This is at least the second large brokerage firm to have been investigated by a state securities regulator for Auction Rate Securities sales practices.  In June, the Massachussetts Securities Division filed a Complaint against UBS Financial Services.  In the Complaint, the Division charged UBS with fraud and is seeking relief for citizens of Massachussetts.  More information is available here.

This does not appear to be the end of the Auction Rate Securities investigations.  Individual investors have also been actively pursuing their rights by filing arbitration claims to obtain damages and/or rescission for Auction Rate Securities fraud.  The Nygaard Law Firm actively represents individual investors in securities arbitration and if you would like to obtain information, please feel free to contact our firm to speak with one of our attorneys.     

Many ARS issuers are municipalities or quasi-municipal entities engaged in student lending.  In fact, Bloomberg.com reports that “municipal obligations made up about half of the $330 billion in auction-rate securities at the beginning of the year . . . .”  These entities have limited budgets from which to pay interest expenses.   As a result, these issuers have made a “business decision” not to redeem their ARS. 

The vast majority of ARS owners who have contacted our firm were sold ARS by their stockbroker or financial advisors as “short-term,”  ”safe,” “liquid,” “cash equivalent” investments.  In addition, virtually all of these individuals never received a prospectus at any time.  These brokers/advisers were often provided necessary information on an “as needed” basis, which generally means they were given information after the auctions failed in February.  Worse yet, many brokers/advisers were never provided the necessary information by their firms.  As many investors discovered in February, the most substatial risk to investing in the ARS market was liquidity risk (being able to access your money by selling your ARS at the auction).  The broker-dealers who employ the brokers/advisers were largely responsible for keeping the ARS market afloat by using their liquid reserves to purchase the ”unpurchased” ARS at the auctions.  In February, these same firms decided, without warning, to pull their support from the ARS market.  As a result, investors were left with few options to access their money.  What makes this truly appalling is that these same firms were typically the underwriter and/or broker-dealer listed in the prospectuses, which means that these firms knew of the liquidity risks in the ARS market. 

Many ARS owners have been asking, “what can I do about this?”  Yesterday, Liz Rappaport, of the Wall Street Journal Online, gave a very consise outline of these options, including “File an arbitration claim.”  Because many issuers are making “business decisions” similar to those discussed above, ARS owners who do nothing could be in for a long wait.  In addition, to the extent that a “secondary” market exists, it has provided little benefit to ARS owners because the only “trades” in this aucton occur at rather large discounts.  Many broker-dealers have offered “loans” to their clients; however, in recent months, many of these firms have written down the value of thier clients’ ARS holdings and have also reduced the loan-to-value ratios (again, the broker-dealers change the rules of the game after it has already begun).   As a result of this double-whammy, many ARS owners who have elected this option have received notice from their broker that they need to repay a portion of the loan.  This is particularly troublesome when an ARS owner’s only liquid asset was their ARS and they took their loan to fund a major purchase (such as a home, car, or education expenses) because now these individuals do not have any liquid reserves from which to pay back a portion of the loan.  In addition, it is quite likely that these markdowns and loan-to value adjustments have not ended, which means that more and more people who were “helped” by their broker, will soon learn that this assistance, much like the ARS market itself, was a sham.

Selling in the secondary market will result in losses, which are recoverable in arbitration.  In most states, rescission and restitution (legal jargon for giving an investor his or her money back) is available to investors who were misled by their broker/adviser that ARS were “short term” and “liquid” investments.  After all, if the broker sold ARS as “liquid,” the investor is entitled to hold them to it.  At the end of the day, unless an issuer redeems their outstanding ARS, an individual’s best option for recovery may truly be to file a claim in arbitration.   

The article does not discuss the auction rate preferred securities issued by closed end funds, nor the student loan ARS, but the conclusion seems clear:  ARS are a thing of the past.

