Auction rate securities

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An auction rate security (ARS) typically refers to a debt instrument (corporate or municipal securities) with a long-term nominal maturity for which the interest rate is regularly reset through a dutch auction. Since February 2008, most such auctions have failed, and the auction market has been largely frozen. In late 2008, investment banks that had marketed and distributed auction rate securities agreed to repurchase most of them at par.

See also municipal securities and Municipal Securities Rulemaking Board.

Contents

Background

The first auction rate security for the tax-exempt market was introduced by Goldman Sachs in 1988. [1] However, the security was invented by Ronald Gallatin at Lehman Brothers in 1984. [2]

Auctions are typically held every 7, 28, or 35 days; interest on these securities is paid at the end of each auction period. Certain types of daily auctioned ARSs have coupons paid on the first of every month. There are also other, more unusual, reset periods, including 14 day, 49 days, 91 days, semi-annual and annual. Non-daily ARS settle on the next business day, daily ARS settle the same day.

As bank loans became more expensive, the auction market became increasingly attractive to issuers seeking the low cost and flexibility of variable rate debt. Buyers received a slightly higher interest and an apparent assurance of liquidity through the auction process.

By early 2008 the ARS market had grown to over $200 billion, with roughly half of the securities owned by corporate investors. [3]

Because of their complexity and the minimum denomination of $25,000, most holders of auction rate securities are institutional investors and high net worth individuals.

In February 2008, the auction market failed, and many auction rate securities have been frozen since then, with holders unable to dispose of their securities.

Investment banks that participated in the distribution and marketing have agreed to repurchase around $50 billion in securities from investors, including municipalities, under duress of investigations by U.S. state attorneys general. [4]

Student loan auction rate securities (SLARS) make up a large percentage of the ARS market.

The future, if any, of the auction rate securities market remains unclear as of late 2008.

Auction rate securities overview

The interest rate on ARS is determined through a Dutch auction process. The total number of shares available to auction at any given period is determined by the number of existing bond holders who wish to sell or hold bonds only at a minimum yield.

Existing holders and potential investors enter a competitive bidding process through broker/dealer(s). Buyers specify the number of shares, typically in denominations of $25,000, they wish to purchase with the lowest interest rate they are willing to accept.

Each bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid rate at which all the shares can be sold at par establishes the interest rate, otherwise known as the "clearing rate". This rate is paid on the entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate receive no bonds, while those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period.

Many financial services companies have been involved in packaging a collection of similar instruments, such as municipal bonds, into closed funds that were sold as both preferred and common shares. One of the largest issuer of auction rate securities was NUVEEN Investments, which since the failure of the auction market has begun to provide disclosure on their website. [5]

These funds were then labeled with names, such as "MuniPreferred", and actively marketed by brokers, such as TD Ameritrade. According to multiple reports, these were widely sold as "cash equivalents", such that the cash would be available for return within as little as 7 days. However, once the auctions were abandoned by the banks, thousands of investors were left with these illiquid funds since February 2008, without knowing when their cash will be returned.

Price Talk

Before the day's auction starts, broker-dealers will typically provide "price talk" to their clients which includes a range of likely clearing rates for that auction. The price talk is based on a number of factors including the issuer's credit rating, reset period of the ARS, and the last clearance rate for this and other similar issues. It might also take into account general macroeconomic events, such as announcements by the Federal Reserve Board of a change in the federal funds rate. Clients, however, are not required to bid within the price talk range.

Types of ARS Orders

  • Hold - Hold an existing position regardless of the new interest rate (these shares are not included in auction).
  • Hold at Rate - Bid to hold an existing position at a specified minimum rate. If the clearance rate is below the bid to hold rate, the securities are sold. (A "Hold at Rate" is not identical to a "Buy", but it's one type of "Buy". It is the same as "Buy" bidding with a certain rate (a hold rate) and current amount in participating the auction. Therefore, if the clearing rate is lower than the hold rate, the holder fails to win the auction and the securities are sold. And if the clearing rate is higher than (or the same as) the hold rate, the holder wins the auction and gets the same amount of securities at the clearing rate.)
  • Sell - Sell an existing position regardless of the interest rate set at the auction.
  • Buy - Submit a bid to buy a new position at a specified minimum interest rate (new buyers or existing holders adding to their position at a specified interest rate).

