The Auction Rate Securities Debacle Continues – Corporate America Takes on Wall Street

 

The Wall Street Journal reports that “hundreds of businesses are fighting to recover billions of dollars tied up in frozen auction-rates securities, a year after Wall Street firms agreed to $60 billion in settlements over the collapsed market for the investments.” See “Firms Fight Banks Over Billions in Frozen Notes,” WSJ 1/2/10. While regulators stepped in to help individual investors after the auctions froze in February 2008, many corporate and institutional investors did not benefit from settlements between banks, broker-dealers and the SEC, FINRA and state attorneys general. According to Atlanta attorney Craig T. Jones, investors were left holding about $330 billion in illiquid securities when the auctions froze, so $60 billion in settlements is only a drop in the bucket.”

Auction rate securities (ARS) are fixed-income debt instruments ? usually municipal bonds or preferred shares ? for which interest or dividends are regularly reset through a Dutch auction. Auction rate securities were once routinely marketed as safe, cash equivalents that were highly liquid, but the broker-dealers who sold them failed to disclose that liquidity was entirely dependent upon the success of the auction process, which was being artificially supported by the undisclosed participation of brokers bidding in auctions where they had an interest. Auctions were once held every 7 to 35 days by the brokerage firms that dealt in auction rate securities, but because of the subprime lending crisis and its effect upon the financial markets, ARS auctions ground to a halt in February 2008 because they were no longer viable investments and broker-dealers who had previously propped up the market by bidding in their own auctions were no longer inclined to invest in them. The result has been that ARS holders have been unable to sell even at a loss, and investors who were led to believe that they were purchasing a liquid cash equivalent have learned that they have no liquidity at all.

Since the market collapse, there have been regulatory settlements with many broker-dealers that have allowed many investors to redeem their auction rate securities at par, but many of those investors have made claims for consequential damages caused by the loss of liquidity?for example, lost business opportunities that they were unable to take advantage of. Many more investors have still not achieved liquidity, however, because the broker-dealers who sold them their auction rate securities were not party to the regulatory settlements or because the investors were not eligible under the terms of the settlements, which primarily benefited smaller individual “retail” investors. Some investors who have been unable to redeem their securities have been able to sell them, at a steep discount, in a limited secondary market, forcing them to take substantial losses. Others have continued holding the securities, which have long-term maturities but are locked into paying short-term interest rates?in some cases less than one percent for periods of more than thirty years.

“While corporate and institutional investors suffered greater losses in the aggregate than individuals who purchased these securities,” says attorney Jones, “bigger investors may have a more difficult time recouping their losses because the defense is to paint them as more sophisticated investors.” However, while sophistication is a defense often raised in claims made by investors against brokers-dealers, it does not obviate the duty of a broker-dealer to truthfully represent what it is selling. According to Jones, “there were all kinds of developments in the market that increased the risk of auction rate securities from 2007 to 2008, and anyone who sold those securities?or advised their client to continue holding them?had a duty to disclose those increased risks. The failure to disclose known risks can be fraud, just as it fraud to knowingly misstate those risks.”

The fact that a company employs people with financial expertise to invest corporate funds does not necessarily mean that they are familiar with auction rate securities, and corporate financial managers typically rely on the expertise of their investment bankers rather than doing their own homework. For example, says Jones, “a corporate CFO is more likely than a novice investor to rely on a AAA bond rating,” says Jones, “because a CFO is too busy to do homework that he knows the rating agencies have already done, plus he knows that a professional broker-dealer has a legal duty to disclose all material risks,” says Jones. “It boils down to a question of reasonableness?that is, whether it was reasonable for the corporate investor to rely on the broker’s statements, or whether it is more reasonable to let a dishonest broker off the hook because the investor could have checked out the broker’s story and didn’t.”

The recent Journal article demonstrates that many corporate investors have lost patience with regulators and are seeking their own justice before the statutes of limitations expire on their legal claims. While many business investors have traditionally frowned on litigation, the magnitude of the auction rate securities collapse took a big toll on businesses at a time when they needed liquidity the most. At least one company cited by the Journal has had to lay off employees because of its losses on these securities, and others have had to sell performing assets to make up for the dead weight of the auction rate securities on company balance sheets.

“Nobody is too big to be a victim,” says Jones. His law firm, Page Perry, is based in Atlanta but represents both large and small investors in securities fraud cases all over the country. Most of the claims being handled by Page Perry Jones are being brought through arbitration, which is widely regarded as being more business-friendly than the court system. Settlement is still an option, but often it is necessary to file an arbitration claim before a bank or brokerage firm has incentive to settle. “We have been successful in negotiating settlements for some investors,” says Jones, “but we are always prepared to go as far as it takes to see that our clients get their money back.”