Peoples State Bank of Ellettsville Takes Issue Over ARS Sales

The Peoples State Bank of Ellettsville says it was misled by Stifel Nicolaus & Co. three years ago after investing more than $13 million in auction-rate securities. Shortly thereafter, the market for those products froze up, leaving Peoples – as well as thousands of institutional and retail investors across the country – with illiquid investments.

Peoples State Bank of Ellettsville is now suing Stifel Nicolaus & Co. As reported Jan. 11 by the Indianapolis Business Journal, the lawsuit claims a Stifel broker, Michael Sullivan, contacted the bank in early November 2007 and, within days, convinced it to spend $7.5 million on a security backed by federal student loans. During the course of the next two months, Peoples State Bank invested another $6.15 million in auction-rate investments.

Peoples’ officials never reviewed a prospectus before placing their order, according to the bank’s lawsuit, nor did they realize that their investment was subordinate to another investor who bought securities on the same batch of student loans.

“Peoples, which had never purchased ARS’s before, reasonably relied upon Sullivan’s representations about market liquidity and security of the ARS collateral,” Indianapolis attorney Chris Roberge wrote in Peoples’ lawsuit. “Sullivan represented to Peoples that ARS’s were liquid, investment-grade securities that could be sold at any auction date … Sullivan never mentioned the possibility of a market freeze.”

In February 2008, that possibility became reality when the market for auction-rate securities abruptly came to a standstill. For Peoples State Bank, the market’s failure sent its investments into a default status, meaning Peoples earns little to no interest on its investments. The bank still has $11.8 million tied up in the auction-rate securities, which do not mature for 35 years.

According to the IBJ article, Peoples has asked Stifel to sell its investments for at least two years. Its requests, however, apparently have fallen on deaf ears. Stifel allegedly has not even pitched the products to investors, according to the Peoples’ lawsuit.

Whether Peoples’ argument that Stifel Nicolaus misled the bank about the risks of auction-rate securities and the auction market in which the securities were traded proves successful in court remains to be seen. Says Mark Maddox of Maddox Hargett & Caruso in the IBJ article:

“An institutional investor has a harder road, because they are assumed to be a sophisticated investor. But then you have to ask the question, ‘OK, how sophisticated is this institutional investor?’” Maddox said. Still, “a smaller institutional, like a smaller bank, is still going to be held to a higher standard than a retail investor,” he said.