Transforming the Attitude in the Securities Industry (Auction Rate Securities)
There are several types of auction-rate securities. There are essentially four different types of auction-rate securities. They are as follows:
- Municipal auction-rate securities – these are long term municipal bonds whose interest rates reset on a short term basis; many of these investments have been refinanced; they were the safest of the auction-rate securities;
- Student loan auction-rate securities – these are auction-rate securities issued by trusts that hold student loans, many of which are guaranteed by state and federal agencies; these were the second worst type of auction-rate security because the penalty rates which they paid were limited by loan payments collected;
- Auction-rate preferred securities – these are auction-rate securities issued by closed end mutual funds and used by those funds to leverage their investment portfolio; some of these securities have been refinanced;
- Structured finance vehicle auction-rate securities – these are auction-rate securities issued by structured finance vehicles and backed by pools of mortgages, subprime debt, or other assets; they have been the worst of the auction-rate securities.
Auction-rate securities are essentially long- term bond types of instruments, which have their interest rates reset at very short intervals: 7, 14, 28, and 35 days. So while they are long-term bonds and debt instruments, they pay interest at short-term interest rates.
Traditionally, the rates were reset in what is known as a Dutch auction process. Candidly, very few of the auctions would have been successful without strong support from the brokerage firms that issued and sold the securities. For many years, the brokerages firms stood behind them and put in support bids at the auctions to make sure the auctions were successful. For the better part of 20 years, there were very few failed auctions; maybe 10-12. As the sub-prime crisis developed last year, firms were becoming much more guarded with how they spent their money. Many corporations began unloading auction-rate securities, creating a flood of supply and reducing the demand, so the firms were called upon more and more often to actually support the auctions with their own bids. In February of this year, the firms across the board withdrew that support, which resulted in the auctions freezing and the securities becoming illiquid.
When brokerage firms sell securities, they have an obligation to make full and fair disclosure to their clients. The brokerage firms were telling clients that the auction-rate securities were cash equivalent money market type of instruments that were very liquid. By the middle of 2007, that was far from true. There were a number of auction failures that occurred in mid-2007, and continued to occur for the rest of the year. At the same time, the firms themselves were discussing and trying to implement strategies to withdraw from the market. Their withdrawal from the market essentially would destroy the auction-rate market. None of these negative factors and the risks attended to them were disclosed to investors, who were going merrily along repurchasing their securities every 7, 14, 28, 35 days. When the firms uniformly decided to pull away from the market, investors were left holding something they had no idea they were buying in the first place.
Financial institutions in the spotlight, along with Merrill and USB, include Citigroup, Bank of America, Morgan Stanley, Credit Suisse, Oppenheimer, Raymond James, Wachovia, and Lehman Brothers. Others were also involved in the sale of these securities. Most of the major firms were selling these securities in the same way.
I think clearly the legal implications will revolve around two basic concepts. The first is what you would call misrepresentation and omission. Did the brokerage firms provide the disclosure that the law and their own industry standards require them to provide? I think the evidence indicates no, they did not. Second is suitability. Were the recommendations made to particular clients suitable and appropriate for the clients, given their objectives? I think that again, in general they were not. In many clients’ cases, if the clients were – as many were – seeking liquid, cash equivalents, those are compelling claims. If the investors had different objectives and were looking at a long-term holding, then in that case I think the suitability claims would have an uphill battle.
When you talk about the economic implications, obviously the instruments have some value. Most of them are, in effect, the equivalent of long-term bonds paying low interest rates. As far as the clients go, the economic implications are that the securities that remain illiquid are worth much less than they were to begin with. They can only be sold at a discount, and they pay below-market interest rates for a long-term instrument. For the brokerage firms, to the extent there are litigation or arbitration claims and/or settlement with the regulators, they are looking at billions of dollars worth of potential exposure.
One other thing from the customers’ perspective: there is a concept in law called consequential damages, which in this case would mean that where an investor is denied access to his funds, and by virtue of being denied that access ends up suffering additional damages or harm, he is entitled to seek recovery of that. A simple explanation would be people who invested in these to pay their taxes, had a big tax liability come April 15, were unable to pay it, and ended up paying penalties and interest charges because of their inability to pay it. Under those circumstances, the investor would be entitled to request consequential damages.