Investors who were sold Auction Rate Preferred Shares, also known as ARPS, continue to remain unable to access their invested capital.  These “preferred” shares are similar to other preferred stocks, except that the interest rates paid to shareholders of ARPS are determined in the auction market.  Unfortunately, these “preferred” shareholders also depended (unknowingly) on these auctions in order to have access to their capital.  Therefore, when the auction market collapsed, these “preferred” shareholders lost access to their money. Over the past few months, several of the larger issuers of ARPS have begun to redeem some of their outstanding shares.  However, PIMCO, the fourth largest issuer of  ARPS has done nothing to help its “preferred” shareholders access their money.  According to an article on Bloomberg.com, PIMCO has issued approximately $4.3 billion in ARPS.  The article reports that Allianz, PIMCO’s parent, has the audacity to state that “it had so far rejected refinancing options as too risky for common shareholders.”  Ironically, if a common shareholder needs access to his or her money tomorrow so that he or she can make a down payment on a new home, he or she can sell their shares in the open market and fully liquidate their position.  However, if a “preferred” shareholder needs money for a down payment on a  new home, he or she is without access to their money and must wait indefinitely. PIMCO (and Allianz) had no problem taking the $4.3 billion under the guise that the ARPS were “preferred” shares.  However, PIMCO (and Allianz) have clearly subordinated the interest of “preferred” shares by rejecting plans to refinance ARPS because of the potential detriment such action might cause to common shareholders. 

Update on the status of lawsuits, arbitrations and liquidity

Many class action lawsuits have been filed against the brokerage firms underwriting and selling the auction rate securities: Morgan Stanley, Merrill Lynch, UBS, E*Trade, Ameritrade, Citigroup, Wachovia, Raymond James, Deutsche Bank, and Wells Fargo. These cases so far involve allegations that the entire class of people were deceived when these securities were sold to them.  However, such class actions may or may not be certified.  If the common questions of fact or law predominate (as they do in most cases involving a “he said/she said” dispute), the courts will not certify the cases as a class action.  For most individual investors, therefore, we believe that filing an individual FINRA arbitration is the better course.  They are faster, get the investors’ claims on the table for resolution faster, and almost always result in a much greater return for the investors than securities class actions.

FINRA arbitration

The arbitration agreements signed when opening an account at a brokerage firm require that all disputes involving the account be submitted to FINRA (formerly the NASD) arbitration process. We have represented thousands of investors in these, and have begun filing these for auction rate securities investors.  The process begins with filing a Statement of Claim, setting forth the facts and law supporting the claim.  The Respondents (Defendants) then file their response, stating their position as to the fact and law.  There are no depositions in arbitration unless there are extraordinary circumstances, so there are no court reporter expenses.  The parties exchange documents and information.  The parties choose a panel of two “public” arbitrators (people who are not in the securities industry) and one industry person.  Although over 95% of cases settle, if the arbitration goes to hearing, it is conducted like a trial.  The Claimant’s attorney does an opening argument, presents witnesses, and then the Respondent puts on their case.  Briefs can be submitted and closing arguments made.   The Panel’s decisions are binding, with limited appellate review.

ARS with low reset rates

We are particularly troubled by some of the auction rate securities that clients have been sold which have a reset interest rate of zero.  There is no incentive for issuers of these to refinance and liquidate them.  Similarly, many of the other municipal, tax-free issues are resetting to only modestly higher interest rates, and we don’t expect to see a secondary market develop for these.

MOHELA, the Missouri higher education loan administration has over $2 billion of auction rate securities outstanding, which have been sold nationally.  MOHELA has had some well-publicized political and financial problems, and the Board has allowed funds to be used to finance the construction of buildings rather than to provide student loans.  We are seeing clients who were sold millions of dollars of these loans.  The underwriters were Banc of America, Commerce Bank, and A.G. Edwards (Wachovia). Many of the clients were sold bonds by one of these firms, and, as underwriters, they have increased legal liability for recommending the purchase of such bonds in their inventory.  Given the unique problems of the issuer, these bonds are subject to special scrutiny.

Update on Refinancings by Closed End Funds

In the last few weeks, some of the closed end funds that issued auction rate securities have liquidated or announced a plan to liquidate some or all of them.

