Tri-City Medical Center exited the auction-rate bond market earlier this year, following many not-for-profit hospitals that fled the market after its 2008 collapse. But unlike other hospitals, Tri-City Medical Center has sued its bank and bond insurer over the now-largely defunct financing vehicle.
Taking it to court
California hospital sues Citigroup, insurer over auction-rate bonds, saying it wasn't told of the market's risks
The district-owned hospital in Oceanside, Calif., last month filed a lawsuit in the Superior Court of Orange County against Citigroup and MBIA, alleging the bank and insurer misled the hospital directors with claims the auction-rate market bore low risk and were negligent in failing to disclose bank intervention in the market, including bids to prevent failed auctions.
The lawsuit appears to be one of the first brought by a healthcare bond issuer against banks that marketed auction-rate bonds before the market seized in February 2008 amid investor panic and mounting bank distress. It has not returned.
Alex Samuelson, a Citigroup spokesman, declined to comment on the lawsuit. MBIA spokesman Kevin Brown declined to comment on the litigation.
Tri-City's legal argument boils down to this: No one advised the hospital of the risks, despite an obligation to do so.
The lawsuit alleges Citigroup wrongly claimed auction markets were open and fair and the bonds were relatively low risk, but failed to adequately disclose activity to support and manipulate markets that was the subject of an inquiry by the Securities and Exchange Commission in 2006. The SEC fined 15 banks $13 million in May 2006 for failing to disclose intervention in the auction market, including Citigroup. The banks neither admitted nor denied the claims, but were also ordered to generally disclose potential market activity.
By 2006 “the entire auction-rate securities market was not a free-market operation matching willing investors with willing issuers, but instead was an engineered, artificial market supported by the activities of the investment bankers designed to postpone a collapse, and such support could not continue indefinitely,” the lawsuit said.
In July 2007, eight months before the nation's emerging credit crisis paralyzed the $330 billion auction market, the hospital went to market to refinance roughly $68 million of long-term debt to auction-rate bonds.
At the time Tri-City moved its debt to the auction market, the hospital's seven-member board, elected by the district, was nearly all medical or healthcare professionals, including a retired registered nurse and a retired pharmacist. The one member not working in healthcare was a certified public accountant.
The hospital paid roughly $3.2 million—going to underwriters for the insurance premium; fees for attorneys, trustees and ratings agencies; and miscellaneous costs to refinance the debt, bond documents show.
The lawsuit also names the hospital's attorneys and financial advisers and alleges they were negligent in failing to alert the directors that the 2007 bond deal could violate California law that sets a limit on interest paid for hospital district debt.
Soaring interest on the bonds exceeded the 12% limit for auction-rate securities issued by hospital districts, the lawsuit said. Interest in Tri-City's auction bonds climbed above the state limit in multiple auctions between November 2008 and December 2009, repeatedly reaching 14.5%, according to the complaint.
The interest rate hikes cost Tri-City Medical Center $15 million beyond what it would have paid had debt not been refinanced.
Larry Anderson, CEO of the 330-bed hospital, who dubbed the bonds “heinous,” said the hospital also paid roughly $6 million when it terminated its hedge against interest rates on the debt, known as a swap, two months after his arrival in January 2009. Anderson said the hospital used $51 million in financing from CapitalSource, Chevy Chase, Md., and cash to buy back $58 million of the outstanding bonds, secured by the hospital's cash. Anderson remains CEO after the district voted in April to reverse its decision a week earlier to fire him, a spokeswoman said.
Foley & Lardner and Orrick, Herrington & Sutcliffe, the legal advisers named in the lawsuit, did not return calls seeking comment. In written a statement, Kenneth Kaufman, managing partner of financial adviser Kaufman Hall, dismissed the lawsuit as completely without merit and said the firm will vigorously defend itself against the allegations. Kaufman Hall advised Tri-City Medical Center on its swap deal, the lawsuit said.
“It appears to attempt to blame advisers for the hospital's losses that occurred when the financial markets collapsed, and Tri-City's auction-rate securities were impacted,” Kaufman said in the statement. “Tri-City had been fully advised of all risks relating to these securities, and was solely responsible for final decisions on their financing program.”
The auction-rate market's seizure was an early casualty of the 2008 credit crisis (Feb. 25, 2008, p. 6).
The securities emerged in 1984 and mushroomed to $330 billion before their collapse in February 2008. Borrowers in the market—which sold long-term debt to short-term investors in frequent auctions—often relied on bond insurance for top credit ratings to attract investors.
But as the housing bubble burst, bond insurers with exposure to risky mortgages began to falter. Investors panicked. Banks that had previously stepped in to buy bonds when investors showed no interest sat on the sidelines. And by December 2007, no new borrowers were entering the market, which had issued $38.7 billion in municipal debt that year, including $10.8 billion from tax-exempt healthcare borrowers, Thomson Reuters data show (See chart, p. 6).
Frustrated investors could find no buyers for bonds that many had believed to be easy to quickly cash out. The paralyzed market, along with allegations that banks marketed the securities as highly liquid, has spurred 14 settlements with state and federal securities regulators by banks that have paid investors $61 billion, said Bob Webster, spokesman for the North American Securities Administrators Association. Banks did not admit or deny claims made in the settlements. The New York attorney general's office said investors who faced increasing risk from the bonds had been sold the bonds as “safe, cash-equivalent products,” in a news release announcing a recent settlement.
Meanwhile, borrowers saw interest rates soar to penalty levels that were set to kick in should auctions fail—the term for an auction without enough demand to close a sale—unleashing a rush of not-for-profit hospitals seeking to refinance the expensive debt (Dec. 1, 2008, p. 42).
Conditions worsened as the credit crisis erupted. Hospitals that hedged auction-rate bonds with interest-rate swaps saw the cost to break such deals soar amid market turmoil.
“It was unexpected,” said Jeff Asher, executive director of the Connecticut Health and Education Facilities Finance Authority, which brings municipal bond issues to market on behalf of Connecticut not-for-profit hospitals. “It caught everyone by surprise.” Asher's agency and others like it across the U.S. moved to swiftly yank debt from the paralyzed market. Before its collapse, the authority's borrowers had $1.1 billion in outstanding bonds in the market. All but $60 million have been refinanced, Asher said.
No Connecticut hospitals have sued banks over the financing vehicle to Asher's knowledge, he said. Borrowers moved to refinance debt and minimize damage from the seized market. Many are becoming more conservative, he noted. “I think people moved on,” he said.
James Cox, professor of corporate and securities law at Duke University Law School, said auction-rate bond markets operated to the advantage of both borrowers—who paid short-term rates on long-term debt—and investors—who had an attractive alternative to other highly liquid investments—but did so without complete information about demand for the bonds prior to the 2006 SEC action that required banks to alert investors of possible intervention.
Not ‘inherently manipulative'
“There is nothing inherently manipulative” about the auction-rate bond market prior to 2006, Cox said. “It had a risk that was being ignored by the underwriters and was unknown by the issuers and the investors.”
Regulators recently proposed new disclosure rules for auction markets, despite apparently little expectation of the market's future. The Securities Industry and Financial Markets Association announced this year it would discontinue the calculation of its auction-rate indexes for lack of activity.
The Municipal Securities Rulemaking Board has proposed rules that would require public disclosure of whether dealers intervened to support auctions when bonds fail to attract investors.
“Transparency of bidding information is important because it reflects demand for an auction-rate security product and also the depth of the market,” Lynette Kelly Hotchkiss, executive director of the board, said in a statement. “These factors indicate liquidity for the product and whether the program dealer is providing that liquidity.”
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