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How Did FINRA Know the ARS Market Was Failing Well Before 2007?

Posted by Larry Doyle on December 1, 2010 10:24 PM |

If you knew a market were starting to fail, would you step in and purchase that asset?

If that market were failing, but simultaneously being propped up by underwriters, do you believe regulators should protect you?

If that market were failing and a regulator charged with protecting you actually dumped some of those failing assets from its own portfolio, how would you feel?

If you owned some of these securities, do you think you might be protected by the regulator? The government?

Let’s reenter the world of auction rate securities and continue to bang the drum for those investors in America who have been so badly mistreated by the financial industry, the regulators charged with protecting them, and our government.

Although I have written voluminously on the auction-rate securities market, I was never fully aware of when auctions started to fail. Until now.

With what I learned today, I have absolutely zero doubt that representatives of Wall Street’s self-regulator FINRA were fully aware the ARS market was failing when they dumped their own portfolio holdings of $647 million ARS in mid-2007. What does one call it when a regulator possesses material, non-public information about a market and acts upon it for their own self-interest? Where are the attorneys general, state securities regulators, and federal officials to look into this transaction? Who is willing to blast this development?

Well, give me that megaphone.

In the process of reviewing an ARS related Notice of Charges brought against E*Trade by the State of Colorado, I was struck by the following paragraph under the heading The Failure of the Auction Rate Securities Market:

The systemic auction failures starting in 2008 did not represent the first example of auction failures. As early as 1987 and 1988, Dutch auctions for ARS had failed for long term bonds issued by MCorp and Kroger. In 2006, the Securities and Exchange Commission issued a Cease and Desist Order imposing sanctions upon numerous large broker-dealers, including Bear, Stearns & Co., Citigroup, Goldman Sachs, J.P. Morgan Securities, Inc., Lehman Brothers, and numerous others in case number 3-12310, In the Matter of Bear Stearns & Co. Inc et al. (the “SEC C&D”). The SEC C&D in particular found that the named broker-dealers conduct in the Dutch auction process included various examples of interference in the ARS Dutch auction market, including (but not limited to) bidding to prevent failed auctions.

Wow. So auctions were failing as early as 2006? Could they have been failing even earlier? If so, FINRA – which by its own admission liquidated its own holdings in mid-2007 – must have known about the failing nature of this marketplace. Let’s connect the dots and review the SEC Cease and Desist Order:

Washington, D.C., May 31, 2006 – Today the Securities and Exchange Commission announced the institution of proceedings against 15 broker-dealer firms for engaging in violative practices in the $200 billion plus auction rate securities market. Auction rate securities are municipal bonds, corporate bonds or preferred stocks with interest rates or dividend yields that are periodically re-set through Dutch auctions. Simultaneously with the institution of the proceedings, the firms, which neither admit nor deny the findings in the order, consented to the entry of an SEC cease-and-desist order providing for censures, undertakings, and more than $13 million in penalties.

$13 million? Not even pocket change.

The SEC, in determining the structure of the settlement and the size of the penalties, considered the amount of investor harm and the firms’ conduct in the investigation to be factors that mitigated the serious and widespread nature of the violations. In particular, the firms voluntarily disclosed the practices they engaged in to the SEC, upon the staff’s request for information, which allowed the SEC to conserve resources.

Amount of investor harm was a factor that mitigated the serious and widespread nature of the violations? So, the harm was not all that great? Are you kidding me? Less than 24 months after this Cease and Desist Order was issued, the $330 BILLION market froze and the lives of so many along with it…….and FINRA was not aware the market was failing? STOP IT!!

Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, said, “This matter highlights both the industry-wide violations that existed in the auction rate securities market and the benefits to firms that cooperate with the SEC to quickly address problems. This case signals that the Commission is willing to take measured sanctions when broker-dealers are cooperative with the SEC in curing industry-wide violations and there is relatively modest investor harm.”

Curing industry-wide violations? That obviously did not happen.

Relatively modest investor harm? Are you kidding? Seriously, how do people like Linda Chatman Thomsen sleep at night?

…..and FINRA was not aware the market was failing when they dumped their ARS bonds in mid-2007? STOP IT!!!

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.

Some of these practices had the effect of favoring certain customers over others, and some had the effect of favoring the issuer of the securities over customers, or vice versa. In addition, since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities. By engaging in these practices, the firms violated Section 17(a)(2) of the Securities Act of 1933, which prohibits material misstatements and omissions in any offer or sale of securities. (LD’s highlight)

BINGO!! Who was charged with protecting the investors? FINRA. What did FINRA do? They dumped their own ARS holdings. FINRA has NEVER been held to account.

The SEC order (1) censures each firm; (2) requires each firm to cease and desist from committing or causing any violations and future violations of Section 17(a)(2) of the Securities Act; (3) requires each firm to pay a penalty; (4) requires each firm to provide certain disclosures of its material and current auction practices and procedures; and (5) requires each firm, not later than six months after the date of the order, to have its CEO or general counsel certify that it has implemented procedures that are reasonably designed to prevent and detect violations in the auction rate securities area.

The order requires the respondents to pay the following penalties based upon their relative market share and conduct: 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. – $1,500,000 each; and A.G. Edwards & Sons, Inc., Morgan Keegan & Company, Inc., Piper Jaffray & Co., SunTrust Capital Markets Inc., and Wachovia Capital Markets, LLC – $125,000 each. 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.

The Commission’s investigation is continuing as to other entities that participate in the auction rate securities market.

If the SEC’s investigation was continuing then and should be continuing now, then why doesn’t it take on the SRO which it is constitutionally charged with overseeing? I brought a wealth of information on this entire scenario to the SEC’s Office of Compliance Inspections and Examinations. That office is charged with the following:

Examiners in Washington DC and in the Commission’s 11 regional offices conduct examinations of the nation’s registered entities, including broker-dealers, transfer agents, investment advisers, investment companies, the national securities exchanges, clearing agencies, the nationally recognized statistical rating organizations (“NRSRO”s), SROs such as the Financial Industry Regulatory Authority (“FINRA”) and the Municipal Securities Rulemaking Board, and the Public Company Accounting Oversight Board (“PCAOB”).

Going on five years from the issuance of this Cease and Desist, and almost three full years from the date when the ARS market totally failed AND ~$135 BILLION of ARS still remain frozen. Along with those funds remaining frozen, so do the lives of so many individuals who were counting on their ‘cash equivalents’ to fund education, pay for retirement, and so much more.

While those individual lives are frozen, the regulator FINRA charged with protecting investors and overseeing those broker-dealers SOLD its own portfolio holdings of $647 million ARS mere months before the ARS market froze.

Who in our nation is calling FINRA to account? Who in the media? Who in the government?

Does anybody in those power structures have the balls to take on FINRA?

The dots are all connected.

Let’s see FINRA’s trade ticket.

This is America?

Larry Doyle

P.S. I want to thank the reporter from Reuters who brought the Notice of Charges in State of Colorado in re: E*Trade to my attention. He will be entered into the Sense on Cents Hall of Fame during our next induction ceremony.

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I have no affiliation or business interest with any entity referenced in this commentary. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

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