State College Area School District SWAP Fiasco

State College Area School District SWAP Fiasco A Tale of Regret and the Complete Loss of $9 Million of

Taxpayer Funding

February 3, 2013

Introduction by Watchdog In 2007, the State College Area School Board (SCASD) (Pennsylvania) entered into a SWAP agreement (a form of derivative) with the Royal Bank of Canada to hedge interest rates for a $58 million debt incurrence. The debt was intended for a high school construction project. The project was cancelled later in 2007 (before bonds were issued) because the only bid exceeded budget by 20 percent ($99 million to $119 million), but the $58 million SWAP was not cancelled. Instead, the 2007 school board extended the SWAP through 2007. It is opined that the 2007 school board extended the SWAP to negate future requirements for public referendum for new spending by then required by Pennsylvania Act 1 (Taxpayers Relief Act). The SWAP, it is opined, was also extended in a desperate move to avoid millions of dollars in termination fees. The district could have terminated the SWAP at a cost ranging from $365,000 to $1 million immediately after cancellation of the high school project. Alas they decided to speculate instead of hedge. Speculation is not public policy, it is gambling with the public’s tax payments. When the SWAP was extended, the hedge became a speculation. Pennsylvania prohibits a school district from incurring debt without an approved project plan or to speculate with debt incurrence. There was no longer such an approved plan. The LIBOR index upon which the SWAP hedge is calculated moved against the district and in favor of the bank. (The LIBOR is under investigation at this time by the SEC for reported and alleged manipulation by many big banks, but that is another tale.) Rather than terminate the SWAP, the district argued in federal court that the SWAP was null because the district circumvented both Pennsylvania municipal debt law and common sense. In December 2012, the district lost the federal law case and is required to pay a $9 million termination fee for debt never borrowed. This is truly an example of dumb and then dumber decisions – SWAP followed by extension. The public document that follows this introduction provides a chronology of events. Hopefully it will encourage other school districts to forgo hedges and speculation when they have not a clue what they are doing and when dealing with banks exercising expert knowledge and perhaps other advantages not known to naïve school boards and administrators or so called educational financial consultants (an oxymoron). The document that follows is an explanation and statement of regret. It was approved by eight of nine present school board members in executive session. Of the two members who were also on the board in 2007, one did not approve the document. Presumably the other members of the 2007 school board have chosen to remain silent.

Because the document and its approval was voted in executive session before its public release but missing an indication of who voted yes, no, or abstain, invoking the Pennsylvania Right-to-Know and Open Records laws was required for full disclosure. The law eventually prevailed. The expert school consultants who led the flock to this slaughter agreed to return their $160,000 shepherding fees. By the way, $9 million equals the equivalent of an 11 percent school property tax increase for the district. It also represents 11 percent of a reasonable construction cost of High School Project -- 2013. Given the average cost for one SCASD teacher of $105,000 per year (total loaded cost, not salary), $9 million also represents 86 teachers, one year. It is emphasized that school board members serve without compensation and that the work required, when performed diligently as is mostly the case, becomes a second full time job never fully appreciated by the public. Faultless performance is neither expected nor possible. The 2007 school board, however, is not criticized for a mistake but rather the arrogance that created it. Some other lessons learned useful for other school boards:

• When any body of elected officers votes 97.3 percent of the time unanimously for 261 non procedural motions covering a wide diversity of issues over 18 months the board has a big problem called group think or collusion.

• When a district has the problem described above the public suspects collusion outside of

public meetings – big problem.

• Do not close Citizen Advisory Committees (CAC) meetings and records to the public. That’s dumb.

• When the board is sued by citizens in the County Court of Common Pleas for failure to

comply with the Pennsylvania Sunshine Laws – there is a problem.

• When the public asks during an Act 34 Meeting (public hearing required to be held on all new construction) what the CAC for Finance recommendation is and the Board president refuses to provide the answer – big problem called arrogance.

• When a school district has an Act 34 meeting that requires police presence in a

community like State College, Pennsylvania, the school board has a very big problem. If it were possible to fail an Act 34 meeting, the SCASD would have.

• No one expects a school board to be experts in derivatives. If you don’t know what you

are doing, don’t do it. Don’t look to the Pennsylvania School Boards Association or school financial consultants in this area for guidance – they are generally incompetent and shills.

• Stay away from SWAPS or other interest rate gambling schemes.

This document is a compilation by Watchdon @ of two documents obtained separately inaccordance with the Pennsylvania Right-to-Know and Open Records Laws. The original statementwas prepared in executive session; added is also a list of eight of nine school board memberswho agreed during executive session, but not previously made public, to accept the statement ofregret.

