The auction-rate securities saga is back on center stage, with UBS Securities LLC. playing the lead role.
Massachusetts filed a lawsuit charging the Swiss-based financial firm with securities fraud for its marketing of auction-rate securities as “safe, liquid, money market instruments,” when the firm knew they were not.
Auction-rate securities (ARS) are municipal bonds or preferred corporate shares with rates that reset in periodic auctions (typically every seven or 28 days) overseen by the brokerage firms that sold them. They are long-term securities that were marketed by most major brokerages as cash or cash equivalents, with higher yields than traditional money market funds.
Safe until they weren’t
For decades, the auction-rate market operated as advertised, providing investors the option to either liquidate their investment at regularly scheduled auctions or remain invested at the new reset rate.
The ARS market collapsed in February, as financial institutions and corporate investors became unwilling to support the auctions, leaving thousands of investors unable to access their funds.
The Massachusetts complaint charges that UBS brokers did not disclose to investors the extent to which UBS itself was supporting auctions to prevent them from failing. The suit contends that no true auctions existed without this extensive dealer participation.
The Commonwealth further alleges that UBS representatives did not disclose the conflicts of interest, which existed because of its dual role of underwriting and selling these securities. The complaint also states that UBS contemplated exiting the auction-rate market as early as September of last year, but pressured its brokers to aggressively sell ARS to reduce the firm’s burgeoning inventory of these securities.
States join forces
State securities regulators investigating ARS formed a task force to share their findings. The task force was comprised of representatives from nine states, including Florida, Georgia, Illinois, Missouri, New Hampshire, New Jersey, Texas and Washington. New York Attorney General Andrew Cuomo opted out of the task force, preferring to conduct his own investigation. This ongoing regulatory activity would suggest that the Massachusetts lawsuit may be the first of many.
Although a UBS spokesperson said the firm has always been “committed to serving the best interests of our clients,” certain e-mail messages attached to the Massachusetts complaint suggest otherwise.
According to The New York Times, the dilemma UBS faced began last August, when credit markets seized up. Corporations who were formerly large buyers of ARS began to sell. The Times contends that if UBS did not find new buyers for the securities it was underwriting, it would be forced to take them into its own inventory.
This created a second major problem for the firm, which was already reeling from losses attributable to subprime mortgages carried on its books.
The e-mails cited in the complaint display the firm’s urgency to get ARS off its books and into the hands of clients.
Particularly damning is the allegation that while David Shulman, global head of fixed income distribution, stressed the need to reduce the firm’s ARS inventory by selling it to clients, he was, at the same time, unloading his own personal stake of these securities.
During this period, UBS’ Web site continued to identify auction-rate securities as a highly liquid cash alternative.
Since the lawsuit was filed, it has been widely reported that at least five major firms warned Massachusetts about the faltering ARS market. Treasurer Timothy P. Cahill said these firms were acting properly by warning the state of the ARS market turmoil. He added, however, that the fact they did not provide the same information to smaller investors was “unforgivable.”
Previously, 17 Massachusetts cities and towns complained to UBS about the lack of disclosure when purchasing ARS from UBS. The financial firm agreed to pay them $37 million in a May settlement.
Other investors in auction-rate securities have not been as fortunate. While Massachusetts and other large investors were being warned about the failing auction markets, most individual investors were taken by surprise.
Still in the dark
It is anyone’s guess how the ARS crisis will play out, but it is clear that there will be no shortage of victims, and no shortage of lawsuits. Countless individual investors remain in the dark as to when they will have access to their funds, and how much of their investment will be returned.
Ironically, most of the individual brokers and financial advisors who sold these securities also failed to understand the inherent risk. In an interview with regulators, one broker said he did not inform his clients of any liquidity risks or that an auction might fail because, to his knowledge, there were no risks.
Warren Buffett has always cautioned investors to avoid buying financial products they do not understand. Regrettably, it now applies to sellers as well.