All-Hold Auction

If all current holders decide to hold their securities without specifying a minimum rate, the auction is called an "All Hold" auction and the new rate will be set to the "All Hold Rate" defined in the offering documents for the issue. The "All Hold Rate" typically is based on a certain percentage of a reference rate, usually the London Interbank Offered Rate (LIBOR), the Bond Market Association (TBMA) index, or an index of Treasuries. This rate is usually significantly below the market rate.

Failed Auction

If there are not enough orders to purchase all the shares being sold at the auction, a failed auction occurs. In this scenario, the rate is set to the maximum rate defined for the issuer (typically a multiple of LIBOR or the TBMA index). The purpose of the higher rate is to compensate the holders who have not been able to sell their positions. Broker-dealers usually bid on their own behalf to prevent failed auctions from happening. This made failed auctions extremely rare, although they did occur on occasion. In 2008 the market froze when broker-dealers withdrew.

Secondary market for ARS

Although not obligated to do so, auction-running broker-dealers may provide a secondary market for auction rate securities between auctions. If such a market develops, securities can be traded between interested clients at a discount from par value with accrued interest.

However, auction-running broker-dealers are generally reluctant to facilitate secondary trading at a discount from par, due to the fact that in doing so they would necessitate markdowns to the value of other clients' holdings.

Regulatory actions and 2008 failures

The SEC Cease-and-Desist Order of 2006

In 2006, the SEC concluded an investigation of 15 firms, representing the auction rate securities industry. The SEC summarized its findings: "between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws." The SEC issued a cease-and-desist order to stop these violations [6].

The SEC order finds that, between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws. The violative conduct included

  • allowing customers to place open or market orders in auctions;
  • intervening in auctions by bidding for a firm's proprietary account or asking customers to make or change orders in order to prevent failed auctions, to set a "market" rate, or to prevent all-hold auctions;
  • submitting or changing orders, or allowing customers to submit or change orders, after auction deadlines;
  • not requiring certain customers to purchase partially-filled orders even though the orders were supposed to be irrevocable;
  • having an express or tacit understanding to provide certain customers with higher returns than the auction clearing rate; and
  • providing certain customers with information that gave them an advantage over other customers in determining what rate to bid.

The order requires the respondents to pay the following penalties based upon their relative market share and conduct:

$1,500,000 each;

  • Bear, Stearns & Co., Inc.,
  • Citigroup Global Markets, Inc.,
  • Goldman Sachs & Co.,
  • J.P. Morgan Securities, Inc.,
  • Lehman Brothers Inc.,
  • Merrill Lynch, Pierce, Fenner & Smith Incorporated,
  • Morgan Stanley & Co. Incorporated/ Morgan Stanley DW Inc., and
  • RBC Dain Rauscher Inc. -

$125,000 each.

  • A.G. Edwards & Sons, Inc.,
  • Morgan Keegan & Company, Inc.,
  • Piper Jaffray & Co.,
  • SunTrust Capital Markets Inc.,
  • Wachovia Capital Markets, LLC -
  • Banc of America Securities LLC is required to pay $750,000 rather than $1,500,000 based on the quality of its self-monitoring capabilities in the auction rate securities area.

2008 auction failures

Beginning on Thursday, February 7th, 2008, auctions for these securities began to fail when investors declined to bid on the securities. The four largest investment banks who make a market in these securities (Citigroup, UBS AG, Morgan Stanley and Merrill Lynch) declined to act as bidders of last resort, as they had in the past. This was a result of the scope and size of the market failure, combined with the firms' needs to protect their capital during the 2008 financial crisis.

On February 13th, 2008, 80% of auctions failed.

On February 20th, 62% failed (395 out of 641 auctions).

