Auction Rate Securities Present a "Hotel California" Nightmare for Investors

By James Eccleston

nvestors have discovered Wall Street's version of the Hotel California: they have "checked in" to an investment that they cannot leave. Since mid-February, a significant number of auctions (70% according to Thestreet.com) in "auction rate securities" have failed, leaving the $330 billion market in disarray.

At least one state securities regulator has commenced an investigation, and FINRA (the Financial Industry Regulatory Authority) has issued guidance for investors ("Auction Rate Securities: What Happens When Auctions Fail"). Additionally, UBS and Goldman Sachs are among the financial services firms which have decided to markdown the value of these securities on client statements, with most markdowns between 3% and 5% but some as high as 20%. Moreover, one secondary market provider has reported transactions completed recently with 30% discounts!

Let's examine the problem and explore the recourse that investors may have.

First, what are auction rate securities (ARS)? According to the FINRA guidance, there generally are two types of ARS, bonds with long-term maturities (typically 20 to 30 years), and preferred shares with no maturity dates at all . The bonds are issued by municipalities; the preferred shares are issued by closed-end funds. The interest paid on the bonds and the dividend paid on the preferred shares are variable; that is, they are set through auctions for a specified short term (such as 7, 14, 28 or 35 days). Historically, ARS have paid approximately one percentage point more than money market funds. Notably, the difference between ARS bonds and ARS preferred shares is important when auctions fail, as discussed below, because the caps on interest rates paid on municipal bonds normally are much more attractive than the caps paid on closed-end funds, which currently are approximately 3.25%.

Second, why have auctions failed? FINRA answers that question by stating that auctions fail when the supply of ARS attempted to be sold exceeds the demand for ARS attempted to be bought. In the present context, FINRA states, "Unfortunately, due to recent developments in the credit market - including the downgrades in the credit ratings of bond issuers and bond insurers - a significant number of auctions have failed, leaving some investors who counted on immediate access to their funds wondering about their options." In short, the auction market failed because the auction participants (the financial services firms) pulled out after finding it was not profitable.

Third, how did ordinary investors become ensnared in this mess? Several years ago, financial services firms dropped the minimum investment in ARS from $250,000 to a mere $25,000, and began marketing them to ordinary investors. Regulators have been concerned with investor protection. In May, 2006, the Securities and Exchange Commission (SEC) fined 15 financial services firms $13 million for engaging in practices that violated the securities laws. In its press release the SEC commented that "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 [ARS] securities." The SEC ordered each firm to provide "certain disclosures of its material and current auction practices and procedures."

Nonetheless, recently the top securities regulator for Massachusetts subpoenaed Merrill Lynch, UBS and Banc of America Investment Services for information. In a statement, William Galvin, Massachusetts' secretary of the commonwealth, expressed the same concern: "[M]y office has received many calls from people who thought they were investing in safe, liquid investments only to find that they had, in fact, purchased auction market securities that are now frozen and they cannot get their money."

Indeed, most financial services firms have shown ARS on client statements as "Cash Equivalents." Representing ARS as a cash equivalent flies in the face of Statement of Financial Accounting Standards 95 of the Financial Accounting Standards Board, which defines the term cash equivalent in a much more limited manner.

Fourth, what does FINRA recommend and do investors have any other recourse? FINRA recommends that investors read the ARS offering documents (if provided) to determine whether the ARS issuer has made any provision for illiquidity and failed auctions. For investors wanting to liquidate their ARS holdings but unable to do so, FINRA discusses four options: (1) continuing to hold for the next auction; (2) selling in the secondary market; (3) borrowing on margin; and (4) liquidating other investments. Each option has drawbacks, however. For example, continuing to hold for the next auction is problematic because, as FINRA recognizes, there is a chance that subsequent auctions will fail as well. Likewise, selling in the secondary market may yield a greatly discounted value, and investors will incur costs and fees associated with that transaction. Regarding margin use, that is fraught with risks, and also currently carries a margin interest rate charge of about 7%. Finally, liquidating other investments may not be prudent for a host of reasons, as FINRA recognizes, including incurring transaction costs, triggering adverse tax consequences and impacting the balance of the investment portfolio.

An additional avenue of recourse - which FINRA does not mention - is to pursue a legal action for rescission to recover the purchase price paid for the ARS. Investors who were led to believe that ARS were cash equivalents may find this to be their best remedy.

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James Eccleston, an attorney specializing in adviser and broker-dealer issues, is a partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston in Chicago.