Auction Failure

Lawyers in the two dozen or so proposed class action suits filed in connection with the failure of the auction rate securities markets may be “unable to prove their clients lost money or collect fees for themselves,” writes Bloomberg’s Thom Weidlich. We’re not so sure the defendant broker-dealers and issuers in these cases should be so confident.
Find out why after the jump.

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A key question in the liability of brokerages in the failure of the auctions for auction rate securities is what customers were told about the risks of the products they bought. The brokerages now claim they properly warned customers about the products, and that they never considered them cash or cash equivalent. Most individual brokers we’ve spoken to off the record say that this is very inaccurate, and every retail customer we’ve spoken to (including some who are friends and family of DealBreaker editors) say they bought these securities with the understanding that they were “highly liquid” or “cash equivalents.”
So what did the brokerages tell retail customers? There were lots of disclosure documents that say a variety of confusing things but almost none of them reveal the risk of systemic and perhaps permanent auction failures for the auction rate preferred securities that pay low interest rates even after auction failure. And, as the screen shot of a ARPS customer online account above reveals, the brokerages did, in fact, take actions that encouraged customers to regard the ARPS as cash. This account comes from a Merrill Lynch customer account. (Click on image for a bigger version.)

Auction rate securities, including the auction rate preferred securities that remain frozen and often pay low interest rates capped at low levels, were sold to retail customers (including some investors close to DealBreaker staffers) by retail brokers. A key question in the lawsuits that have been filed against Merrill Lynch and Morgan Stanley, among others, is what the retail brokers told customers about the the securities they sold.
At least at one firm, we know that asset managers were told that they were to regard the securities as “cash equivalents” because the auctions had not failed for decades. Indeed, it seems that some brokers were given a “script” that urged the so sell these as “cash equivalent” or akin to “money market funds” or “highly liquid” securities.
We know this because brokers and others in wealth management groups have told us. But we’d like to see training materials that spell this out. It will be an important indicator about whether the firms themselves were selling the auction rate securities based on misleading marketing or whether, as some firms are already whispering, it was just a few overeager rogue brokers who oversold the auction rate securities. If the retail brokers were provided with misleading sales materials, they should not be blamed.
Merrill Lynch, for instance, seems to admit the auction rate securities were sold as equivalent to money market type securities in some of its documents. “Auction rate securities have generally been issued as either bonds or preferred stock and are designed to serve as ‘money market-type instruments,'” Merrill says in a document describing auction rate securities on its website.
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Merrill Lynch Hit By Auction Rate Securities Lawsuit

A class action lawsuit was filed in federal court yesterday against Merrill Lynch, hours after we reported that Merrill had been threatened with suits by brokerage customers whose assets were frozen in auction rate securities. Merrill is the latest entrant in a club that includes Morgan Stanley, Deutsche Bank and UBS, all of whom have been separately sued over alleged deceptive marketing of auction-rate securities.
Merrill also faces a separate arbitration claim from ASTAR Air Cargo, which seeks compensatory damages of $9.125 million and punitive damages of at least $27.375 million. ASTAR, an air carrier based in Wilmington,Ohio, filed the claim with the Financial Industry Regulatory Authority to gain access to ASTAR’s funds that currently are frozen in illiquid auction rate securities in the company’s Merrill Lynch account.
According to ASTAR, the air carrier instructed Merrill Lynch to place its cash reserves in products that would provide complete safety of principal and complete liquidity. In response, Merrill Lynch reportedly recommended the company purchase various ARS.
Update: Here’s a copy of the complaint against Merrill.

Merrill, Morgan Stanley sued over auction rates
ASTAR alleges Merrill Lynch fraud [Willmington New Journal]

Morgan Stanley Sued Over Auction Rate Securities

More auction rate securities lawsuits are hitting the courts. A lawsuit was filed today in federal court in Manhattan alleging that Morgan Stanley “deceptively marketed” auction-rate securities as cash alternatives, Market Watch is reporting.
“Instead of disclosing the true nature of ARS and the substantial liquidity risks associated with them, Morgan Stanley continued to push as many ARS as possible onto its customers in order to unload the inventory off its already troubled balance sheet,” the lawsuit said.
The complaint seeks to compel Morgan Stanley to refund investor money by having it rescind millions of dollars of ARS transactions. It also seeks compensatory and punitive damages. The lawsuit is being brought as a class-action suit on behalf of thousands of investors who acquired auction-rate securities from Morgan Stanley between March 25, 2003, and Feb. 13, 2008,.
Similar suits have been filed against Deutsche Bank and UBS. Merrill Lynch has also been threatened with lawsuits by investors, although none have been filed. Goldman Sachs has been rumored to have been quietly bailing out some customers, including high ranking Goldman executives, whose assets were frozen when the auction failes.

