Former Credit Suisse broker Eric Butler, who was convicted of fraud by a New York federal court jury in August, was sentenced last week to five years in federal prison. Along with former Credit Suisse colleague Julian Tzolov, Butler was accused of making misrepresentations in the sale of auction rate securities, claiming that they were backed by federally-insured student loans when in fact they were backed by high-risk collateralized debt obligations, or CDOs. Prosecutors alleged that Butler and Tzolov had switched their clients to the CDO-backed securities because they paid higher commissions.
Auction rate securities are securities backed by debt instruments?typically bonds or preferred shares?which pay interest or dividends that are determined by periodic auctions held every 7 to 35 days. They were widely marketed as safe cash equivalents that could be liquidated at the next scheduled auction, but the liquidity was dependent upon the success of the auction process?which was in turn dependent upon the support bids made by investment banks and broker-dealers to make sure that the auctions did not fail. The fact that liquidity was contingent upon successful auctions, as well as support bids from the market makers, was generally not disclosed to investors who thought that they were buying a highly liquid alternative to money market funds.
Some auction rate securities, such as the ones that Butler and Tzolov were selling, were backed by collateralized debt obligations (CDOs)?a structured finance product in which a large number of mortgages or other debt instruments are pooled in multiple layers or ‘tranches’ that pay interest to investors based on the risk and priority of each tranche, with the senior tranches paying lower rates because they are safer investments and the junior tranches paying higher returns for comparatively higher risk debt. Because CDOs are typically highly leveraged, they are susceptible to wide fluctuations in value based on the performance of the underlying debt. According to Craig T. Jones, an Atlanta attorney with Page Perry, “there was a double risk involved in auction rate CDOs: one being the default risk and market volatility associated with CDOs, and the other being the liquidity risk associated with auction rate securities. Neither of these risks were adequately disclosed to most investors.”
Jones suspects that Credit Suisse offered its brokers higher commissions to sell the higher-risk auction rate securities because it was trying to unload from its own inventory. “According to its own analysts,” says Jones, “Credit Suisse knew in early 2007 that the risks of mortgage-backed securities were increasing exponentially due to adverse conditions in the real estate and financial markets, and it was time to get out of those investments.” During the same time frame, the risk of auction rate securities was also increasing. “By August 2007,” says Jones, “the perfect storm had arrived, because there was no longer enough broker-dealer support for these risky CDOs to keep the auctions going.” Auctions froze for the CDO-backed auction rate securities sold by Credit Suisse and others.
Thousands of investors are still unable to liquidate their auction rate securities except by selling them at a steep discount on a limited secondary market. There have been regulatory settlements and voluntary redemptions that have restored liquidity to many investors, but those have primarily been the lower-risk municipal bond and student loan-backed auction rate securities. Investors have had much less success in getting liquidity for auction rate securities backed by CDOs or other mortgage-backed instruments, forcing many of them to turn to legal action to get access to their money.
According to attorney Jones, “it will soon be three years since the CDO and auction rate securities markets started to fail, and any investors who are still locked out of their money from these investments need to start worrying about the statute of limitations for making a legal claim.” Jones’ law firm, Page Perry, is based in Atlanta but represents investors in securities arbitrations and lawsuits all over the country. “If you are still holding auction rate CDOs or other securities that you have been unable to liquidate due to the collapse of the market in 2007-2008,” says Jones, “you need to talk to a lawyer now before it is too late.”