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Auction Rate Securities Failures

Auction Rate Securities have often been marketed by large brokerage firms as a safe, liquid alternative to money market funds. Investors are finding this is not always the case.

Auction Rate Securities and Auction Rate Preferred Securities (ARS) are securities made up of long term bonds or preferred stock with variable interest rates and yields.  The yields are periodically reset through Dutch auctions.  ARS are often marketed and sold by a single dealer with the only resale market being through a successful auction.  Problems have arisen this year as a result of the failures of the auctions, leaving investors in the lurch and unable to redeem the now illiquid securities.  ARS have often been marketed by brokerage firms as a safe, liquid alternative to money market funds.  Investors believing they had their money in a safe liquid investment are understandably concerned by the failures in the marketplace for these securities. Our firm has been representing ARS clients in FINRA arbitration and otherwise, and monitoring the regulator settlements being reached with some of the involved firms.  Misrepresentations and omissions in the sale of a security can form the basis for a claim for securities fraud as well as other legal claims for recovery of damages.

As recently as 2006, the SEC censured 15 of the largest brokerage firms for sales and auctions of Auction Rate Securities. As stated by the SEC in its press release, “since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities.” The SEC further stated that “the firms violated Section 17(a)(2) of the Securities Act of 1933, which prohibits material misstatements and omissions in any offer or sale of securities.” The fifteen firms which were censured were Bear, Stearns & Co., Inc., Citigroup Global Markets, Inc., Goldman Sachs & Co., J.P. Morgan Securities, Inc., Lehman Brothers Inc., Merrill Lynch, Pierce, Fenner & Smith Incorporated, Morgan Stanley & Co. Incorporated/ Morgan Stanley DW Inc., RBC Dain Rauscher Inc., A.G. Edwards & Sons, Inc., Morgan Keegan & Company, Inc., Piper Jaffray & Co., SunTrust Capital Markets Inc., Wachovia Capital Markets, LLC, and Banc of America Securities LLC. 

In this Barron’s article, written before many of the larger firms agreed to buy back their ARS, the author sets out one of the more complete analyses we have seen regarding the various types of frozen Auction Rate Securities, and their likelihood (or unlikelihood) of being redeemed or sold in the future.  The various types of ARS reviewed in the article include Municipal Issuers, Taxable Closed-End Funds, Municipal Closed-End Funds, Student Loans, and Collateralized Debt Obligations (CDO).

Unresolved Issues Despite Regulator Settlements

The not yet finalized settlements reached by regulators regarding auction rate securities sales with many of the large brokerage firms fail to help medium to large businesses who were also sold ARS.  Although the required buyouts in the settlements with UBS, JPMorgan Chase, Morgan Stanley, and Wachovia Corp. reached $35 billion, this amount only approximates 18% of the $200 billion estimated to be still outstanding. 

Although the settlements call for the firms to use their best efforts to help institutional investors stuck with the frozen ARS, they fall short of requiring a buyback.  This situation may force mid-sized to large companies to seek redress on their own through the arbitration or court system. 

Also unresolved in the regulator settlements is the issue of consequential damages.  Although Wachovia, JP Morgan Chase, UBS, Morgan Stanley, and Citigroup have reached settlements related to their sale of Auction Rate Securities, left open is the recovery of consequential damages suffered by buyers of the allegedly liquid ARS who couldn’t access their cash.  The press releases and articles related to the settlements reference that customers will be able to seek recovery of their consequential damages through arbitration, with the firms admitting liability, but not conceding damages. 

Settlements have not been reached at this time with many of the regional and smaller firms that did not underwrite ARS, but sold ARS to customers.  Even though these firms were not conducting the auctions, they still may be liable under the securities laws and other causes of action for misrepresentations and omissions of fact related to the liquidity and safety of the ARS they were selling.  Additionally, the firms conducting the auctions may also still be found jointly or separately liable due to their misconduct related to the auctions.

If you or your business suffered consequential damages as a result of the frozen auction rate market, and/or if the firm who sold you ARS has not agreed to repurchase the securities, please contact Greco & Greco for a free consultation of your legal options with one of our attorneys.


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