As a comparison, from 1984 until the end of 2007, there was a total of 44 failed auctions. [7]

On March 28th, 2008, UBS AG said it was marking down the value of auction rate securities in brokerage accounts from a few percentage points to more than 20%. The markdowns reflected the estimated drop in value of the securities because the market had frozen, while UBS didn't offer to buy the securities at the new lower prices. [8]

Beginning in March 2008, class action lawsuits were filed against several of the large banks. The lawsuits were filed in federal court in Manhattan alleging that these investment banks deceptively marketed auction rate securities as cash alternatives.

On July 17th, 2008, a national task force, said to be composed of officials from several states including Missouri, began investigating at the St. Louis, Missouri headquarters of Wachovia Securities, a division of Charlotte, North Carolina-based Wachovia Corporation.

Some in the media were calling it a raid; officials called it a "special investigation" at the St. Louis offices. Media reports also said that the "special investigation" was prompted by the failure of Wachovia Securities to comply with requests by officials. In addition, it was reported that other securities firms were also a part of the investigation. The Missouri state action came after complaints to the state about a total of more than $40 million of investments that were frozen. [9]

On August 1, 2008, the New York State attorney general notified Citigroup of his intent to file charges over the sale of troubled auction rate securities and claimed Citigroup destroyed documents. [10]

On August 7, 2008, in a proposed settlement of state and federal regulators' charges, Citigroup agreed in principle to buy back about $7.3 billion of auction rate securities it had sold to charities, individual investors, and small businesses. The agreement also called for Citigroup to use its "best efforts" to make liquid all of the US$12b auction-rate securities it sold to institutional investors, including retirement plans, by the end of 2009. The settlement allowed Citigroup to avoid admitting or denying claims that it had sold auction rate securities as safe, liquid investments. [11]

Also on August 7, a few hours after Citigroup's settlement announcement, Merrill Lynch announced that effective January 15, 2009, and through January 15, 2010, it would offer to buy at par auction rate securities it had sold to its retail clients. Merrill Lynch's action created liquidity for more than 30,000 clients who held municipal, closed-end funds and student loan auction rate securities. Under the plan, retail clients of Merrill Lynch would have a year, beginning on January 15, 2009, and ending January 15, 2010, in which to sell their auction rate securities to Merrill Lynch if they so wished.

In August 2008, the Securities and Exchange Commission’s Division of Enforcement engaged in preliminary settlements with several of the larger broker-dealers including Citigroup, JPMorgan Chase, Merrill Lynch, Morgan Stanley, RBC Group and UBS. The proposed settlement called for these broker-dealers to repurchase outstanding ARS from their individual investors. [12]

MSRB seeks to disclose ARS prices to the public

The top rulemaker in the $2.8 trillion municipal bond market is seeking greater transparency on auction-rate securities and variable-rate demand obligations to help investors, the regulator’s executive director said.

The Municipal Securities Rulemaking Board, in proposals to the Securities and Exchange Commission this week, seeks to broaden disclosure about bids in auctions and how variable-rate yields are set. The Alexandria, Virginia-based panel plans to collect the details from dealers and post them on the Electronic Municipal Market Access Web site.

“By expanding the available information about auction-rate securities and variable-rate demand obligations, the investing public will have even more information with which to make investment decisions,” said Lynnette Kelly Hotchkiss, the organization’s executive director, in an e-mailed statement.

Under the proposals, dealers would have to disclose details on the types of bidders and orders for auction-rate securities, such as the number of orders to buy and sell and whether dealers are bidding. The variable-rate disclosures would tell investors more about how and when interest rates are set and the identity of the provider of the so-called liquidity facility.

The MSRB began seeking expanded disclosure in floating-rate debt after the collapse of the $330 billion auction-rate market in February 2008, when dealers stopped bidding to prevent failed auctions. Investors complained that they hadn’t been given enough information on how bids were set. Today the market is about $70.1 billion.

Auction-rate securities are long-term debt with interest rates usually reset weekly or monthly through auctions. While variable-rate debt also resets periodically, it customarily has a letter of credit or other arrangement that requires sellers to buy back the debt if investors don’t like the new yield. With auction-rate debt, investors are stuck until they can find a buyer.

