What's a Swaption?

From the Erie Times News

Suit: Swap cost district $1M
Erie school system claims excessive fees, fraud in financial deal

BY ED PALATTELLA Published: September 03. 2008 12:50AM

The Erie School District is claiming that a huge investment bank, an Erie broker and a Philadelphia-area investment adviser colluded to defraud the district of more than $1 million in a financial transaction in 2003.

The disputed deal is known as an interest-rate swap. The district is suing to try to force JPMorgan Chase & Co. and others to repay what the district believes are excessive fees that JPMorgan collected.

The other defendants are David DiCarlo, JPMorgan's local broker at the time; and Investment Management Advisory Group Inc., or I.M.A.G.E., which the school district paid $60,000 to provide independent advice on the swap, or "swaption."

The district is alleging in the suit that JPMorgan, through DiCarlo, recommended that the school district retain I.M.A.G.E., and that JPMorgan and I.M.A.G.E. "were involved in a collusive arrangement in the market for Swaptions" at the time of the district's deal. The district claims collusion and "anti-competitive conduct" allowed JPMorgan to procure "excessive transaction fees."

"I.M.A.G.E. and the individual Defendants had knowledge of the ... anti-competitive collusive conduct and participated in it," the district claims in the suit.

As part of the swap -- a form of bond refinancing -- the district received $755,000, which the district plugged into its budget in 2003. Based on its calculations, the district said in the suit, JPMorgan should have received no more than $128,000 in fees for handling the swap. The district claimed JPMorgan instead received $1,227,415 in fees.

The Erie School District, according to the suit, "has been damaged in the amount of $1,099,415, representing the difference between what it should have received under a properly structured swap transaction ... and what was received as a result of the School District being fraudulently induced to enter into the transaction."

The suit does not itemize how much DiCarlo might have collected in fees or commissions.

A spokeswoman for the New York-based JPMorgan said the bank would have no comment on the suit, though the bank previously said the swap was handled properly. A representative from I.M.A.G.E., which is based in Pottstown, did not immediately return a phone call on Tuesday, though that firm has previously defended the handling of the swap.

DiCarlo, reached Tuesday, said JPMorgan has advised him not to comment on the school district's claims.

DiCarlo said he stopped working for JPMorgan as of July 31. He said he retired from JPMorgan because the Erie office was closed.

A spokesman for the bank, Brian Marchiony, confirmed DiCarlo's departure and declined, through an e-mail, to comment on the reasons DiCarlo left.

A national issue
The Erie School District's suit, docketed in U.S. District Court in Erie on Tuesday, culminates months of research that the school district conducted on the swap. The district said in the suit that school officials in October learned through Bloomberg Markets, a national magazine, that the fees might have been excessive.

The suit also represents the Erie School District's legal plunge into the nationwide dispute over swaps, which are unregulated by the federal Securities and Exchange Commission, and which the school district claims were not legal in Pennsylvania until September 2003. The Erie School Board approved the swap with JPMorgan on Sept. 4, 2003.

Other municipalities across the United States are also claiming they were victimized in swap deals, and in March, they filed a class-action suit against JPMorgan and others in federal court in Washington. The case has been moved to U.S. District Court for the Southern District of New York, which includes Wall Street.

In addition, the FBI, SEC and Internal Revenue Service are investigating swaps and similar transactions nationwide. No one has been charged, though a federal grand jury in New York City has been empaneled in the probe, according to public records.

Erie schools Superintendent James Barker, the head of the district for 15 years, has said the district will aggressively pursue any money it believes it is owed in the swap deal. The district hired a Harrisburg law firm, McNees, Wallace & Nurick, to handle the suit, and the lawyers on the case, James DeAngelo and Delano Lantz, commented through a brief statement Tuesday.

The lawyers said the district is seeking to recover damages from the conduct of the defendants.

The eight-count suit claims securities fraud, two other types of fraud and civil conspiracy against all the defendants; breach of implied covenant of good faith and fair dealing against JPMorgan and I.M.A.G.E.; and breach of contract, breach of fiduciary duty and negligence against I.M.A.G.E.