Morgan Stanley sued over auction-rate securities marketing
[Market Watch]

Auction Rate Securities: Still Frozen After All This Time

More than a month after the trouble started, much of the auction rate securities market remains frozen, leaving hundreds of millions of investor dollars locked-up in illiquid securities. No-one has come forward with a solution, and there is little hope that the market will unfreeze anytime soon. Brokers have offered to loan money to clients with frozen money but this has provoked outrage from customers who are being asked to pay a premium by the same brokerages that led them to invest in the frozen securities in the first place. And most brokerages are refusing to do what many customers demand: buy-out the customer positions.
Joe Mysak at Bloomberg reports that the problem stretches much deeper into the investor world than many suspected.

I’m still getting e-mail on this situation. Closed-end- fund, preferred-share holders, at least the ones I’ve heard from, are livid at the fund companies and feel betrayed by their brokers. I find it very odd that the fund companies and the brokerage houses feel that they can alienate this crowd.
Who buys auction-rate securities? It’s not just “the rich.” I’ve heard from self-employed people who thought it was a good, temporary place for their life savings, at least until they decided what else to invest in. I’ve heard from people who sold businesses and put the money there, and from people who inherited some money and did the same.
The amount of money ranges from $50,000 to several million dollars. In each case, the investors say they were advised by their brokers that their money was in a cash equivalent. The investors rarely looked at prospectuses.

He also notes that if the market for these securities ever does come back, we can expect a lot more regulation.

Auction-Market Investors Look to Regulator for Hope

Auction Rate Securities: How One Investor Got Out

Fred Wilson tells the story of how he got out of the auction rate securities he bought almost a year ago: he was fortunate to hold securities with high penalty rates.
“When risk is appropriately priced, there is a market for something. And in the case of auction rates, the risk is illiquidity and so you must focus on the penalty rates,” he writes.
We still haven’t been able to get a satisfactory explanation as to us why some auction rate securities were issued with very low penalty rates. Doesn’t this undermine the market clearing function that was supposed to guarantee their liquidity? The brokers we asked about this gave a clear and unsatisfying answer: since the auctions hadn’t failed for decades, people just stopped paying attention to the penalty rates.

Our Run-In With Auction Rate Securities – And What It Taught Me About Markets
[Seeking Alpha]

When Journalists Get Stung, The SEC Starts Buzzing

It looks like the Wall Street Journal’s James Stewart got caught up in the auction-rated securities trap. And he is not happy about it.

Last year, when some money-market funds turned out to hold some mortgage-backed securities and faced a liquidity crisis, their sponsors stepped in and redeemed the shares at face value. This seemed the only decent course, not to mention a good investment in customer loyalty.
But when I asked a broker at Merrill Lynch if it would do the same for owners of these money-market equivalents, the answer was “no” — not after the multibillion-dollar write-offs Merrill has taken on illiquid assets. Merrill Lynch and the other big banks that sold these shares have stopped making a market in them, which is a major reason the auctions have failed.
Merrill Lynch, when asked for comment, told me: “We are offering our clients loans which can give them liquidity.” It wasn’t yet clear whether these would be interest-free loans, which they certainly should be, in my opinion.

He ends the column by calling for the SEC to investigate. “At least two states are investigating, and I would expect them to be joined by the Securities and Exchange Commission,” he writes. Since we know SEC enforcement lawyers get their tips from newspapers, you can bet someone has opened a file on this. And with Merrill Lynch playing a central role in Stewart’s story, they are probably on the top of the SEC’s list.
Risks of a ‘Safe’ Investment Are Found Out the Hard Way [Wall Street Journal]