For a number of years, stockbrokers told individual and institutional clients with significant cash holdings that there was a safe way to earn a better return than money market funds, without risking a loss of principal. The place to get these returns was in Auction Rate Securities (ARS). It turns out the ARS were not at all what they were represented to be and, worse still, Wall Street had every reason to know better.
The Auction Rate Securities market was created in the 1980s to do something that may, in reality, not have been possible—allow bond issuers to borrow money for the long-term, but only pay short-term interest rates.
Auction Rate Securities are issued with long-term maturities such as 20 or 30 years. ARS reset their coupon rates through periodic auctions, at which they are sold at par. The “winning” bidders at auctions are those who are willing to buy the bonds at the lowest interest rates.
Typically, an ARS issuer enters into an agreement with a broker-dealer to underwrite its offering and then manage a “Dutch auction” process whereby the interest rates for the ARS securities are periodically reset at auctions held every 7, 14, 28, or 35 days. The broker-dealers’ duties include soliciting potential bidders (its customers) to purchase the securities at the auctions. A typical sales pitch involved assuring clients that Auction Rate Securities are as safe as CDs or money markets, but offer higher yields. The monthly account statements sent to clients usually listed them as cash or cash equivalents.
The auction market was not as safe or liquid as broker-dealers suggested. Between 1984 and 2006, approximately 13 auctions failed because, in effect, there were more people who wanted to sell their ARS than were willing to buy them.
While the ARS process appeared stable to the outside world (i.e., customers), broker-dealers involved in auctions knew that the auction process was perilous. In May 2004 the SEC commenced an investigation into what it ultimately determined were wide-spread dishonest, deceptive, and unfair practices in the auction rate market. By the time the SEC completed its investigation in 2006, essentially all of the major players in the ARS market including, Bear Stearns, Citigroup, Goldman Sachs, Deutsche Bank, E-Trade, Piper Jaffray, Raymond James, RBC Dain Rauscher, TD Ameritrade, Lehman Brothers, Merrill Lynch, Morgan Stanley, Banc of America, Morgan Keegan, SunTrust, UBS, Wells Fargo, Oppenheimer, and Wachovia were found to have engaged in multiple violations of the securities laws in connection with ARS auctions. In a Consent Order dated May 31, 2006, the SEC made findings of violations of anti-fraud provisions of the Securities Act of 1933 by virtue of several undisclosed and inherently corrupt practices, including broker-dealers secretly bidding for their own proprietary accounts or asking customers to make or change bids in order to prevent “failed auctions.” In addition, the SEC investigation showed that firms had submitted or changed bids after auction deadlines, revised bids after the bidding had been concluded and collaborated with customers by asking them to bid at auctions and then compensated them with higher than clearing rates in the secondary markets. In short, it is now clear that the auction rate process was corrupt and falling apart. The fact that these kinds of abuses were so common belied broker-dealers’ claims to clients that Auction Rate Securities provided cash equivalents which were a sound alternative to money market funds.
Even after the SEC Consent Order, firms continued to peddle ARS to customers and persisted in describing them as cash equivalents. And, notwithstanding the efforts of the broker-dealers to continue business as usual in the fading auction rate market, in August 2007 approximately 60 auctions worth $60 billion failed. The auction process continued for a few more months, until it finally collapsed in early February 2008 after all of the major broker-dealer’s stopped propping up bids and allowed auctions to fail. This left investors holding billions of dollars of ARS which they could not redeem. There is a growing body of evidence to suggest that as some brokerage firms began to realize that the auction process was unraveling, they cleared their own inventories of ARS and pushed their brokers to place these securities with unwitting customers.
While a number of firms settled regulatory complaints by agreeing to buy back ARS sold to certain clients, not all of the guilty parties have agreed to do so. And, even among those who settled, there are certain classes of investors whose losses were not made good. Ironically, in many instances those left out in the cold were large clients with substantial ARS holdings. Those clients will have to pursue recovery on their own. FINRA has had to create special procedures to handle the influx of ARS cases.
We have handled claims for a number of large ARS clients and would be pleased to speak to investors who believe they were misled about the safety and liquidity of ARS sold to them.