The MSRB has filed today with the Securities and Exchange Commission ("SEC") a proposed rule change that would enhance the interest rate and descriptive information currently collected and made transparent by the MSRB on municipal Auction Rate Securities and Variable Rate Demand Obligations.

Summary of SEC settlements

FINRA awards $81 million to ARS holder

Purchasers of auction rate securities that have sued for consequential damages resulting from the illiquidity of their investments have not fared well in court; for example, Aimis Art Corp. v. Northern Trust Securities, Inc., 641 F. Supp.2d 314 (S.D.N.Y. 2009), held these damages claims to be "speculative" and violative of section 28(a) of the Exchange Act.

There is some evidence that purchasers may get better outcomes in arbitration.

A FINRA arbitration panel, set up as part of a special arbitration program for ARS purchasers from firms that settled SEC charges, awarded an investor $81 million in consequential damages against UBS Financial Services. UBS says that it will seek to vacate the award, although the grounds for vacating are very narrow. Inv. News, UBS will seek to have $81M Finra ruling overturned.

Arbitrate, litigate or settle

"Citi Smith Barney and Raymond James Financial Services Inc. have won major arbitration claims involving institutional and individual clients seeking tens of millions of dollars in restitution for the purchase of auction rate securities.

A three-member Finra arbitration panel last month in Miami denied claims, including fraud and breach of fiduciary duty, brought against Smith Barney, or Citigroup Global Markets Inc., by the Banco Industrial De Venezuela that totaled $118.7 million — the firm's most significant win yet in auction rate securities cases.

As is typical of the Financial Industry Regulatory Authority Inc., it did not provide reasoning behind the decision.

Also last month, a Finra arbitration panel denied a claim from an investor who bought $10.7 million worth of auction rate securities from a Raymond James broker in 2006 and 2007, according to the arbitrators' explanation of the award.

Smith Barney and Raymond James played very different roles in the $330 billion ARS market, which froze in February 2008 as a result of the credit crisis. Smith Barney's former parent, Citigroup Inc., was one of the largest dealers of ARS, while Raymond James did not underwrite the securities but sold those of other firms.

Earlier this year, Citigroup sold Smith Barney group to Morgan Stanley. Raymond James Financial Services is the independent contractor arm of Raymond James Financial Inc.

One source with knowledge of the Smith Barney case, who also asked not to be identified, said it was the “best result yet” for the firm regarding ARS. Citigroup argued that the Banco Industrial De Venezuela's Miami Agency understood what it was buying, and it's the firm's first decision in an ARS case involving a significant institutional client, the source said...."


FOR many holders of auction-rate securities — investments that Wall Street once peddled as safe, sound and as fully liquid as cash — life in the frozen zone drags on.

Not only are some brokerage firms still refusing to let customers redeem their securities — Oppenheimer and Raymond James are two examples — but also investors’ efforts to be repaid through class-action lawsuits are being stymied. Judges overseeing at least 23 auction-rate class actions have dismissed them in recent months, leaving investors who were hoping for some relief out of luck again. In September, one judge said the plaintiff was not specific enough in his allegations.

Municipalities, student loan companies, closed-end funds and tax-exempt institutions like hospitals and museums all issued auction-rate securities as either preferred shares or debt instruments to companies and individual investors. The interest rates that issuers paid investors were supposed to reset periodically, usually every week, in auctions overseen by the brokerage firms that sold the securities.

Problems in the market emerged in early 2008, when weekly auctions that allow investors to cash in their holdings simply stopped functioning. Wall Street firms sponsoring the auctions could no longer match buyers with sellers, and the machinery supporting the $330 billion auction-rate trade ground to a halt.

State securities regulators have forced some of the larger brokerage firms in the market to redeem their customers’ holdings, but not all investors have been so fortunate.

So what is an investor to do?

On the corporate side, a coalition of executives from 25 companies holding $8 billion in frozen auction-rate securities backed by student loans is arguing that if companies and individual investors could cash in those securities, jobs would be created, investments would be made and money would be spent.

The overall market for auction-rate securities backed by student loans is sizable: about $70 billion.

