New Market Crisis Has Lawyers, Funds Scrambling

The two-week-old crisis in the auction rate securities market is reaching a new intensity, with lawyers readying a number of lawsuits that claim brokers misrepresented the risks inherent in the investment vehicles, and the funds that issued these bonds desperately attempting to figure a way out of the mess.

Several lawyers are preparing to bring arbitration cases before the Financial Industry Regulatory Authority, which oversees the brokerage industry. The claimants, ranging from individual investors to large institutional clients, are alleging that brokerage firms did not forewarn them of the risks involved in auction rate securities and falsely touted them as similar to money market investments. At the same time, the funds that issued these securities are struggling to find a solution: They must strike a balance between assuaging those who bought their auction rate securities and fulfilling their fiduciary duty to their equity investors.

"This is one of the biggest surges in claims I've seen in my practice," a securities fraud lawyer, Andrew Stoltmann, said. "A tsunami of claims will fall upon the shoulders of brokerage firms over the next six to 12 months." He is representing five clients — four companies that lost between $400,000 and $3 million each and one individual who lost $200,000 by investing in the now illiquid market.

The Financial Industry Regulatory Authority said through a spokesman that it is paying close attention to how the brokerage firms marketed the securities. The Securities and Exchange Commission said in a statement: "We are aware of the issue and considering what action, if any, might be appropriate."

The more than $300 billion auction rate securities market consists of long-term bonds, with maturities that can stretch as long as 50 years, which have interest rates that "reset" every seven to 28 days. The securities are reset through an auction process that is facilitated by the brokerage firms.

Brokerage firms, which generate large fees by underwriting the securities and administering the auctions, have traditionally helped support the market when demand was weak. In the past several weeks, however, demand has plummeted and rather than buoy the market, brokerage firms recently began allowing the auctions to fail. This means that investors cannot sell the securities and redeem their investments. It also means investors who paid higher prices for these securities because of their supposed liquidity are now stuck with overpriced investments the principal of which they may not recoup.

"The politicians and regulators are concerned with the municipalities, but what about all these consumers who didn't understand what they were getting into?" a partner at the law firm Shepherd Smith & Edwards, Kirk Smith, asked. He is representing a handful of "good old-fashioned folks who had money set aside that they thought was as good as cash."

Auction rate securities are complex vehicles, yet brokers are required to supply investors with prospectuses detailing how these securities work only when they are first issued. This means that when the bonds are re-marketed every week or so, investors buying them are not usually supplied with any explanation over and above what they are told by their broker.

"For many, many years, these things did trade as if they were short-term vehicles, so it is quite possible there were brokers who became complacent and thought of them as short-term vehicles," a portfolio manager of the Bancroft Fund and the Ellsworth Fund, Tom Dinsmore, said.

Part of the confusion in the market is that there are two types of auction rate securities: those issued by municipalities, schools, and hospitals, and those that are issued by closed-end funds, a type of mutual fund. There are important differences between these types of auction rate securities, one of the most significant of which is the penalty rate. The penalty rate is the interest rate the security will pay to investors if it becomes illiquid and cannot be reset. The securities issued by municipalities and other stable entities often carry significant penalty rates, while those issued by closed-end funds carry very low or zero penalty rates. As long as the issuer continues to pay the penalty rate, there is very little recourse for the investor, even if that penalty rate is less than what the investor was being paid via the auction.

Mr. Dinsmore, who is also the president of the Closed-End Fund Association, said the industry is struggling under the current scenario. It has a fiduciary duty to both the investors in auction rate securities and common shareholders, who invested equity in the funds directly.

"This is a situation where there is no bad guy, but there are very conflicting requirements, as it were, of each holder," he said. "The danger actually comes in doing something rather than doing nothing."

There are some possible solutions on the horizon that could end the logjam between the investors, the brokerage firms, and the issuers. To fix the problem in the short term, Merrill Lynch is offering its clients loans of up to 50% of the amount of the auction rate securities the clients own. The loans, however, include "standard pricing terms, acceptance criteria, and maintenance rates," according to an internal memo obtained by The New York Sun.

According to one source familiar with the situation, the brokerage firms are also considering buying their clients' auction rates securities, but at a discount.

Another option is an electronic trading platform on which a secondary market for these securities could be created. A trading firm is expected to launch such a market next month, according to Mr. Dinsmore.

In all of these scenarios, however, the investors would likely have to sell their auction rate securities at a deep discount from what they paid.

"Even if they do create a secondary market, these securities have very low yields and long maturities, so it will be almost impossible to get the full principal back," Mr. Smith said.