On March 20, Calamos hosted a conference call about its attempt to liquidate the ARS it had issued in tandem with some of its closed end funds.  It alone has issued about $2.5 billion of ARPS, but has yet to announce the actual plan to repurchase or refinance its ARS.  It manages five leveraged closed end funds, and has been a substantial issuer of ARS.

On April 15, Blackrock announced that is would replace the $1.9 billion of ARPS issued both by taxable and tax exempt closed end funds. It is attempting to develop other kinds of bonds, or debt instruments, which it claims would be eligible for purchase by money market funds.  That is a rather frightening thought, as we all are careful about money markets maintaining their $1.00 net asset value in the face of the credit crisis.

In March, Eaton Vance did refinance all the auction rate securities for its Eaton Vance Tax Advantaged Dividend Income Fund, Tax Advantaged Global Dividend Income Fund, and Tax Advantaged Global Dividend Opportunities Fund.  This week, it announced that three of its municipal bond funds would redeem an additional $580 million of outstanding auction rate preferred shares, but not all shares are being bought back.  Eaton Vance did not announce the method it will use to redeem shares.  We don’t know whether only people who have complained will be compensated first, or whether they will be redeemed in order of purchase, orwhether they are using another formula.  Furthermore, Eaton Vance still has more than $2 billion of ARPS outstanding as to which no plan has been announced. 

The Current Value of Auction Rate Securities

UBS has marked down the values of auction rate securities by 15-30%, using some internally generated formula. Clients’ statements are now showing this reduced value, although there is no market, so putting any market value on these seems optimistic at best, and misleading at worst. 

Using the Martin Act, the New York state securities act, which has more teeth than any other state or federal investor protection statute for prosecutors, Attorney General Mario Cuomo of New York has announced the issuance of subpoenas to several of the brokerage firms selling these securities.  He’s an aggressive, ambitious, prosecutor and will probably make more progress than other states’ regulators, who do not have the benefit of strong investor protection statutes.

Some brokerage firms are offering margin loans so that our clients can pay taxes, etc.  However, we have seen people whose margin interest exceeds the default rates on the ARS.  We have negotiated with firms so that the rates are at least the same, if not lower than the interest being earned.  We caution all investors who are considering taking out a margin loan to make sure the loan documents do not include any release from liability, or even a limitation on the firm’s liability (for example, waiving punitive damages, or claims for interest or attorneys fees) for the brokerage firm. 

We are committed to representing our clients by pursuing their legal claims efficiently and quickly, as well as by obtaining for them any other assistance available by way of the secondary market, or by negotiating interest rates with issuers and sellers of these auction rate securities.  Please contact us at http://www.nygaardlaw.com for more information, or if you have additional information that you think would be helpful to us in prosecuting these cases.

Every day, the news for investors who have been left holding these illiquid and risky investments has gotten worse.  Last week, several states, including Missouri, have announced investigations into investment banking practices related to the sales of Auction Rate Securities to investors.  The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have also put their hats in the ring.  However, while regulators try to sort out the mess that once was a $330 billion market, individual investors are left holding what are essentially worthless pieces of paper.

Bloomberg.com has recently reported estimates that approximately $60 billion of the auction rate securities in the market three months ago have been redeemed or will be converted by the issuers.  While this 18% “reduction” in the market is good news for some investors, it unfortunately means that 82% of the market continues to remain unresolved.  The fate of this 82% is in serious doubt, as Citigroup, Inc. has predicted that the auction rate market will “cease to exist.”

With all of the issues in the financial markets, it seems as though investors in Auction Rate Securities are receiving the least amount of assistance.  This has led to the filing of several class actions on behalf of Auction Rate Securities owners, as well as individual attempts to resolve disputes through arbitration or settlement negotiations with the firms who sold these investments.  As a result of these legal actions, it appears that some good is being done.  Several firms have now added information about Auction Rate Securities on their websites and securities regulators are spreading the word.  Unfortunately, this may all constitute to be “too little, too late” for many investors.