James Butkiewicz and William Latham, economics professors at the University of Delaware, estimated in research conducted for the coalition that 15,000 jobs and $2.3 billion in spending would be created for every $1 billion redeemed in auction-rate securities backed by student loans.


Source: Investors Without a Lifeline New York Times, August 1, 2009

"...Unlike larger Wall Street firms that both underwrote and sold auction-rate securities, Raymond James simply sold the shares and notes to its customers. Last week, it said its clients currently held some $800 million of illiquid auction-rate securities, down from $1 billion earlier this year.

That decline is largely a result of redemptions by issuers of the securities, like closed-end funds and municipalities. Raymond James has shown no interest in redeeming customers’ holdings.

“We are fully cooperating with the pending regulatory investigations that have been ongoing for over a year,” said Anthea Penrose, a Raymond James spokeswoman. “We have a very sound capital position and don’t expect the situation to change other than to reduce the outstanding ARS holdings. We continue to work with issuers to redeem their auction-rate securities and with clients to meet their needs for liquidity.”

The problem for Raymond James is that redeeming the $800 million in auction-rate securities would be tough. That figure is equal to 4.4 percent of the company’s total assets and 42 percent of its shareholder equity, according to the March 31 quarterly filing.

In that filing with regulators — its most recent — the company said that if it were to “consider resolving pending claims, inquiries or investigations by offering to repurchase all or some portion of these ARS from certain clients, it would have to have sufficient regulatory capital and cash or borrowing power to do so, and at present it does not have such capacity.” The filing added that if it had to buy back securities at 100 cents on the dollar, the potential loss “could adversely affect the results of operations.”

And so Raymond James’s long-suffering clients remain frozen in auction-rate securities hell. They can be forgiven if they resent some outlays their firm willingly makes to others.

Last year, for example, amid the market collapse, auction-rate mess and credit crisis, the company raised its dividend 10 percent. That’s nice for its shareholders, of course, but it is especially bountiful for Thomas James, its C.E.O. He owns 12.2 percent of its shares outstanding, according to its most recent proxy filing.

Dividends on those shares generated roughly $6 million to Mr. James last year and will total another $6.5 million this year if the company continues to pay the current rate of 44 cents a share.

These payments are in addition, of course, to Mr. James’s pay package, valued at $3.55 million last year. Give the Raymond James board at least some credit: Mr. James’s package last year was 13.5 percent less than the previous year’s, when earnings were 6.5 percent higher..."

Cuomo sues Charles Schwab

Source: Cuomo Sues Schwab Over ARS August 17, 2009

NEW YORK -- New York Attorney General Andrew Cuomo sued Charles Schwab Corp.'s brokerage business on Monday, alleging it made misrepresentations to clients about the liquidity and risks of auction-rate securities.

In a statement, Mr. Cuomo said brokers at Charles Schwab & Co. repeatedly represented the securities as liquid, short-term investments without disclosing the risks, comparing them with money-market funds or certificates of deposit.

"Charles Schwab owed its customers a duty to properly understand and make accurate representations concerning auction rate securities," Mr. Cuomo said in a statement. "Today we commenced a lawsuit to remedy Schwab's repeated breach of that duty. This filing should send a signal that anyone in the industry who misrepresented the risks of investing in auction rate securities will be held accountable."

Monday The Wall Street Journal, citing people familiar with the matter, reported Mr. Cuomo was expected to file a lawsuit against the San Francisco company as early as Monday.

The Financial Industry Regulatory Authority and California's Department of Corporations assisted the probe, Mr. Cuomo said.

The lawsuit, filed in New York State Supreme Court in Manhattan, alleges Schwab knew or was reckless or negligent in not knowing about rising problems in the auction-rate securities market beginning in August 2007. The complaint was brought under New York's general business law, the Martin Act.

Schwab received daily reports from major underwriters, which showed that the inventories of those underwriter broker-dealers were increasing dramatically starting in the final months of 2007, Mr. Cuomo said.

According to the lawsuit, Schwab failed to adequately educate its brokers about the securities or train them in their sale.

