and its findings, JP Morgan agreed to reach a settlement. This included: the payment of $50 million to JC in compensation for unlawful payments, for the purpose of assisting displaced County employees, residents and sewer ratepayers; the payment of $25 million to the SEC as penalty; and the forfeit of $648 million for future swap termination payments.

 (Altalex, 11 march 2014. Article by Vincenzo Bavoso) 

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