Auction Rate Securities

February 14, 2010

Auction Rate Securities Collapse:

How the Auction Rate Securities Market Works

Auction Rate Securities (“ARS”) refer to a type of debt security with nominally long-term maturities (as long as fifty years) and variable coupon rates.  Periodic Dutch auctions are held by the underwriting financial institution, usually every seven to thirty-five days, to set the coupon rate for each period and allow for bondholder redemptions in a successful auction.  ARS, however, are a fundamentally flawed product in that they rely on the historically failed model of utilizing short term borrowing for long-term financing.  At an ARS auction, existing and potential investors theoretically enter into a competitive bidding process for all of the outstanding securities until a bid level is reached where the entire block can be purchased by bidders with yields at or below the level.  All winning bidders are to be paid at the new yield level until the next auction.

Prior to the decision of all of the major financial institutions to withdraw support from the ARS market, broker-dealers supported the auctions by providing a clearing bid.  The clearing bid assured that when not enough competitive bidders showed up at an auction, the broker-dealer would buy the excess securities for its own account and resell them at a later auction in order to prevent a failed auction from occurring.  Hence, the major financial institutions regularly provided a needed liquidity backstop to the ARS market.  As such, the auction market depended upon the continued participation of broker-dealers to sustain the auctions through their purchase of any excess securities for their own accounts.

In 2006, the Securities and Exchange Commission Division of Enforcement concluded an investigation into the ARS market.  On May 31, 2006, in connection with imposing a fine in the amount of $13 million against fifteen leading brokerage firms, the United States Securities and Exchange Commission (“S.E.C.”) issued a release in connection with the penalty indicating that:

Some of these practices had the effect of favoring certain customers over others, and some had the effect of favoring the issuer of the securities over customers, or vice versa.  In addition, 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.  By engaging in these practices, 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. (emphasis added)

Despite the strong admonition of the S.E.C. many broker-dealers continued to market Auction Rate Securities as “cash equivalents.”  Furthermore, many failed to apprise investors as to the liquidity risks associated with failed auctions.  As the credit markets started to dry up, the corporate sell off of ARS escalated in the last quarter of 2007 when corporations reduced their ARS holdings from $170 billion in July 2007 to $98 billion in January 2008. Additionally, strong evidence is surfacing that financial institutions, such as UBS and Citigroup Smith Barney, warned preferred institutional investors of the problems associated with the ARS market while continuing to market the securities as “cash equivalents” to retail investors. As is the case with other investment frauds of the past, individual retail investors invariably got saddled with the losses arising out of the failed auctions. Many investors now find themselves in a position where they cannot sell securities that were considered to be “cash equivalents.” The problem is exacerbated for investors who need immediate access to cash for taxes, medical expenses and other financial obligations.

Possible Auction Rate Securities Legal Claims

As a result of the auction failures, investors’ funds are tied up in illiquid securities for which no secondary market exists.  The problem is compounded by the fact that these investors often need immediate access to this money, based on their understanding that these securities were “cash equivalents.” Auction Rate Securities give rise to a number of legal claims, most commonly: suitability, breach of fiduciary duty, fraud, negligence, and breach of contract.  Depending on the unique facts surrounding an investment some or all of these legal theories of recovery may be available.

1. Rescission/Equitable Relief

2.  Suitability

New York Stock Exchange Rule 405 provides that before any investment can be considered suitable, the broker-dealer must make certain that the customer fully understands the risks attendant to the investment, wants to undertake the risks, and, according to the broker’s own analysis, can afford to undertake the risks.  Additionally, the Financial Industry Regulatory Authority adopted its own conduct rules with respect to suitability that must be followed by all broker-dealers.   Although the suitability provisions adopted by the NYSE and FINRA differ slightly, the purpose of each of the rules is to ensure that brokers make suitable recommendations to their customers.  The recommendation and sale of unsuitable investments to investors gives rise to liability for damages.

In most instances involving the sale of ARS, the broker-dealers did not disclose the material risks.  In particular, the broker-dealers routinely failed to disclose the liquidity risks associated with the failure of the industry to support the auctions.  Furthermore, the broker-dealers misrepresented ARS as “cash equivalents” without disclosure of the liquidity risks as mandated by the S.E.C. following the 2006 investigation into the ARS market. If the broker dealer knew of an investor’s ongoing liquidity needs, then the purchase of ARS invariably constituted an inherently unsuitable investment.

In most jurisdictions, a broker possesses a fiduciary duty of utmost good faith and loyalty to his/her customers. The fiduciary duty encompasses: (a) the duty to recommend an investment only after studying it sufficiently to become informed as to its nature, price and financial prognosis; (b) the duty to carry out the customer’s orders promptly in a manner best suited to serve the customer’s interests; (c) the duty to inform the customer of the risks involved in purchasing or selling a particular security; (d) the duty to refrain from self-dealing; (e) the duty not to misrepresent any material fact to the transaction; and (f) the duty to transact business only after receiving prior authorization from the customer.  Rule 2110 of FINRA’s conduct Rules state that: “A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade.”  Broker-dealers may be guilty of breaching their fiduciary duties to the investor with respect to the handling of the account, thereby abusing the trust and confidence placed in them, if they purchased ARS for accounts they knew required liquidity. This claim would entitle the investor to actual damages in the form of lost property as well as consequential damages and lost profit opportunities.

Broker-dealers may have traded accounts with the sole purpose of generating commissions without regard to the financial consequences to the investor.  These actions would amount to a fraud perpetrated upon the investor. Additionally, the creation and support of the illusory ARS market before abrupt abandonment of it in February of 2008 could further constitute a fraud upon the investor.  This claim could entitle the investor to have the trade rescinded and all commissions charged to the account disgorged.  Additionally, it even may be possible to recover punitive damages under this claim.

Broker-dealers owe investors a duty to act with reasonable care in the handling of their funds.  This duty is measured by the customary standards and practices of the securities industry.  If a failure to use reasonable care caused a breach of this duty, thereby directly causing the investor to suffer actual economic damages, punitive damages may be available.

Most written customer-brokerage agreements obligate the brokerage firm to handle customer funds in a suitable manner and pursuant to industry rules and regulations including appropriate disclosures.  Additionally, these contracts imply a covenant that each party will deal with the other in good faith, and not act in a way that would deprive the other party of the benefits of the contract.  However, the financial industry as a whole breached its customer agreements by purchasing illiquid investments in direct conflict with the expressed needs of the investors and by failing to continue to support the ARS market.

Do I have a Claim Against my Broker if I own Auction Rate Securities?

Obviously, this analysis will depend largely on the specific facts of your securities, but below is a checklist which sets forth some of the factors that may have a bearing on recovery against your Broker:

• Did the Broker make any representations to you about the Auction Rate Securities?
• Did the Broker disclose the risks associated with Auction Rate Securities?
• Did the Broker provide a prospectus with respect to the Auction Rate Securities?
• Did the Brokerage Firm list the Auction Rate Securities as “cash equivalents” on your monthly statements?
• Did the Brokerage Firm fail to mark down the value of the Auction Rate Securities on your recent monthly account statements?
• Do you have exigent circumstances requiring immediate access to cash that is now tied up in illiquid Auction Rate Securities?

Crosby & Higgins LLP would be happy to evaluate your case and discuss the particular legal options in confronting the problems created by the collapse of the Auction Rate Securities market.  Please feel free to contact Todd A. Higgins, Esq. at 646-452-2304 or thiggins@crosbyhiggins.com for more information.