Statement by members of the

State College Area School DistrictBoard of School Directors

January 2013

At its January 14,2013 meeting, the Board of School Directors of the State College Area School

District took action to seffle the District's lawsuit with the Royal Bank of Canada (RBC) over the

enforceability of an interest rate swap agreement. This settlement will cost the SCASD $9 milliondollars over the next 5 years. Since the parties entered the agreement more than six years ago, most ofthe Board membership has changed, senior District administrators have moved on, and the economic

climate has changed dramatically. We believe it is important to summarize the circumstances leading to

our decision.

ln 2004, the District received authorization from the Pennsylvania Department of Community

and Economic Development to issue $58 million in variable rate bonds as part of the plan to fund

renovations to its high school buildings. In April 2006, the Board unanimously approved a financial

derivative contract with RBC to link these bonds to a "forward looking interest rate swap." The

agreement obligated the District to make semi-annual payments to RBC at a "synthetic fixed interest

rate" of 3.884Yo based on a "notional amount" of $58 million for 20 years. In exchange, RBC would

make monthly variable payments to the District based on a percentage of the London Interbank Offered

Rate, or LIBOR. The exchange of payments was set to begin in December 2007.

The agreement tried to simulate a more favorable interest rate by converting variable rate bond

payments into fixed payments. In reality, the net cost would depend on the movement of global interest

rates. Rising or stable rates would place the District in a more favorable financial position to continue or

terminate the swap. If rates fell, the difference between the payments would increase in RBC's favor. In

a declining or low global interest environment, like today's market, the District would owe RBC a final

payment to terminate the swap.

After bids for the proposed high school came in $17 million over budget in May 20A7, the Board

canceled the project, and the $58 million in bonds were never issued. At that time, the cost to terminate

the swap agreement would have been several hundred thousand dollars.

In the fall of 2007, plummeting interest rates continued to erode the District's financial position in the

swap. Facing $3 million in termination fees and a future, albeit undetermined, high school project, the

Board voted in November 20A7 to extend the start date of the swap for another three years.

Throughout 2009, interest rates continued to fall, and the cost to terminate kept rising. By the summer

of 201 0, the District faced $ 10 million to $ I I million in termination fees for a swap agreement that

remained linked to bonds that were never issued, for a project that had been canceled. Because no bonds

had been issued and the building project had been canceled, the appropriateness of the swap extension

was questionable. In August of that year, the District authorized special counsel to file suit against RBC

in the United States District Court for the Middle District of Pennsylvania, seeking to have the 2006

swap agreement and the 2007 amendment declared void and unenforceable for failure to comply withPennsylvania law. When the District did not make its scheduled swap payment on May 1,201 1, RBC

filed a counterclaim to recover a $ 1 0.3 million termination fee.

On Octob er 5,2012, the Court ruled that the 2006 swap agreement was valid and enforceable under

Pennsylvania law. Rather than pursuing a lawsuit that would require additional costly and prolonged

litigation to resolve, the board believes that it is in the best financial interest of the District to settle its

dispute with RBC at this time.

With the assistance of special counsel and an independent financial expert, we have negotiated a

settlement that will end litigation related to the swap agreement. It will cost the SCASD $9 million over

the next 5 years, which is less than the District's current $10 to $14 million exposure. The District has

requested and received $160,000 toward the settlement from our former financial advisor and fotmer

bond counsel who advised the swap transaction. The remainder of the settlement will be paid from the

District's reserve funds.

It is worth noting that the District would now be in a precarious financial situation if it had continued

the 2007 high school project, activated the swap, and issued the bonds. The combined expense ofswap payments, variabl e rate bond payments, and a termination fee would exceed $ l8 million today.

Refinancing to take advantage of lower interest rates would not have been possible without paying $3-

$ l0 million to terminate or renegotiate the swap agreement, depending on the date. Although it was not

foreseen at the time the District entered into the swap, at no time since the project was canceled was this

financial instrument advantageous for the District.

We profoundly regret that from inception to termination, many millions of dollars will have been spent

on this transaction with no benefit to public education. While this is a difficult outcome to accept, we are

asking for the community's support as we put this expensive chapter in the District's history behind us.

The SCASD is not the only school district to lose money through such financial derivatives. State laws

regulating municipal debt were relaxed in 2003, allowing school districts and other local government

units to engage in swaps and other complex financial derivatives. By 2009 nearly $15 billion ofmunicipal and school district debt statewide were tied to swaps and similar derivatives. Few school

districts benefited from the use of swap agreements. Many lost millions of dollars, prompting the

Pennsylvania Auditor General to issue a20A9 report recommending that the use of financial derivatives

by local governmental units, "should be prohibited by law." We agree with this conclusion and call on

our state representatives to support legislation that would either prevent school districts from extending

forward swaps or ban school districts from using swaps and other derivatives altogether.

To summ arize, this settlement ends all litigation and reduces the cost to terminate the swap by more

than $1 million. The District is prepared to absorb the remaining $8.8 million cost; its financial footing

r_--

remains secure. Our mission - to preparerstudents for lifelong success through excellence in education -

remains our top priority.

Sincerely, t

The State College Area School Disfict Board of School Directors

I accept the board statement dated !/LO/L3 regarding the SWAP.

Jim Pawelczyk

Ann McGlaughlin

Amber Concepcion

Dorothea W. Stahl

Penni Fishbaine

J. Gowen Roper

James A. Leous

Laurel Zydney