Auction Rate Securities Update

February 15, 2010

The collapse of the auction rate securities market and the resulting freeze of more than $330 billion dollars in investor capital in February 2008 foretold of the catastrophic global financial meltdown that would follow just a few months later.  Indeed, even as major financial institutions, some of which have since disappeared, were negotiating regulatory settlements to begin redeeming action rate securities held by certain customers, the basic ability of many of these institutions to survive was quickly unraveling. Now, two full years after the market collapse, over $100 billion dollars in auction rate securities held by institutional, corporate, high net worth, “downstream” and other individual investors remains frozen, with little prospect of liquidity anytime soon, at least not without substantial loss of principal.  It has become clear that amid the bleak news there is a path to recovery which is providing hope for investors; arbitration.

Although some brokerage firms who sold auction rate securities are redeeming the securities held by individual, charitable, and small business investors under regulatory settlement agreements, they are inexplicably refusing to redeem the auction rate securities held by several distinct groups of investors including; institutional investors, former brokerage firm employees, third party investors, those investors who purchased from “downstream” sellers, and investors who purchased after the auction market crashed. These investors, subjected to an identical pattern of wrongdoing by the firms involved, are saddled with illiquid securities for which there is no viable secondary market. Generally speaking, those investors that have been left out of auction rate securities settlements, given the sheer enormity of the $100 billion in frozen auction rate securities that they hold, and the likelihood of continuing market uncertainty, should expect that it may remain unlikely liquidity will return to the market or that their holdings will be redeemed anytime soon without legal action. As a result, these  investors are left with a choice—continue carrying the risk of owning low-yielding illiquid securities in a time of unprecedented market risk; or take legal action aimed at rescinding the transactions, limiting exposure to liability, and regaining liquidity and access to funds.

The recent months have seen almost no significant action by issuers, financial institutions, or regulators with respect to auction rate securities.  Specifically, the news of redemptions by issuers and buyback offers by institutions has been almost nonexistent recently, with only occasional, insignificant issuer redemption offers, and increasingly negative reports from the financial institutions that suggest little to no prospect investors will get relief anytime soon, if at all.  Additionally, regulators, once the driving force behind settlements, seem to have all but abandoned efforts to force institutions to redeem the investors not included in earlier settlements. In fact, the regulatory hearings involving Oppenheimer & Co. were recently delayed for a fourth time and are not scheduled to even begin until March of this year. Further, Oppenheimer & Co. has recently announced that its attempts to secure alternative funding for a buyback have been unsuccessful, increasing the likelihood that issuers will continue to be saddled with these illiquid securities indefinitely.  Likewise, class action suits brought by investors in court have recently been dismissed for various reasons, dimming the hope that investors would receive some form of collective legal relief.  Taken together, these recent developments make clear that auction rate securities’ investors should seriously consider filing individual arbitrations with the Financial Industry Regulatory Authority as a path to recovery.

Although there are no guarantees, recent statistics show that arbitration is proving to be a promising solution for auction rate securities investors.  The Financial Industry Regulatory Authority recently reported that 500 auction-rate claims had been filed by investors since February 2008, 253 of which are still pending and 242 of which have been closed.  Interestingly for investors, most of the cases were settled by the parities in advance of scheduled hearings; 146 of the 242 closed matters to be exact.  These statistics should encourage investors considering filing an arbitration, particularly in the current financial climate where little else is being offered to seemingly forgotten auction rate securities investors.

Once the decision to proceed with legal action is made, the path ahead is relatively straightforward. The deception surrounding the auction rate securities market was on the regulatory radar as early as May 2006, when the S.E.C. fined fifteen Wall Street firms over thirteen million dollars in connection with the sale and marketing of auction rate securities.   Despite the admonition of the S.E.C., many financial institutions continued to misrepresent the auction rate securities as cash equivalents to both retail and corporate investors. The misrepresentations made to both individual and corporate investors were the same; that auction rate securities constituted safe, liquid, cash equivalents, when in fact they were not.

As a result, the various misrepresentations and other deceptive actions relating to auction rate securities give rise to several potential claims for investors, including:

• Section 10(b) of The Securities Exchange Act and SEC Rule 10-b(5) which prohibit the use of interstate commerce to make untrue statements of material fact in connection with the sale of securities;

• Section 2310 of the Financial Industry Regulatory Authority (“FINRA”) rules of fair practice which requires that any investment recommendations to customers are suitable for the investor based on “reasonable grounds” aligned with the facts disclosed regarding the investor’s other security holdings and overall financial situation;

• Section 2120 of the FINRA rules which forbids the use of manipulation, deception, or other fraudulent devices in connection with the sale of securities;

• Section 2310-2 of FINRA IM which imposes a responsibility of fair dealing in all investor transactions;

• Breach of Fiduciary Duty which requires broker-dealers to always act with utmost good faith and loyalty to their customers;

• Fraud in connection with both specific misrepresentations made about the product as well in connection with support of the illusory market;

• Negligence in the failure of broker-dealers to exercise reasonable care as measured by customary standards in the securities industry, in connection with the sales of these securities;

• Negligent Misrepresentations by the failure of broker-dealers to exercise reasonable care or competence in connection with representations regarding these securities; and

• Breach of Contract based on the written agreements that were entered into with investors while forming the investment accounts.

Almost two years after the freezing of the auction rate securities market, it seems apparent that most financial institutions face little pressure to act on their own, and have generally pledged only to use “best efforts” to help restore markets. Indeed, recent announcements from these institutions evidence that these efforts remain limited at best.  Unfortunately, if we have learned anything, it is that market risk remains extraordinarily high, and the prospect for the “normal” return of market conditions anytime soon appears slim.  As a result, abandoned investors must necessarily intensify their own pressure on financial institutions to make them whole, in exactly the same way as retail investors were able to do, by lodging regulatory complaints, commencing arbitrations, and continuously pressing for action.

If you are an investor or are affiliated with an institutional/corporate investor who has  been left out of the auction rate securities settlements and would like to discuss your options further, please feel free to contact Crosby & Higgins LLP directly at 646-452-2304 and ask to speak with Todd A. Higgins, Esq.