Claims against DiCarlo
As the local broker for the 2003 swap, David DiCarlo is the subject of claims throughout the suit. The suit claims DiCarlo, then an Erie-based vice president for JPMorgan Securities, used his years of experience as a local broker to help persuade the Erie School District to agree to a swap that, unbeknownst to the district, would lead to the large fees for JPMorgan. The suit said DiCarlo never disclosed the size of the fees to the Erie School Board, and that I.M.A.G.E. never raised concerns about the fees.

DiCarlo, a former state representative and currently a member of the Erie-Western Pennsylvania Port Authority, worked with the Erie School District and other local municipalities for decades on bond refinancings and other large-scale financial transactions. DiCarlo was a registered broker with RRZ Public Markets, based in the Pittsburgh area, from 1983 to 2003, and a registered broker with JPMorgan Securities, a part of JPMorgan Chase, from May 2003 through August. JPMorgan acquired RRZ Public Markets in February 2003.

The Erie School District claims that, as part of the fraud, JPMorgan "exploited" its expertise on swaps and "the trust engendered by Defendant DiCarlo's history of dealings with the Erie School District."

DiCarlo, the district claims, "held himself out to be a trusted adviser to the Erie School District and had for 20 years represented the Erie School District on multiple refunding issues."

Details Of The Swap

Interest-rate swap deals are often called "swaptions."

In a swap, two parties agree to exchange payments at different rates. One party typically pays a fixed rate, and the other pays a rate tied to a commodity or security.

In the case of the Erie School District, the district in 2003 agreed to exchange payments with JPMorgan Chase & Co. in connection with $37.3 million in bonds the district issued in 2000 for building projects.

As part of the swap, the district received $755,000, which it plugged into its budget, according to the district's lawsuit, filed Tuesday. The district previously put the figure at $785,000.

JPMorgan, in turn, got an option to take over as the district's bond holder on the 2000 issue in 2011. If JPMorgan took the option, the district would have made its bond payments directly to JPMorgan and not the current investors.

JPMorgan in the swap deal also got money from fees -- the amount of money that is at the center of the school district's suit. JPMorgan has never publicly disclosed the fees. The district, in its suit, claims JPMorgan received $1,227,415 in fees, based on the district's calculations.

The district claims JPMorgan should have received no more than $128,000 in fees for handling the swap. The district wants JPMorgan to repay the difference -- $1,099,415. Bloomberg News, including Bloomberg Markets, which reported extensively on the Erie School District swap, had estimated the fees at $3.9 million.

The Erie School Board approved the swap in a 6-0 vote on Sept. 4, 2003. Three of the directors, including Richard Szychowski, a board member since November 2002, were not present. Of the six directors who voted for the swap, three are still on the board -- Jim Herdzik, Mary Frances Schenley and Eva Tucker Jr.

The swap with JP Morgan has since expired. The district restructured it with PNC Bank in 2006.

Nationwide Concerns

As the Erie School District goes to court over its interest-rate swap, similar financial transactions have raised concern nationwide from other municipalities, as well as law-enforcement officials.

The FBI, Securities and Exchange Commission and Internal Revenue Service are investigating swaps. No one has been charged, though a federal grand jury in New York City has been empaneled in the probe, according to public records.

The deals under scrutiny, according to public records, include those involving JPMorgan and the Investment Management Advisory Group, or I.M.A.G.E., the Philadelphia-area business that acted as the Erie School District's adviser in the district's disputed 2003 bond swap.

A class-action suit filed in federal court in Washington has also raised questions about the propriety of swaps and similar investment vehicles known as municipal derivatives.

The suit, filed March 12, claims JPMorgan Chase, I.M.A.G.E. and more than 30 other financial institutions conspired -- through kickbacks and other activities -- to fix prices and rig bids for swaps and similar municipal derivatives throughout the United States from Jan. 1, 1992, to the date the suit was filed.

The suit in June was transferred to U.S. District Court for the Southern District of New York, which includes Wall Street.

What's Next

JPMorgan Chase & Co. and the other defendants have 20 days from the time they are served to respond to the lawsuit the Erie School District filed in U.S. District Court in Erie. The case has been assigned to Chief U.S. Magistrate Judge Susan Paradise Baxter.

The school district filed the suit in federal court because it involves claims under federal antitrust and securities law, according to court records.

The district said it filed the suit within the five-year statute of limitations for claims involving the swap, which the Erie School Board approved Sept. 4, 2003.