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Auction-Rate Securities

Uncertainty Abounds in Market for Auction-Rate Securities. What Recourse Do Investors Have?

Much to their chagrin, investors who purchased auction-rate securities — in the form of preferred shares in closed-end mutual funds, or corporate or municipal bond instruments — are discovering that these securities are hardly the safe, liquid, slightly higher-yielding, tax-exempt alternative to money-market funds that they were marketed as. Contrary to their expectations — based on what they were told at the time they invested in these products — investors are now learning that they cannot redeem them for cash on short notice, long notice or even any notice at all. Instead, they are finding — as we noted in our February 20, 2008 post — that the market for auction-rate securities has essentially collapsed and their funds are frozen. What had been sold to them as a “sure” and readily available source of cash is now anything but that.

Like Wall Street Journal reporter James B. Stewart, who bought auction-rate preferred shares in a BlackRock closed-end mutual fund, many investors are alarmed to learn that there is “no guarantee” that they will ever be able to redeem their auction-rate securities. Goldman Sachs and Lehman Brothers have also told investors that their securities — and cash — are frozen. When Stewart questioned a broker at Merrill Lynch, which owns nearly half of BlackRock, what the firm intended to do for its clients, he was told they would be offered “loans which can give them liquidity.”

Whether or not Merrill Lynch intends these loans to be interest-free — as indeed they should be — is beside the point. The sad fact is that nothing is certain. If the credit crisis subsides, the auction-rate securities market may eventually recover. It may recover next month, next year or sometime in the future. There is also the very real possibility, however, that it may never recover. In the meantime, investors are left in limbo.

There is no way to predict what will happen with the $330 billion auction-rate securities market in the foreseeable future. As reported yesterday by Michael McDonald on Bloomberg.com, Bill Gross — manager of the $120 billion Total Return Fund, the world's largest bond fund -- sees signs that “the contraction in the credit markets will last.” This fact alone should alert investors of the need to investigate their options for recourse sooner rather than later. One course of action they may wish to pursue is to seek rescission. Many firms sold these securities on assurances that they were short-term investments as safe, as liquid and as reliable as money-market funds. Since recent events have proven just the opposite — and auction-rate securities have now become long-term investments with an uncertain redemption date — an investor can demand the return of the money he invested, i.e., rescission. An investor's inability to get his money out, without any other losses, may be enough to hold a firm liable.

Corporations also invested in auction-rate securities in the belief that they were safe, conservative investments. For example, as reported in a February 15, 2008 New York Times article by Jenny Anderson and Vikas Bajaj, last year, pharmaceutical giant Bristol-Myers Squibb was forced to take a $275 million write-off on funds it had invested in auction-rate securities.

Besieged by complaints from investors that they could not sell their shares of preferred securities in closed-end mutual funds, despite the fact that they were touted as short-term investments, state regulators are investigating just how these securities were marketed and sold. According to reporter McDonald, William Galvin, Secretary of State of Massachusetts, recently requested information from nine mutual fund companies about failed auctions that left investors unable to redeem their shares. Ohio's Attorney General has indicated that his office may file lawsuits against firms that sold auction-rate securities to various state funds. BlackRock and Nuveen Investments, among other mutual fund companies, sold approximately $60 billion of the securities to raise additional capital for their closed-end funds.

Investors in auction-rate securities are not the only victims in this crisis. Issuers of auction-rate securities — state agencies, municipalities, hospitals, colleges and universities, non-profit organizations and other entities — are also suffering. Many of the leading Wall Street securities firms, most notably, UBS, Citigroup and Goldman Sachs are greatly reducing or eliminating altogether its purchases of auction-rate securities in the face of concerns about the credit strength of bond insurers backing the underlying debt obligations of these securities.

In a Wall Street Journal article today, reporters Randall Smith and Liz Rappaport quoted David Brow, executive director of the New York State Dormitory Authority, who criticized the firms for their reluctance, if not failure, to make a market in auction-rate securities. “[T]his is not the finest hour of the investment banking community.” Rather than making a market in the securities, auction dealers are recommending debt restructurings “where they will earn yet another investment banking fee.” The New York State Dormitory Authority markets municipal debt for such esteemed institutions as Memorial Sloan-Kettering Cancer Center, Cornell University, New York University and Rockefeller University. In addition to Citigroup and Goldman Sachs, the Authority listed J.P. Morgan Chase, Morgan Stanley, Merrill Lynch and Lehman Brothers as the firms responsible for auction failures.

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