The lawsuit said Schwab produced audio recordings as part of the probe that confirm repeated misrepresentations were made to customers in connection with the sale of auction rate securities.

"The frequency of instances of misinformation heard on these recordings suggests that Schwab's misrepresentations were systematic and a common feature of its nationwide sales practices," the complaint said.

In one recording, a Schwab broker represented to a Massapequa, N.Y., resident that investors could get their money out of the securities every week, according to the lawsuit.

"The hardest part of this auction is getting into it," the broker reportedly said. "[T]hat would be the tough part. I mean, getting out is something as easy as just selling it."

Auction-rate securities are debt instruments whose interest rates are meant to be reset periodically at daily, weekly or monthly auctions.

Several auctions failed in February 2008, driving up interest rates for auction-rate securities issuers, while leaving investors locked into long-term investments that some firms had promoted as safe and liquid.

Mr. Cuomo's office has reached agreements with more than a dozen banks and securities companies that underwrote the auctions to repurchase more than $61 billion of the securities.

TD Ameritrade Inc., a so-called "downstream" broker that didn't underwrite the securities or run the auctions, but instead acted as a distributor, agreed to buy back $456 million in auction-rate securities as part of a settlement with Mr. Cuomo's office last month.

In a letter Friday, Faith Gay, a lawyer for Schwab, said the company didn't underwrite auction-rate securities, didn't actively market them to its customers, didn't buy the securities for its own account, didn't enter support bids in any auctions and didn't pay its representatives for auction-rate transactions or otherwise induce them to sell the product.

Ms. Gay called the refusal by Mr. Cuomo's office to take into consideration these differences "unjust."

"The Attorney General's decision to sue Schwab for a market calamity that it neither caused nor could have foreseen is the foregone conclusion of an investigation that was driven from the outset by a self-imposed mandate to reach a predetermined result: nationwide buybacks of illiquid ARS by every firm, regardless of fault and despite major differences in the roles that each firm played in the ARS market," Ms. Gay wrote.

A Schwab spokeswoman didn't immediately have a comment when reached Monday.

Corporate ARS buyers suffer substantial losses

Source: Wall Street Betrayal Seen in $4.8 Billion Company Debt Losses Bloomberg, August 28, 2009

"Eighteen months after investment banks quit supporting auction-rate securities that were once marketed as an equivalent to cash, companies from Dallas-based Texas Instruments Inc. to Israel’s Teva Pharmaceutical Industries Ltd. have more than doubled writedowns on the debt to $4.8 billion.

While U.S. state and federal regulators have announced settlements with 23 banks since December 2008, obliging them to repurchase a total of $61 billion in the bonds from individual investors, almost all new sales are failures. More than 400 companies stuck with $22 billion worth of the debt are selling at losses of as much as 40 cents on the dollar to get cash, according to SecondMarket Inc., a New York-based brokerage firm. Others have decided to wait decades until the securities mature.

“We’re not happy about this,” said James B. Flaws, chief financial officer of Corning Inc. The glass-fiber maker is one of two owners of Midland, Michigan-based Dow Corning Corp., a manufacturer of silicone products that holds $1.1 billion of the securities in a market once worth $330 billion.

Corning wrote down its share of the portfolio by $33 million and reclassified the assets as a long-term investment, according to a Securities and Exchange Commission filing for the quarter ended June 30. Its affiliate trusted the auction-rate market after functioning smoothly for more than two decades, Flaws said in a telephone interview.

‘Very Liquid Market’

“They invested in auction-rate securities based on the understanding that this was a lot like a money-market instrument, and there was a very liquid market for these,” he said. “There should be a market for this. We are appealing, pressuring, trying to get the banks to reopen the market.”

While markets from mortgage to municipal debt have rebounded this year from the worst credit crisis since the Great Depression, with a record $875 billion in corporate bonds sold through Aug. 19, $160 billion of auction-rate securities haven’t been refinanced, according to Kevin O’Connor, a SecondMarket managing director.

Of 449 publicly traded companies holding $22 billion in the debt, all but 45 have recognized a loss in their value, according to a survey of SEC filings by Pluris Valuation Advisors, a New York-based firm that analyzes illiquid assets and is affiliated with SecondMarket."

