The Peoples State Bank of Ellettsville says it was duped three years ago into plunking more than $13 million into auction-rate securities—just before those markets froze up. Now it’s suing its broker, Stifel Nicolaus & Co., to get the money back.

The tiny bank based west of Bloomington sued St. Louis-based Stifel late last year, and the case has no been moved to federal court in Indianapolis.

The lawsuit claims a Stifel broker, Michael Sullivan, called the bank in early November 2007 and, within days, convinced Peoples to spend $7.5 million on a security that was backed by federal student loans. Over the next two months, Peoples poured $6.15 million more into the auction-rate investments.

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

Their purchases represented 15 percent of their investments at the time, according to data from the Federal Deposit Insurance Corp. Peoples has 11 branches in Monroe, Brown, Owen and Morgan counties, according to the FDIC.

Then, within weeks, investors across the country bailed on the monthly auctions of the securities, which had been sold as ways to invest in corporate and municipal debt, and for those debt issuers to obtain more attractive interest rates.

The failure of the auctions kicked Peoples’ investments into a default status, in which it earns little to no interest on its investments. It still has $11.8 million tied up in the auction-rate securities, which do not mature for 35 years.

For two years, Peoples has asked Stifel to sell its investments, but Stifel has not even pitched them to investors, according to Peoples’ lawsuit.

Stifel says Sullivan worked in its Chicago office but is no longer with the firm. A call to Stifel’s attorney, Jim Riley of Indianapolis-based Riley Bennett & Egloff LLP, was not returned.

Meanwhile, Peoples has been under the spotlight of banking regulators. In November 2009, the Federal Deposit Insurance Corp. and the Indiana Department of Financial Institutions charged Peoples with various “unsafe and unsound banking practices.”

In March, Peoples agreed to a consent order, which required it to boost its capital levels and to develop plans to reduce its bad loans and develop better oversight of its investments and interest rate risks.

Those requirements, as well as ratings downgrades on the auction-rate securites Peoples bought, forced it to boost its reserves from $2.5 million to more than $4.6 million, according to Peoples’ lawsuit.

“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. He added, “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.”

A call to Roberge was not returned Monday morning.

Whether Peoples’ case is persuasive in court is uncertain. Mark Maddox, a securities attorney in Fishers, said institutional investors face a higher bar in court than individual investors do.

“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, he added, “A smaller institutional, like a smaller bank, is still going to be held to a higher standard than a retail investor.”

A year ago, Stifel Nicolaus signed an agreement with three state securities regulators, including Indiana. According to a press release about the agreement, Stifel will buy back auction-rate securities from all its clients by the end of 2011.

But Peoples claims in its lawsuit that the agreement with regulators only applies to retail investors, and therefore will not help its situation. People has been bleeding cash, losing $550,000 during the first nine months of 2010, on revenue of $8.1 million.

In all of 2009, the bank had revenue of $14.3 million, and a loss of $540,000.