Investors who have been financially burned by the frozen state of the auction-rate securities market aren’t the only ones up in arms these days. Apparently, financial advisors are angry, as well, saying they believed auction-rate securities to be safe as cash because that’s exactly how the products were explained to them in company training sessions.
Now, many of these brokers and advisors are scrambling to cover themselves in the event of future lawsuits over the misguided investments, collecting company sales materials and presentations that describe auction-rate securities as safe, 100-percent liquid investment vehicles.
Auction-rate securities are municipal bonds, corporate bonds, or preferred stocks that have interest rates reset through auctions held every seven, 14, 28, or 35 days. In theory, investors typically should be able to liquidate their ARS holdings at face value during the auctions - that is until the market seized up in February 2008 and auction-rate securities became illiquid. Investors who thought they were holding safe investments that they could cash out of at any time learned the opposite to be true.
Understandably fed up, many clients have headed to court, filing individual arbitrations and lawsuits against the brokerage companies and securities firms that they say never fully explained the true risks of auction-rate securities and instead pitched them as “cash equivalents.â€
Investor complaints over auction-rate securities have led state regulators from New York to Illinois to Kansas City to even Alaska to step up their inquiries into the auction-rate market and, specifically, into the ways in which Wall Street banks sold auction-rate securities investors.
In March, a nine-state national task force, headed by Bryan Lantagne, director of the Massachusetts Securities Division, was formed to look into the auction-rate problems. The Securities and Exchange Commission (SEC) also has launched an inquiry of its own.
An unraveling of the auction-rate market seemed like an impossible concept. For more than two decades, the $330 billion auction market rode a wave of financial success. Then in February, the bottom fell out as bidders failed to show up for auctions. The investment banks that once gave financial support pulled back, and news of auction failures became the fodder of daily headlines.
As a result of the auction failures, issuers of the auction bonds, including municipalities and nonprofits, faced stiff penalties in higher interest rates - sometimes as high as 20 percent. They are now either buying back their bonds or in some cases refinancing.
For retail and brokerage clients, they’ve been presented “alternatives†that include 50 percent margin loan offers against the value of their auction-rate securities holdings.
As the furor over auction-rate securities continues to grow, so too, do the lawsuits. To date, the majority of Wall Street’s major investment banks and brokerage firms, including Citigroup, E-Trade Financial Corp., Merrill Lynch, Morgan Stanley, Raymond James Financial, UBS, AG, Wachovia Corp. and Wells Fargo Investments, are the target of investor litigation over failed auction-rate securities.
The outcome of these lawsuits is anyone’s guess. Regardless, an even bigger problem now awaits Wall Street: an unprecedented crisis in confidence with investors. The unspoken bond of trust between broker and client is supposed to be sacred; once broken, it’s difficult, if not impossible, to reconstruct. It becomes a situation reminiscent of the age-old children’s nursery rhyme in which, “all the king’s horses and all the king’s men couldn’t put Humpty together again.â€
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