Clearly there is a connection here with the sub-prime crisis, which has had a broad impact on a number of municipalities. As a result of the subprime crisis, their tax bases and revenues are off and their ability to raise the same level of funds is much tougher. Similarly, the volatility in the market has made it harder for closed end mutual funds to perform as well as they have in the past. The crisis has made it more difficult for non-profits to raise the funds they have raised in the past. All of this has a negative impact on the issuers of auction-rate securities. Frankly, it has increased their risk, and that has required them to pay more interest in the short-term market to keep auction-rate securities marketable.
So there is no question that it has had an impact on the issuers. From the brokerage firms, we have all read about the billions of dollars that have been lost by virtue of some of the financial derivatives and structured finance products that were designed and implemented by Wall Street. I think there is no question that Wall Street’s desire to continue supporting the auction-rate markets was adversely affected by their own financial problems, caused, in part, by the sub-prime crisis.
These events have adversely affected a number of investors, both individual and corporate, by virtue of being denied access to their funds. Obviously from a negative perspective, I do not think this is going away. I think the brokerage firms that sold these securities will end up being negatively impacted in order to ultimately resolve the problems.
From a positive perspective, I hope the situation results in a little bit of a change in the attitude within the securities industry; realizing the importance of making full disclosure and fair disclosure about the risk and the problems in what are basically esoteric types of securities. It behooves brokers in the long run to do this, and will make our capital market system work as it was intended to. One of the problems that I have observed in the last several years is that many of the investments sold to the general public have been opaque. Stated another way, investors knew little, if anything, about the securities they have been sold or the risk attendant to them. I think it is very important that Wall Street and our capital market system change their ways to provide transparency to investments sold to the investing public.
Now, however, we have an increase in lawsuits. When people are told they have a cash equivalent, and then find they own an instrument that may not mature for 30-40 years, if ever, you have clients that legitimately believe they have been lied to. That loss of liquidity, and the fact that if you want to sell the auction-rate security in the private marketplace you are going to take a loss of anywhere from 10-50 percent, I think that combination of factors is clearly pushing people to decide to file actions. One of the problems that I have observed in the last several years is that many of the investments sold to the general public have been opaque. Stated another way, investors knew little, if anything, about the securities they have been sold or the risk attendant to them. I think it is very important that Wall Street and our capital market system change their ways to provide transparency to investments sold to the investing public.
I think the saddest thing about the Merrill and USB cases is that the documents that have been released show clearly that internally, both firms were in a crisis mode. They realized there were serious problems with the auction-rate securities market. In the case of UBS, its own officers were liquidating their positions. Both firms were discussing strategies to get out of the market. They both knew that the risk in the marketplace had changed dramatically, and yet none of the investors were told this. Equally appalling are disclosures that the major brokerage firms did go to certain preferred clients. The state of Massachusetts received a number for communications from Merrell Lynch and Lehman Brothers, essentially saying: this is a risky marketplace, you better consider the options. Those go back into the late fall and winter of 2007-08. No individual customers, and to my knowledge no corporate customers, were told that information. I think that is a travesty and a violation of brokers’ obligations to its clients to tell them the true facts about what they are buying.
There have been several very good lessons learned from these cases. If you read some of the allegations made by the states and made in the press by the state and federal regulators, the message is: You owe people the obligation to be upfront, forthright, and provide full and fair disclosure. Not only are we going to be looking over your shoulder, but you expose yourself to significant financial risk and liability if you fail to comply with this basic premise. I think the cost ramifications for Wall Street should send that message loud and clear.
