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Auction-Rate Securities UPDATE: SEC Brief May Help ARS Investors

Posted by Larry Doyle on July 26, 2011 8:21 AM |

37 months and counting and still thousands of Americans holding untold billions of dollars in frozen auction-rate securities await the return of THEIR money.

The question of whether the injustice of all that went on in the ARS scandal might ever truly see the light of day seems to have long since been dismissed. Regrettably that fact would seem to mitigate a full understanding of the ARS mess and minimize the lessons that may otherwise have been learned by future generations. What a shame!!

Despite these realities, the fight goes on supported by the billions of reasons that may appear to be frozen in those outstanding ARS but are very much alive.

I have always maintained that the ARS market was the greatest scam ever perpetrated on Wall Street. What is new on the ARS front? Let’s navigate as Bloomberg recently highlighted, SEC Brief in Auction-Rate Case May Help Investors Suing Banks, Lawyer Says,

Auction-rate securities holders seeking to win back part of the $330 billion they’ve invested, may get help from a U.S. Securities and Exchange Commission legal brief supporting claims that Merrill Lynch & Co. rigged the moribund market, a lawyer involved in the case said.

More than a few ARS investors have shared with me that it was not just Merrill Lynch that may have been involved in rigging the ARS market. Dare I say, I believe that virtually each and every dealer involved in the ARS market likely rigged the auction process.

Merrill Lynch, now part of Bank of America Corp. (BAC), failed to adequately inform investors of its alleged role in “propping up” auctions, the SEC said in the brief, filed in the U.S. Court of Appeals for the Second Circuit in New York.

“We think the SEC has come down on the side of investors,” Jonathan Levine, a lawyer with Girard Gibbs in San Francisco, said in a telephone interview. His firm represents investors in the appeal.

SEC Chairman Mary Schapiro moved to reinvigorate the enforcement unit after President Barack Obama appointed her in January 2009. Investigations surged by 32 percent and the agency went to court seeking emergency orders four times as often as it did a year earlier, Enforcement Director Robert Khuzami said at a congressional hearing in May 2009.

If the court agrees with the SEC’s argument, it may lead to the reversal of other dismissed auction-rate cases alleging brokers and dealers rigged the market, Levine said. “Now it depends on whether the court accepts the view of the SEC.”

Lawsuits by the agency and state regulators led to the return of at least $60 billion to individual investors. Other holders of the securities had their lawsuits dismissed. About $55 billion of the debt remains outstanding, the Municipal Securities Rulemaking Board said yesterday. Trading in the market has fallen about 59 percent, the industry regulator said.

To the best of my knowledge the total figure of outstanding ARS runs far higher than the $55 billion quoted here. I would believe this figure represents merely ARS backing municipal borrowings and not those funds borrowed by mutual funds or corporate entities.

After sanctioning Wall Street’s biggest dealers for manipulating the markets by using inside knowledge of bids to influence yields when they ran auctions in 2006, the agency let the practice continue as long as it was disclosed to investors.

I have not heard from even one ARS holder that he was ever informed of the practice used by dealers to prop the auctions. That disclosure would have highlighted that the ARS market did not have the supposed liquidity which dealers represented.

In February 2008, dealers, which had routinely bid to prevent auction failures, withdrew their capital and stopped bidding, leading to a market collapse that left investors with bonds they couldn’t sell and sticking some borrowers with high penalty rates, sometimes as much as 20 percent.

Merrill and the SEC reached a preliminary settlement in April 2008 that called for the firm to buy back $7 billion of the securities. The agency said at the time that the dealer had misrepresented them as “safe, highly liquid investments equivalent to money-market instruments and cash,” and that it didn’t make adequate disclosures to investors.

The SEC’s friend-of-the-court brief filed last month may affect the appeals panel, where the agency has “generally been fairly persuasive and deferred to,” said James Cox, a Duke University law professor in Durham, North Carolina. The agency’s argument may be persuasive if it provides sufficient analysis of the market and what should have been disclosed to investors so they’d understand how dependent it was on dealer participation.