Now in private practice I’m hearing the same stories from people desperate to get some of their hard earned money back after trusting friends and relatives with their savings. Sometimes they have been duped; however, there are also circumstances where small businessmen and entrepreneurs have all the right intentions and good ideas. Without proper planning and capitalization, not to mention skill, timing, and often luck, small businesses fail. This leaves the investor holding an empty bag.

So what can you do if this has happened to you? If you feel that your friend hasn’t been honest with you, you can always file a complaint with your state securities regulator. They will likely investigate and if there is evidence that your friend didn’t fully disclose to you all of the risks, told you things that later turned out not to be true, or engaged in other wrongdoing, the regulator may order the entrepreneur to “cease and desist” from engaging in the activity. Sometimes these cases may even be criminally prosecuted if there is evidence of fraud. However, this approach will most likely not result in a return of the investor’s money because in most cases the money is gone.

Another option is to hire a private attorney. Once again, if there is evidence that there was wrongdoing, and if there is money left somewhere, a private attorney may be able to recover some on your behalf.

The best advice is forethought. Before you invest in a friend or relative’s business idea, do some homework. Ask questions. It may seem rude or distrusting, but this is your money. Call your state securities regulator and see if complaints have been made in the past. Do a Google search of your friend’s name, his business name, and others she claims to be working with. Finally, contact a private securities attorney and have them review the materials you have been given. At the very least you should have a document detailing the business plan, the risks involved, the experience level of those involved, and how your money will be used. Only then can you determine if the investment is legitimate, or if you would be better off keeping your money in…your mattress?

Because we are securities attorneys, we are receiving calls from panicked investors. They have realized that these “just like cash” investments were traded in a market that has dried up.  If there are no buyers, there’s no market.  They can’t get out.  Just a few weeks ago, they were blissfully unaware that they, too, had been sold a “too safe to fail” security.  However, there is no white knight riding to their rescue.

There have been a few companies, like Nuveen, which have given lip service to the possibility of standing behind these securities.  Nuveen, about two weeks ago, said it hoped to refinance the ARS backing its 120 closed-end funds to the tune of about $15.4 billion.  So far, however, none of the Nuveen ARS investors who have contacted this law firm have received a dime.  Eaton Vance has made an attempt to cash out holders of ARS in three of its funds.  The problem is these companies face a liquidity crisis, too.  

Ms. Morgenson’s article was insightful in that it described the closed end mutual funds’ defense that it owes a fiduciary duty to its common stockholders. They were receiving an extra “kick” in return due to the fairly low rate of return that they paid the holders of the ARS.  The ARS holders, though, thought they had a money market or C.D.-like security. They had no idea, from what I am hearing from angry investors, that there might be a small problem.  It’s the problem that Mark Twain famously described: “I’m not so concerned about the return on my money - it’s the return of my money.”  

The mutual funds and other issuers of ARS are telling investors that they should sue the brokers who sold them.  They were sold without prospectuses, so the issues will probably vary from investor to investor, based on what their stockbroker told them and what they understood about the risks.  Although class actions have been filed, unless a script or a brochure was required to be given or read to the potential investors, it will be difficult to get a class certified based on a common question of law or fact. 

We are recommending that investors file arbitrations against the brokers who sold them ARS - if they represented that they were safe, liquid investments, like a money market or a C.D.  

Class actions have been filed against Citigroup, Morgan Stanley, and Merrill Lynch, but we are seeing ARS holders who were sold these by E-Trade, regional and discount brokerage firms.     

Once again, investors were sold investments that promised a higher return than money markets or C.D.s, and were “as safe as C.D.s”. They were too complicated to be sold without prospectus, but they were – due to another big “loophole” designed to help our “capital markets”.  Somebody forgot, though, whose capital creates the markets.

ARS are in a long and dubious line, succeeding the limited partnerships of the 80’s, the “high yield” (junk) bonds of the 90’s, and the CDO’s, mortgage securities, and equity indexed annuities of this decade.

Soon there might be a secondary market for these products - fueled by speculators willing to snatch these up for pennies on the dollar, just as happened with viaticals, deferred annuities, and limited partnership interests.  At least investors had better hope that a secondary market emerges, because the primary market doesn’t look so good.