Investor sues raters and banks over ARS

Source: Anschutz Sues Bond Raters, Banks Over Auction Rate Securities Bloomberg, August 20, 2009

" Anschutz Corp. sued the three major bond-rating companies and two investment banks over $59 million in losses from auction-rate securities underwritten, rated and sold by the companies.

Anschutz, controlled by Colorado billionaire Phil Anschutz, claims the banks deceived investors about the risks of the securities and the ratings services erroneously promoted the products as safe by giving them high credit ratings, according to a complaint filed Aug. 17 in federal court in San Francisco.

Standard & Poor’s, Moody’s Investors Service and Fitch Ratings all gave their highest or second-highest ratings to the securities while receiving billions of dollars from the banks for the assessments, according to the lawsuit.

Anschutz purchased $59 million in auction-rate securities in 2006 and 2007, thinking they were safe and liquid, and has been unable to sell the securities, the complaint says."

ARS litigation

Raymond James & Associates must face a lawsuit claiming it defrauded buyers of auction-rate securities, the first class-action complaint following the market’s 2008 collapse to survive a judge’s initial review.

At least 19 underwriters and broker-dealers were sued in class-action, or group, suits since the $330 billion market for auction-rate securities cratered in February 2008. At least eight financial firms, including Citigroup Inc. and Deutsche Bank AG, got complaints tossed when judges ruled they didn’t meet pleading requirements. In some cases, the investors were allowed to refile complaints with more detail.

U.S. District Judge Lewis A. Kaplan in New York upheld part of the complaint against the unit of St. Petersburg, Florida- based regional brokerage Raymond James Financial Inc., allowing the case to move to the discovery, or evidence-gathering, stage.

“A trier of fact would be entitled to find that it would have been important to a reasonable investor, in deciding whether to buy or sell ARS, that the ARS -- supposedly liquid investments -- were liquid only because auction brokers routinely intervened in the auctions to ensure their success,” Kaplan wrote in his Sept. 2 opinion. “RJA was under a duty to disclose this information.”

Kaplan threw out an earlier complaint in the case.

Merrill Lynch won dismissal of an investors' class-action lawsuit over auction-rate securities, at least the seventh such victory since the market collapsed in February 2008.

U.S. District Judge Loretta A. Preska in New York found that Merrill Lynch, a unit of Bank of America Corp., couldn't have manipulated the market by propping up the auctions with its own bids, because it disclosed that it participated in the bidding.

“The market is not misled when a transaction's terms are fully disclosed,” Preska wrote in an opinion yesterday. “The fact that Merrill Lynch could prevent failed auctions through the placement of support bids was disclosed in numerous publicly available documents.”

The case is in re Merrill Lynch Auction Rate Securities, 09-md-2030, 08-cv-3037, U.S. District Court, Southern District of New York (Manhattan).

Chief Executive Officer Vikram Pandit was among Citigroup Inc. officers and directors who won dismissal of a lawsuit claiming they breached their duty to the bank by manipulating the market for auction-rate securities.

U.S. District Judge Laura Taylor Swain in New York today dismissed the so-called derivative lawsuit on procedural grounds because the plaintiffs failed to ask the bank to bring the case itself. She gave the plaintiffs an opportunity to file a new complaint.

Plaintiffs led by the Louisiana Municipal Police Employees Retirement System claimed New York-based Citigroup was exposed to billions of dollars in settlements, fines and lost business after bankers rigged the market in auction-rate securities to hide a lack of liquidity. The defendants included board members Michael Armstrong and former Chairman Win Bischoff.

Auction-rate securities are municipal bonds, corporate bonds and preferred stocks whose rates of return are periodically re-set through an auction. Brokerages abandoned the $330 billion auction-rate securities market in February 2008, stranding investors who could no longer sell the bonds at weekly and monthly biddings.

State regulators reached settlements with Citigroup, UBS AG, Credit Suisse Group AG, Goldman Sachs Group Inc. and other underwriters that agreed to buy back tens of billions of dollars in securities.

