Corporate & Securities Law

Regulator inquiries are intensifying over auction-rate securities.  This week Goldman Sachs disclosed that it has received requests for information from various governmental agencies and self-regulatory organizations relating to auction products and the recent failure of such auctions. 

The SEC and FINRA are looking into the market.  In particular, investigators want to learn what promises brokers made to investors who purchased auction-rate products.  Likewise, Bear Stearns has disclosed that it received a Wells Notice from the SEC warning that civil charges may be coming "in connection with the bidding for various financial instruments associated with municipal securities."  That Notice comes in connection with a probe by the SEC and the Justice Department regarding the conduct of Wall Street firms that packaged and sold municipal derivatives (securities based on underlying assets such as city bonds) beginning in 1990. 

As well, FINRA has issued a regulatory Notice that now brokerage firms will have to report specifically customer complaints regarding auction-rate securities.  This complaint reporting category goes into effect immediately. 

But most troubling is the fact that even though some Wall Street heavyweights and major corporations have been stung, many of them also appear to have bailed out of the market well ahead of individuals.  At the end of 2006, institutional investors held about 80 percent of all auction-rate securities, according to Treasury Strategies, a consulting firm in Chicago, yet at the end of last year that portion had fallen to just 30 percent.  "A number of corporations understood there was a rising threat to their securities; there had been failures and warnings," according to the chief executive of Treasury Strategies. 

As big holders of those securities accelerated their selling late last year, Wall Street firms overseeing the auctions would have come under greater pressure to find buyers to make the auctions succeed.  It is unclear whether they turned to individual clients to fill this void, but that would have seemed sensible.  Auction-rate securities have morphed from a product sold mainly to corporations to one marketed heavily to individual investors, especially when minimum investments were dropped to $25,000.00.  The top underwriters in the municipal part of the market were Citigroup, UBS, Merrill Lynch and Morgan Stanley. 

Importantly, investors were not provided with the prospectus to outline the risk of these securities because they are viewed as secondary market offerings.  Likewise,  it is now clear that auction securities became a  managed bidding system, and not a true investor auction.  That's according to the chief executive of Saber Partners, a financial advisory firm. "The investor never knew how many investors there were, how often the brokerage firms were stepping in to make the system work, nor that the broker's support could stop all of a sudden...If we had transparency in the system, investors could have judged the ability to sell in the individual auctions and bid accordingly."

Interesting as well is how the firms make money with auctions.  According to recent press, the firms earn money at least twice.  First, when the notes or shares are underwitten, they receive 1.5 percent of the amount of money raised, in the form of a fee.  Then they receive a quarter percentage point (0.25) annually for conducting the auctions and that's a total of $825 million this year, based on the size of the market.  Most amazing is the fact that the firms receive these auction fees even when the auctions fail, so the firms have no incentive to help revive this market.

Investors ought to beware and SNSFE is continuing to investigate claims of auction-rate securities unsuitability on behalf of investors.

Sources:  New York Times; The Wall Street Journal; FINRA; Reuters