Auction Rate Securities: Survey of Potential Remedies
December 29, 2008
Copyright 2008. All rights reserved.
On February 13, 2008, the estimated $350 billion auction rate securities market collapsed. The collapse left investors unable to liquidate an investment that most had originally chosen based upon its characterization as highly liquid, short-term, safe, and as a cash-equivalent. Given the current financial environment where access to cash can be essential, and given the fact than many of those who invested in auction rate securities ("ARS") did so as a money-management tool driven by liquidity considerations, this illiquidity has left many investors, particularly corporate/institutional investors, in a highly problematic situation.
ARS are debt instruments in the form of corporate or municipal bonds, and also preferred stock. Most problematic among those issued were those sold by student loan agencies. ARS are essentially long-term financial instruments that have maturity dates of 30+ years, but which were characterized and marketed as short-term, liquid and cash-like investments given the fact that their interest rates were reset through regular auctions (typically held every 7, 28, or 35 days). ARS were also seen and marketed as safe investments that brought a higher yield than other money market options.
ARS were purchased by individual investors, small companies, and charities, as well as both corporations and institutional investors. It is estimated that roughly half of the ARS market is owned by corporate entities, which were largely using ARS as a means of managing their liquidity and short-term cash needs. A number of ARS buybacks have been announced, however, the buybacks are primarily targeted for individual investors, small companies and charities.
Up until February 13, 2008, large banks had helped the ARS market maintain its characteristic liquidity by filling any gaps in auction bidding to prevent failed auctions and to prop the market. However, as the larger market crisis deepened, these banks refused to act as bidders of last resort as they had done previously, and the market collapsed leaving ARS investors with frozen ARS investments. Investors were no longer able to liquidate their "highly liquid" investments. In some cases, interest rates dropped significantly, and some corporations had to undertake write-downs as they reclassified the investments from short to long term. As the current financial conditions of corporations have worsened and liquidity issues have increased, there has been a heightened sense of these problems associated with investments in ARS.
This article seeks to clarify misconceptions regarding announced buybacks and corporate/institutional investor options when it comes to dealing with the issues associated with ARS. It also outlines possible options for corporations facing their frozen ARS investments - particularly litigation options.
Addressing the ARS market failure
Responses to the ARS market failure differ for individuals and corporations. Corporate responses can be broken down into three main categories: 1) participation in large bank buybacks of ARS, 2) participation in already filed class action law suits, and 3) bringing suit as an individual corporation against relevant entities.
In the later part of 2008, many of the entities involved in ARS sales began offering to repurchase the ARS from their customers. These buybacks are a highly limited option when it comes to corporations and institutional investors. Many of these buybacks are entirely limited to individuals and small companies, and most of these retail customer buybacks have already been completed. Those that are not limited to retail customers can still be limiting for corporations/institutional investors in terms of how much they will be able to sell back, timing, and liquidity. Additionally, while some entities are repurchasing the ARS at par, most others are repurchasing at much reduced rates and also have high transaction fees. This means investors will have to exchange value for liquidity.
A large number of small investors have filed arbitrations, and many settlements have occurred. Furthermore, numerous regulators have undertaken investigations to analyze the sales practices in the ARS industry. State regulators, the Securities and Exchange Commission ("SEC"), the Financial Regulatory Authority ("FINRA"), and notably the New York Attorney General have all initiated such inquiries, and in many cases have concluded that many of the large banks' actions were fraudulent. Such remedies, however, are mainly limited to individual investors and small company investors. Thus, where large investors are beyond the scope of these arbitrations or settlements due to their size or for-profit status, litigation may be an option to consider. Litigation has taken the form of both class actions and individual suits.
Class actions: Numerous class actions have been filed in federal court and under federal securities law against each of the banks which sold ARS. The class members for each class action suit include all persons and entities that purchased ARS from each of those banks. Defendants include: A.G. Edwards (of Wachovia), Ameritrade, Bank of America, Calamos Global Dynamic Income Fund, Citigroup, Deutsche Bank, E*Trade Financial Corp., Goldman Sachs, H&R Block, JPMorgan Chase, Merrill Lynch, Morgan Stanley, Northern Trust, Oppenheimer, Raymond James Financial, RBC, Stifel Financial, Suntrust Banks, UBS, Wachovia, and Wells Fargo.
Individual corporation suits: While all ARS purchasers are already in these above-mentioned class action lawsuits, such suits are not always the solution that is best suited to corporate and institutional investors. For example, such investors may have unique needs for immediate liquidity or for solutions that better address the current economic environment. These investors may also want more control over the litigation process than class actions allow. For this reason, some corporations/institutional investors have filed suit based on their individual circumstances.
Corporations and institutional investors which own ARS are members of the above-referenced class actions. If the ARS were purchased from UBS, Wachovia, Citigroup or Merrill Lynch those investors may be able participate in the buyback programs occurring in 2009 or 2010. However, given the unique financial concerns of corporations/institutional investors, and given the current economic environment, these large entities may want to pursue individual causes of action. Bringing an individual suit may give these large investors a greater degree of control over the litigation process and may allow them to pursue specific damages and specific claims that better address their individual needs and circumstances.
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