Citigroup was the first firm to settle, agreeing in August 2008 to buy $7.3 billion of the debt from individual investors and pay $100 million in fines. The bank also pledged to help 2,600 institutional customers unload $12 billion of securities.

The case is Louisiana Municipal Police Employees Retirement System v. Pandit, 08-cv-7389, U.S. District Court, Southern District of New York (Manhattan).

Centralized access to municipal ARS information

On January 30, 2009, the Municipal Securities Rulemaking Board began to provide free centralized access to up-to-date interest rates and auction results for municipal auction rate securities in connection with each periodic auction through its Electronic Municipal Market Access system EMMA [13]

Interactive Data, Pluris to daily price ARS


Interactive Data, a provider of financial market data, analytics and related solutions, today announced that its Pricing and Reference Data business now offers clients daily valuations for Municipal Auction Rate Securities including Student Loan Auction Rate Securities, from Pluris Valuation Advisors, a provider of market-based valuations of illiquid securities.

"Interactive Data continues to receive requests from clients for valuations of Municipal ARS, and our ability to work with a firm recognized for its capabilities in valuing these hard-to-value securities underscores our commitment to responding to client needs," said Shant Harootunian, managing director, Evaluations, Interactive Data. "Our Evaluated Services team has the depth of experience in providing daily valuations for a wide range of securities, and Pluris has the necessary data and valuation metrics to provide valuations for this particularly challenging asset class."

"Since the auctions for these securities began to fail last year, we have generated monthly and quarterly valuation reports based on ARS transactions including SLARS in the secondary markets, and we are pleased to make these, along with daily valuations for SLARS, Municipal ARS and other difficult-to-value securities available to Interactive Data's clients," said Espen Robak, Pluris president. "Working with Interactive Data provides us a venue for utilizing our proprietary data and pricing algorithms to benefit clients that need daily pricing data."

Apparent benefits of auction rate securities

For issuers, ARS appeared to offer low financing cost, in some cases more attractive than traditional variable rate debt obligations (VRDOs). No third-party bank support was required, and there were typically fewer parties to the financing process. ARS eliminated renewal risk and the risk of increased fees. There was no exposure to bank rating downgrades, and ARS offered the same flexibility found in traditional VRDOs.

For buyers, ARS provided a slightly higher after tax yield than money market instruments due to their complexity with an increase in risk. Most securities were AAA rated as well as federal, state and local tax exempt. They also provided an opportunity to diversify one's cash equivalent holdings.

The collapse of the market in February 2008 revealed that these benefits were largely illusory.

When market participants lost confidence, the auction mechanism failed. As a result, the ARS market has effectively ceased to exist. [14]

Valuation of auction rate securities

Accounting Statement FAS 157 defines fair value, which under the new guideline, is typically referred to as “mark to market” accounting. With auction rate securities no longer being liquid, public companies began to write down their ARS holdings starting in the first quarter of 2008.

Through May 31, 2008, 402 publicly traded companies had reported auction rate securities on their books [15]

Of those 402, 185 had taken some level of impairment. However, there had been no ascertainable trend in the amount of writedowns taken.

Firms have reported discounts ranging from 0-73% of par value [16]

IncrediMail, Ltd. proved the most extreme example of this as it booked an impairment of 98% off face value for its ARS holdings, while Berkshire Hathaway took no impairment on its more than $3.5 billion of these securities.

Some of the higher-profile firms taking writedowns include Bristol-Myers Squibb, 3M and US Airways. Citigroup took a $1.5 billion loss on its inventory of auction rate securities. [17]

Duke University Law School professor James Cox summed this discrepancy up: “I think some people act opportunistically, some people act optimistically and some people act fairly.”[18]

The valuation of auction rate securities has proved especially difficult as Bank of America and other brokerage houses refuse to assign a value to their clients’ holdings. UBS AG has presented clients with several different values for ARS.

Also, Interactive Data Real Time Services, a provider of independent pricing services for the investment industry, discontinued the pricing of approximately 1,100 student-loan auction rate securities on May 5, 2008.

References


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