For years, some large charitable foundations in the Twin Cities tried to earn a little extra cash by hiring Wells Fargo & Co. to lend the securities they owned to Wall Street.
Now, those foundations are engaged in a high-stakes lawsuit that accuses Wells Fargo of costing them -- and the charities they support -- tens of millions of dollars by violating the conservative investment principles that the bank's top executives preached publicly.
The Minneapolis Foundation, Minnesota Medical Foundation, the Robins Kaplan Miller & Ciresi Foundation for Children and the Minnesota Workers' Compensation Reinsurance Association together accuse Wells Fargo of lying about the safety of the investments they made with it in the months before the market's plunge. Instead of safe, plain-vanilla investments, their money was tied up in securities that became so toxic they couldn't be sold except at fire-sale prices, according to the suit filed in state District Court in St. Paul.
The losses likely will reverberate through the Twin Cities for years to come. Many non-profit groups have already seen their funding cut this year.
For smaller charities, the cutbacks can be deadly, as a single grant from the Minneapolis Foundation -- the state's second-largest community foundation ranked by grants paid -- can make or break their chances of attracting additional money.
"Every dollar lost is a dollar that's not available for the community," said Mike Ciresi, partner in the Robins Kaplan Miller & Ciresi law firm and one of the attorneys in the case.
Wells Fargo said in a statement that it "categorically denies" the allegations made in the lawsuit, and that "as with all investments, the investors bear the risk" of losses.
"We continue to vigorously defend against the allegations," the bank said. "We continue to assist clients in working through the extraordinary market events of the past several years." Citing the litigation, the bank declined to comment further.
'On life support'
The full extent of the losses won't become clear until the nonprofits finally untangle themselves from Wells Fargo's securities-lending program.
The nonprofits declined to comment or to make executives available, citing the litigation, and referred calls to attorneys at the Ciresi firm.
But judging from the amount of capital they previously committed to securities lending, the losses are significant.
The latest annual financial statements from the Minneapolis Foundation shows that, for the year ended March 31, 2008, it had $95 million worth of securities loaned to brokers. By March 31 of this year, that figure stood at $30 million, though much of the reduction was due to simply shifting assets away from securities lending.
For the Minnesota Medical Foundation, securities on loan declined from $42 million to $17 million in the year ended June 30.
The asset declines will have a direct impact on how much the foundations give away, since their annual payout rates are calculated as a percentage of assets. And the losses from securities lending come on top of the plunge in value that foundations have seen in their stock investments since last year. The Minneapolis Foundation's investments, outside of securities lending, declined 29 percent in the year ended March 31.
Some nonprofits that have relied on the Minneapolis Foundation recently received notices informing them that their funding will be cut or eliminated for 2010. The foundation has narrowed the scope of its community grant-making to organizations and activities that can demonstrate that their programs benefit Minneapolis residents. It previously supported causes throughout the Twin Cities.
The Minnesota Coalition for the Homeless, a statewide group that represents 150 homeless organizations, last month was turned down for a grant, after receiving money from the Minneapolis Foundation for eight consecutive years. Monica Nilsson, president of the coalition, said the decision means fewer people will be advocating for the homeless, at a time when more families are being forced onto the street or to homeless shelters.
Also turned down was Fund for an Open Society in Minneapolis, which sought $75,000 to advocate for racial equity in public schools and housing.
"We're on life support," said Catie Royce, executive director for Fund for an Open Society.
"The people most hurt by something like this are the ones who can least afford to bear it in this economy," said Steve Paprocki, an adjunct professor of philanthropy at Hamline University and managing partner of Access Philanthropy, a firm that researches nonprofits. "It's a huge black eye for everyone involved."
A $4 trillion business
Thousands of documents and dozens of motions have been filed by both sides since the suit was filed last year. The documents are held in 28 bulging folders stacked high inside a judge's chambers on the 15th floor of the Ramsey County court building in St. Paul.
Many of the details related to Wells Fargo' securities-lending program are sealed, though more information likely will emerge as the suit grinds on. The case is so complicated that a state court judge appointed a special master to oversee the discovery process.
"In my 40 years of practicing commercial trial law," wrote the special master in a report to the court, "I cannot recall a case in which discovery has been more contentious."
The case is being closely watched by attorneys across the country, including those whose clients have lost money in securities-lending programs. It is viewed as the first securities lending case involving a large bank likely to head to trial, now slated for April. Some similar disputes were settled out of court, with the banks agreeing to make good some of the losses.