After the market collapsed, investors who said they didn’t know about the risk of auction failures soon began to seek redress in the courts. Claimants in some cases said the securities had been sold as similar to money-market funds.

“This is uncharted territory before the most respected federal appeals court on securities law issues,” said Jacob S. Frenkel, a lawyer with Shulman, Rogers, Gandal, Pordy & Ecker PA in Potomac, Maryland, who focuses on securities law and white- collar crime. “Because the opinion potentially could impact SEC cases, logic dictated that the court gave the SEC an opportunity to weigh in.”

“The request for an amicus brief by no means indicates that it will follow the SEC,” Frenkel said by e-mail. “No game-changer here; rather, it’s just bringing a very interested stakeholder to the table to express its views.”

Let’s save the hooplas for the SEC as this brief is coming a full three plus years after the initial freezing of the ARS market. That said, better late than never.

Judgments have sometimes gone against investors, including some whose claims against Merrill have been consolidated in the case before the appeals court. Citigroup Inc. (C) in March won the dismissal of five consolidated lawsuits brought by investors who claimed the New York-based bank manipulated prices.

These judgments seemed to rest on the premise of ‘caveat emptor’, that is buyer beware. I personally believed that at the time the courts did not want to saddle the banks with another enormous financial burden while they were hanging on for dear life. Dare I say that justice seemed to take a back seat to restoring the financial health of the banks.

The SEC brief examines the adequacy of disclosure at the request of the court, said Kevin Callahan, an agency spokesman, in a prepared statement.

“We made clear our view that it is not sufficient to disclose the risk that an event may happen when according to the plaintiff’s allegations it is known for a certainty that the event has happened or will happen,” Callahan said.

Under Schapiro’s predecessor, Christopher Cox, the agency instituted policies that slowed enforcement cases and led prosecuting lawyers to conclude their commissioners opposed fining companies, the Government Accountability Office said in a May 2009 report. The GAO is the investigative arm of Congress.

The Securities Industry and Financial Markets Association, a New York-based trade group for securities dealers, called the agency’s argument “a flawed and unwarranted expansion of private civil liability,” in a brief it filed in the New York case July 8. The group asked that the court reject the appeal, according to the filing by William Sullivan, a lawyer at Paul, Hastings, Janofsky & Walker LLP in Los Angeles.

Broker-dealer participation in auctions “reflected a common industry practice that was widely known to investors,” Sullivan said in the brief. “A market manipulation claim cannot survive if the allegedly manipulative conduct was commonly known to market participants.”

Really? CHALLENGE!! I do not know from whom Mr. Sullivan gets his information but if he wants I can put him in touch with a LOT of ARS investors who certainly had no knowledge of market manipulation in the auction process. Write to me, Bill, at!!

In its response to the SEC brief, Merrill told the court July 8 that the agency was trying to turn the case into one of misrepresentation, instead of market manipulation, by focusing on the company’s duty to alert investors to negative market conditions in late 2007 and early 2008.

“The primary thrust of the SEC letter is that Merrill’s disclosure of its auction practices became insufficient in the fall of 2007,” company lawyers said in its response. The company said the SEC’s position conflicts with the agency’s concession in a different case last month that “essentially identical” disclosures by Morgan Keegan & Co. “adequately described the risks” associated with the securities.

Bill Halldin, a Merrill spokesman, declined to comment. Katrina Cavalli, a spokeswoman for the securities trade group, said that its brief “speaks for itself.”

The case is Colin Wilson v. Merrill Lynch & Co., Inc., et al., No. 10-1528, U.S. Court of Appeals for the Second Circuit, New York, New York.

We can only hope that the courts will properly adjudicate this case so the ARS nightmare for the multiple thousands of our fellow citizens can end and they can move forward with their lives.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets, our economy, and our political realm so that meaningful investor confidence and investor protection can be achieved.

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