It looks like there will be some resolutions of this situation. I think the devil of the resolutions is in the details. For lawyers representing clients covered by a potential settlement, make sure that the customers’ needs are being fully addressed. Make sure if the customer is given a release, it is limited to the auction-rate situation, so the release is not covering things the customer may not even know about. If, on the other hand, the release requested from the customer covers all claims, the customer has the risk of giving up valid claims involving other securities which he or she may have been sold. Make sure it is fair under all the circumstances. I think going forward, from the perspective of the clients who end up pursuing legal action, it is important to study the market, what was going on, and study the background. While I do believe that in most cases the instruments were sold as safe liquid cash equivalents, there also were significant problems with the risks affecting the individual securities in the market, which increased dramatically in 2007. Perhaps most importantly, many institutions elected to stop investing in auction-rate securities during 2007. Since institutions had constituted a substantial part of the market, this resulted in an excess supply of auction-rate securities flooding the market. The only way that many auctions were able to succeed was by virtue of heavy support from the various brokerage firms. Institutions reduced their holdings of auction-rate securities by literally tens of millions of shares during 2007. The result was increased inventory being held by brokerage firms and increased capital commitments required by those brokerage firms. These developments, tied together with the increasing problems in the subprime market, caused huge financial burdens for the brokerage firms supporting auction-rate securities. As a result, many brokerage firms began exploring exiting the auction-rate market in or around August of 2007. At that same time, there were a number of auction failures. This put further pressure on the market and resulted in many more institutional investors fleeing the market. At or about the same time, several accounting firms warned their corporate clients about the auction-rate market. As a result of this combination of factors, the auction rate problems for brokerage firms continued to increase throughout 2007 and into 2008. Unfortunately, the brokerage firms, who were well aware of these problems, warned certain states and issuers of the problems but continued to sell auction-rate securities to most investors as safe, liquid, cash equivalents without disclosing the existence of problems. I believe that this failure to disclose risk factors will result in significant liability for the brokerage firms selling auction-rate securities. I think that developing an awareness and an appreciation for what those risks were, and making sure you do not exclude them from a case you bring, would be essential to providing effective representation to a client.
I think the financial institutions play a very important role in our economy. This is a sad chapter, and I hope that they will learn the value of simply telling clients what they are giving them, and provide them with the transparency to know what they are investing in. For years, the securities laws in the country have focused on transparency and disclosure and the truth. What has got us into a lot of the problems, not just with auction-rates but with a lot of sub-prime investments, is almost a complete lack of transparency. That is contrary to the fundamental intent of the securities laws and securities regulation. Our capital markets have always been based on transparency, and I hope that is something that will stick with the Wall Street firms as they go through this experience.
Preventing this situation in the future is an issue of transparency. Tell clients what you are selling, what the risks are and the downside. If risks have increased, tell the clients. They are entitled to the truth, and within reasonable limits the full truth. I think that is pretty basic, and that is where things got going a bit fast. The other part of prevention is to educate your financial advisors. In the cases that have been brought, the financial advisors have almost always said, “I thought this was a cash equivalent. That is the way I sold it.” I think the industry has adopted continuing education requirements, but a financial advisor needs to know not just the good things about the product he is recommending, but the risks and the dangers too. That information needs to be passed on to the customers so they can make an informed judgment.
To restore the market to a sense of normalcy, the obvious thing would be for the firms uniformly to say they are coming back in and fully supporting the market, and will provide the level of support they provided in the past. Then liquidity will return. The real focus of most firms I have read about suggest they are exploring alternative markets, rather than a return to the auction-rate market as it was eight months ago. Unfortunately I think that it is a foregone conclusion that the auction-rate securities markets will not return to the way they were. This will result in many issuers being forced to seek out alternative means of financing. It is clear to me that the jury is still out on exactly what products will ultimately replace the auction-rate securities market.
We have seen the regulators, including the state regulators, have taken an aggressive role here, and that should send a message loud and clear to the firms. This will hurt them in the pocketbook, and often that is what it takes to create a deterrent. This is not a cakewalk; it is going to hurt and be painful, but lots of money was made over the years when the good times were there. The brokerage firms should have known better to try to cut corners in this area, and that it is a lesson that comes at a price.
It is going to be interesting to see if we will end up with reforms similar to what is occurring in the mortgage industry. There has been some discussion in that direction. The real question is if the auction-rate market ever will return to what it was. Certainly a lot of experts think not. Even if they get their money back, people who have been burned in this market would be skeptical about investing in the same market as it was 6-8 months ago. Some of the issuers, such as a municipality that went from paying 4 percent to 16 percent interest, are going to be skeptical. Does that mean there will not be other products, better designed, to fill the gaps that have been created by the demise of this market? I do not think that.
I do think, from the regulators’ and firms’ perspective, this has been a valuable lesson and will likely result in action being taken to try to ensure the same thing does not happen again.