The city of Richmond filed a lawsuit Monday against JPMorgan Chase, Royal Bank of Canada (RBC) and the city’s former financial advisors that seeks to recover “tens of millions” in payments made on derivative contracts that officials claim violated state law.
The lawsuit, filed March 17 in Contra Costa County Superior Court, claims the banks promoted “complex derivative products that provided no public benefit while diverting resources from essential city services,” according to a press release from Richmond Mayor Eduardo Martinez’ office.
Derivatives are financial contracts whose value is based on underlying assets or benchmarks, such as interest rate swaps, which cities sometimes use to manage debt portfolios or lower borrowing costs. However, California law strictly regulates how cities can use these complex financial instruments.
The city is petitioning the court to recoup payments that were made to the banks on these contracts, plus interest. The suit also alleges the city’s financial advisors, Public Resources Advisory Group and The Majors Group, breached their fiduciary duty by failing to advise officials that the contracts were illegal.
“These derivative contracts were not the City’s idea,” the complaint states, quoting from an October 2021 Richmond City Council meeting where city staff acknowledged that “the City would prefer…less complexity and risk than contained in the swaps.”
According to the lawsuit, the complex financial transactions began in 2005 when Richmond issued pension obligation bonds structured as convertible capital appreciation bonds. Between 2006 and 2014, the city entered into 10 swap agreements, including seven interest rate swaps, two basis rate swaps and one swaption.
Interest rate swaps are swaps that trade fixed interest rates for variable ones while basis rate swaps exchange different types of variable interest rates. “Swaptions” are contracts in which the buyer pays a premium to the seller for the right to enter into a swap agreement at a specific future date.
The complaint also alleges the transactions violated state law in several ways, including failing to obtain ratings from two nationally recognized agencies and lacking written evidence that the swaps would not adversely affect bond ratings.
“Payments made under the terms of the contracts greatly worsened the City’s difficult financial condition and led credit rating agencies to downgrade the City’s ratings, which made
additional funding more difficult and more expensive,” the suit reads.
Financial deals led to Richmond’s poor credit rating in 2015
Richmond’s financial situation then deteriorated sharply in 2015 when Moody’s downgraded the city’s credit rating to junk status, triggering termination clauses in some contracts. The city claims it paid more than $70 million in termination fees since the 2008 financial crisis, with tens of millions paid just in the past four years.
“For the banks, the tens of millions of dollars that Richmond paid on these derivatives amounted to money for nothing,” said Richmond District 6 council member Claudia Jimenez in the press release. “Meanwhile, our residents have had to endure higher taxes and reduced public services.”
Jimenez told Richmondside Tuesday that the city began investigating its swaps policy in 2021 after the council got a second opinion of its financial advisor’s recommendation to change one swap for another even after new budgeting policies were adopted by the council.
“In that second opinion, what we had found is that since 2005 to 2019 the city had spent over $60 million in termination fees,” she said. “That second opinion really helped us to understand the magnitude of the issue we had. It allowed us to get new municipal advisors to look into the options at refinancing and because of that we were able to refinance and save somewhere between $84 million and $90 million and be upgraded by Moody’s twice in one year.”
Martinez said in the release that the city wants JPMorgan Chase and RBC “to make the city whole by paying back the money they took from the city in illegal payments.”
The city alleges the banks marketed the derivatives as cost-saving measures, but the transactions were actually costly and failed to comply with state laws that strictly limit when municipalities can enter into such agreements.
California law requires derivatives to be connected to highly rated bonds and permits them only for specific purposes, according to the lawsuit. The city claims these particular contracts did not meet those requirements and illegally diverted public funds from essential services.
“California law is clear: A city’s contract is void if it did not comply with statutory requirements,” said Gary Gotto of Keller Rohrback, an attorney representing Richmond. “The recipient of money paid under a void contract is obligated to return the payments.”
Brad Miller, another attorney for the city, noted that the legal requirements “are there to protect the public interest” and are “designed to prevent waste and the improper use of public funds, and to ensure transparency and accountability.”
Similar lawsuits were filed by cities nationwide following the 2008 financial crisis, when many derivative contracts resulted in significant unexpected costs for cities.
Jimenez said that Richmond was one of many cities taken advantage of by “predatory loans.”
“We are making these payments and putting all this money into the banks for late fees when that money should have gone to other things in our community,” she said. “Hopefully we can learn from it. This is not something unique for Richmond. It’s something other cities are dealing with and I hope this can be good news to show that we can’t continue to allow sucking money out of cities.”
Most of the damage was done during the Butt adminstration 2014 to 2022. The former Mayor was a strong supporter of the swaps though he now seeks to distance himself from any responsibility claiming ” everyone was doing it”. They were not. Thanks to Claudia Jimenez we are rid of these toxic instruments which were simply way beyond prudent City administration.