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State College Area School District Agrees to $9 Million Payment in Interest Rate Swap Agreement with Royal Bank of Canada

by on January 14, 2013 9:22 PM

The State College Area School Board of Directors took action on Monday night to settle the district's lawsuit with the Royal Bank of Canada (RBC) over the enforceability of an interest rate swap agreement.

Below is the full statement released by the board on Monday.

At its Jan. 14 meeting, the Board of School Directors of the State College Area School District took action to settle 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 million dollars over the next 5 years. Since the parties entered the agreement more than six years ago, most of the 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. 

In 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 3.884 percent 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 2007, 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 2007 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 2010, the District faced $10 million to $11 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 with Pennsylvania law. When the District did not make its scheduled swap payment on May 1, 2011, RBC filed a counterclaim to recover a $10.3 million termination fee.

On October 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 five 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 former 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 of swap payments, variable rate bond payments, and a termination fee would exceed $18 million today.

Refinancing to take advantage of lower interest rates would not have been possible without paying $3- $10 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.

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 of municipal 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 a 2009 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 summarize, 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 remains secure. Our mission - to prepare students for lifelong success through excellence in education - remains our top priority.


The State College Area School District Board of School Directors

This piece was submitted by a guest columnist.
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