Securities lending was long considered a risk-free way to squeeze slightly better returns from large investment portfolios. Earlier this decade, as the demand for loaned securities mushroomed along with the stock market, assets in securities-lending programs reached nearly $4 trillion. But the strategy backfired after some of the firms that manage the programs began to invest in riskier securities backed by loans tied to the housing market.
Lending began in the 1980s
Wells Fargo began promoting securities lending to larger institutional investors, such as foundations and insurance companies, in the early 1980s, when it was still Norwest Corp. in Minnesota.
Under its program, Wells Fargo would lend out the securities held by institutional clients for temporary periods to broker-dealers who like to borrow securities for short-selling. (Short-sellers try to profit by selling borrowed shares in the anticipation that the stock will fall, hoping to buy them back later at a lower price and pocket the difference.) Wells Fargo would ask for cash collateral for the loaned securities, then invest that cash to generate a small return, splitting those returns with its institutional clients.
According to the lawsuit, securities-lending agreements signed between Wells Fargo and the nonprofits limited the bank to investing their collateral in "short-term money market instruments," which can be bought and sold easily. The agreements further said that the "prime considerations" of the investments "shall be safety of principal and liquidity," the suit says.
But in recent years, the bank invested in securities, some backed by subprime mortgages, with maturities "that reach out nearly 40 years," according to the suit. These securities lost much of their value and became harder to sell when housing prices began to fall in 2007. Wells Fargo also parked client money in so-called structured investment vehicles, or SIVs -- pools of money also invested in subprime-tainted securities, according to the lawsuit.
The nonprofits say they first learned something was amiss in November 2007 when Wells Fargo informed clients that one of its SIVs -- called Cheyne Financial -- was in receivership. Wells Fargo also said it would no longer value the cash collateral within its securities program "at par," meaning that investors might not get all their principal back.
Alarmed by the losses, the Minneapolis Foundation and other plaintiffs said they tried to withdraw from the program, but Wells Fargo "unlawfully barred the doors," by requiring them to repay any lost cash collateral.
The nonprofits argue that the bank should foot the bill. They accuse it of fraud, breach of fiduciary duty and civil theft, among other things. They demand that Wells Fargo compensate them for their losses and return the securities still tied up in the program.
The nonprofits allege that at one point Wells Fargo even "misappropriated the proceeds" from an unrelated bond fund held by the Robins Kaplan Miller & Ciresi Foundation For Children to compensate for the losses of securities-lending collateral, according to court documents.
"The highest levels of Wells Fargo management knew, or should have known, that Wells Fargo was systematically investing the cash collateral in a risky and unlawful manner," the lawsuit says.
Wells Fargo was not the only bank to run into trouble with a securities lending program. Insurance giant AIG and Northern Trust, among others, were sued on similar grounds over client losses. Though investing in mortgage-related securities "appears reckless now," many of these securities were considered safe just a few years ago, said Andrew Gogerty, a fund analyst at Morningstar.
Wells Fargo has argued in court pleadings that the nonprofits suing the bank are "sophisticated investors" who agreed to "assume the risk of loss relating to collateral investments" in the bank's securities-lending program. Wells Fargo said it warned investors in its securities lending agreements that there was "no assurance" that their investments would maintain a stable value.
"Each of the plaintiffs expressly assumed the risk of loss," Wells Fargo said.
Public statements made by Wells Chairman Richard Kovacevich and CEO John Stumpf, in which they boasted of avoiding subprime lending and SIVs, also are an issue in the suit.
At a conference in September 2007, less than three months before Wells Fargo notified investors of losses in its securities-lending program, Kovacevich said the bank could have originated subprime mortgages, sold them to Wall Street and "not taken any risk."
But Wells Fargo executives thought that the mortgages were "so toxic we wouldn't even do that," he said.
In the bank's 2007 annual report, Kovacevich and Stumpf emphasized the bank's conservative lending and investing policies, saying it "did not participate to any significant degree" in SIVs.
Attorneys representing the foundations have seized on these statements as evidence that Wells Fargo was negligent in investing clients' money in assets it knew were risky.
In a filing with the court in August, the special master overseeing the case said such statements "facially show" that Kovacevich and Wells Fargo "had knowledge of and steered Wells Fargo away" from some of the same credit risks it maintained in its securities-lending program.
He ordered the two executives deposed. Their depositions were taken in late October, each one lasting several hours.
The transcripts remain under court seal.
Chris Serres • 612-673-4308 Staff writer David Shaffer contributed to this report.