With stadium and arena projects slated to launch in New York, Los Angeles, Atlanta, Minneapolis, Edmonton, and many other cities across North America, sports leagues, teams, and municipalities are increasingly asking banks to “Show Me the Money!” But, as these groups explore financing options for their projects, many will proceed cautiously with an eye toward the remnants of the economic downturn of 2007-08 – and a particular focus on the outcome of In Re Merrill Lynch Auction Rate Securities Litigation.
Before the credit crunch sidelined many stadium and arena projects in 2007-08, the sports industry was experiencing a renaissance in facility development with an estimated 27 major teams and cities planning new construction projects. In the midst of this boom, one of the most iconic stadiums in the United States, the Louisiana Superdome, was planning its own renovation, which it would finance through an arrangement with Merrill Lynch (“Merrill”). Under this arrangement, Merrill helped the owner of the Superdome, Louisiana Stadium & Exposition District (“LSED”) raise over $238 million through the issuance of municipal bonds as auction rate securities (“ARS”).
ARS are long-term variable-rate debt instruments that are traded at periodic Dutch auctions. At a Dutch auction, buy orders are entered at interest rates selected by the bidder. Once all bids are collected by a broker-deal, in this case Merrill, the interest rate for all orders is set to the lowest rate at which all of the ARS available at the auction can be sold. This system can be advantageous to an issuer such as the Superdome owners, if a competitive market sets a low interest rate on the debt. But there is a corresponding risk: if buy orders are insufficient to purchase all of the securities offered at the auction, the auction is said to have failed, and the interest rate until the next auction rises to the maximum rate (or failure rate), which in the case of the LSED arrangement was approximately 12%.
The LSED-Merrill arrangement was unique in two respects. First, LSED had the option to convert its variable rate payments, as set by the auction, into fixed obligations. Second, Merrill placed “support bids” at every auction to ensure that no auction would fail. While LSED was not aware of Merrill’s support bid practice when it initially agreed to the ARS arrangement, it was made aware in 2006 when Merrill disclosed this practice and the associated risks pursuant to an SEC Order.
Despite this disclosure, LSED chose to maintain a variable-rate structure, opting not to exercise its right to convert to a fixed rate structure – a critical play-call that later figured into the court’s assessment of LSED’s securities fraud claims against Merrill.
In February 2008, a wave of auction failures resulted in the collapse of the ARS market and LSED’s ARS went down with everyone else’s. Or up, you might say, as LSED’s interest rate climbed from 4% to the failure rate of 12%, increasing its debt cost an additional $65,000 per day.
In 2009, LSED filed a lawsuit against Merrill alleging that it was faced with debt-related costs that were much higher than it anticipated when it entered into the financing arrangement in 2005. More specifically, LSED alleged that Merrill stepped out of bounds by not providing adequate disclosures under the arrangement and breaching its fiduciary duty to LSED.
LSED’s 2009 lawsuit against Merrill alleged liability for material misstatements and market manipulation under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. Both claims require, among other things, that the plaintiff prove that the defendant’s alleged misstatements and manipulation were the proximate cause of its injury.
In December 2010, the District Court for the Southern District of New York granted Merrill’s motion to dismiss with regard to LSED’s federal claims. The court found that because LSED had the option of converting the ARS to fixed-rate instruments after they learned of Merrill’s “support bid” practices, LSED “controlled its own destiny” and could have avoided the risks associated with the variable auction rates. The court noted that, despite receiving the disclosures regarding Merrill’s support bidding, LSED “was content to pay a lower interest rate while the ARS market functioned as it had all along,” but “[u]ltimately, the bet did not pay off.” That, the court found, does not amount to securities fraud.
LSED’s state law claims fared better than its federal ones. LSED alleged that under Louisiana law, Merrill breached its fiduciary duty as LSED’s “advisor, underwriter, broker-dealer, and investment banker” to provide “advice and recommendations regarding the optimal structure for their debt restructuring.” The court declined to dismiss these claims, finding that Merrill’s advisory relationship with LSED was a fiduciary one, despite the fact that Merrill’s presentations to LSED contained boilerplate statements disclaiming a fiduciary relationship. Further, the court found that Merrill’s failure to disclose its support bidding practices at the outset of the relationship with LSED provides a sufficient basis for a claim that Merrill violated a fiduciary duty. The court similarly denied Merrill’s motion to dismiss the claims of intentional and negligent misrepresentation based on Merrill’s alleged misrepresentation of the nature of the ARS market and its failure to disclose its support bidding practices at the outset of the transaction.
Finally, the court also denied the motion to dismiss LSED’s fraud claim, finding that “knowingly selling an unwitting client an allegedly more profitable but flawed financial product raises an inference of an intent to obtain an unjust advantage.” The court found that LSED sufficiently alleged that Merrill’s support bidding practice (which LSED did not know about at the outset of its arrangement with Merrill) enhanced the profitability of Merrill’s services. Because LSED alleged damages as a result of Merrill’s support bidding practice, the court found that LSED sufficiently stated a claim for fraud.
The dispute between Merrill Lynch and LSED highlights the fine line between fair and foul in the world of sports finance. From a federal securities law perspective, this dispute shows that an underwriter will not necessarily be held liable for alleged misstatements and manipulation if an issuer does not adequately claim that the alleged misstatements and manipulation caused the alleged harm. However, this dispute also shows us that, under state law, the same inadequacy with respect to cause may not prevent an issuer from holding an underwriter liable for the same alleged conduct.