Investor Angst, Regulatory Probes and Litigation Intensify Over Auction Rate Securities

By James J. Eccleston, esq.

n my column last month I outlined the auction rate securities (ARS) problem, and explored recourse that investors may have to liquidate their ARS investments, to rescind the purchase and/or to recover damages for losses. Since then, the problem for many investors has worsened. Let's discuss why.

First, the Wall Street Journal's declaration in February, 2008 that the ARS market had "virtually collapsed" has not changed. In May, 2008, the New York Times reported that $300 billion worth of investors' funds were "still locked up" and that 70% of all weekly auctions still were failing.

Second, while some ARS issuers have announced plans to redeem and/or restructure their ARS debt, these issuers largely have been municipalities seeking to minimize their interest costs. By comparison, ARS investors who bought closed-end fund ARS and especially those who bought student loan ARS are not nearly as fortunate as their municipality ARS brethren. Investors in the $85 billion student loan auction rate market are receiving no redemption offers because, when those auctions failed, the interest rate reset to low (or no) interest rates.

Similarly, the fate of investors in the $63 billion closed-end fund auction rate market hangs in the balance as closed-end fund managers navigate through the conflicting interests - those interests of the ARS investors (preferred shareholders of the closed-end fund) who wish for redemption, versus those of the closed-end fund common shareholders who have benefited from the closed-end fund's issuing ARS (first for leverage to buy additional investments; now for the same leverage and, better still, carrying a lower interest rate). Regulators also perceive some room for abuse. In April, the Financial Industry Regulatory Authority (FINRA) issued Notice to Members 08-21, referencing partial redemptions of closed-end fund ARS. In that notice, FINRA cautioned financial services firms, "[W]hen allocating partial redemptions of auction rate securities among their customers, they must adopt procedures that are reasonably designed to treat customers fairly and impartially, and must put their customers' interests ahead of their own."

Third, the quickly-manufactured secondary market (the so-called "Restricted Securities Trading Network") has provided minimal relief and, when it does provide relief, does so at a significant price. As reported by the New York Times in May, the network facilitates only about 10 trades daily with an average size of $350,000 per trade. Municipality ARS trade the best - given the higher reset interest rates discussed above - and trade at discounts (losses) of 2 percent to 10 percent. On other hand, closed-end fund shares trade at a 15% discount (loss), and student loan ARS, hardest to sell, trade at discounts (losses) of 25% or more!

Fourth, several publicly traded companies have reported earnings that recognize significant ARS losses as they acknowledge, "We're not in Kansas anymore." For example, Bristol-Meyers Squibb wrote down the value of its ARS by nearly 50%. Additionally, the company stated that while "ARS were presented as current assets under marketable securities" -- exactly what both individual and corporate investors have been saying -- the "remaining ARS [in the company's portfolio] ha[ve] been reclassified from marketable securities to non-current other assets."

Fifth, financial services firms continue to be paid fees to operate ARS auctions. Firms are paid .25% of the ARS' total issue for each year of its life. Yet, apart from offering margin loans to ARS investors to fabricate "liquidity" - an unwise idea as I discussed in my last article - firms are doing very little, except perhaps bracing themselves for a tsunami of arbitration claims, litigation and regulatory probes. As of the beginning of May, a laundry list of firms was under securities regulatory investigation or subpoena for information. These firms are: AG Edwards, Bank of America, Citigroup, Deutsche Bank, Edward Jones, E*Trade Financial, First Albany, Goldman Sachs, JP Morgan Chase, Lehman Brothers Holdings, Merrill Lynch, Morgan Keegan, Morgan Stanley, Oppenheimer Holdings, Piper Jaffray, Raymond James Financial, RBC Dain Rauscher, Scottrade, Stifel Nicolaus & Co., TD Ameritrade, UBS, Wachovia, and Wells Fargo.

Additionally, as of the beginning of May, the following firms have been named in class action lawsuits: Citigroup, Deutsche Bank, E*Trade Financial, Goldman Sachs, JP Morgan Chase, Merrill Lynch, Morgan Stanley, Oppenheimer Holdings, Raymond James Financial, SunTrust Banks, TD Ameritrade, UBS, Wachovia and Wells Fargo. Investors must beware, however, that class actions often fail to return any sizable recovery to investors, especially those with larger claims. Investors should monitor class actions to ensure that they are not unwittingly being placed in a class action settlement for which they may well receive only pennies on the dollar. Most often, individual actions, normally in arbitration, will be a better avenue for investors.

In conclusion, I will continue to report ARS events as they unfold. ARS investors, especially those subject to class action filings, must be on guard to protect their rights.

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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.