On March 30, 2009, Judge Lawrence M. McKenna granted UBS’s Motion to Dismiss a putative class action complaint filed against it by investors in Auction Rate Securities (ARS). This dismissal was based on Lead Plaintiffs having availed themselves of UBS’s offer to buy back the securities, as mandated by UBS’s settlement with state and federal regulators. Click here to read the memorandum and order.

The suit, originally filed by David and Shelly Chandler (Lead Plaintiffs) on March 21, 2008 (later consolidated into In re UBS Auction Rate Securities Litigation, 08-CV-2967 (S.D.N.Y.)), alleged that UBS, and several related entities and executives, had violated §10(b) of the Securities Exchange Act of 1934 by misrepresenting and failing to disclose the liquidity of ARS, the ARS market and UBS’s involvement in ARS auctions.

ARS are debt instruments whose interest rates are reset through periodic auctions (typically held every 7, 28, or 35 days). In these “Dutch Auctions,” the broker-dealer managing the auction matches buy and sell orders for ARS. If there are not enough buy orders to meet the supply of sell orders, a “failed auction” occurs and no ARS are sold.

UBS, and other broker-dealers, frequently intervened as buyers in the auctions, to prevent auction failures. In fact, Judge McKenna’s order noted that UBS intervened more than 50,000 times between the beginning of 2006 and the end of February 2008. On or about February 13, 2008, UBS and other major ARS broker-dealers stopped supporting the auctions, which resulted in widespread auction failure and illiquidity in the ARS market.

Lead Plaintiffs alleged that UBS did not disclose to investors the frequency with which it intervened in auctions or the fact that without such intervention, the ARS market would likely collapse. Additionally, Lead Plaintiffs alleged that UBS used its knowledge of bid rates at the auctions to set the clearing rates just high enough to clear auctions, but below the level appropriate to compensate for the true liquidity risks in the ARS market.

On August 8, 2008, UBS announced that it had entered into a settlement with state and federal regulators relating to its involvement in the ARS market. Click here to read our post regarding the settlement. In relevant part, the settlement called for UBS to repurchase ARS from retail customers, charities and small businesses.

Pursuant to the settlement, Lead Plaintiffs received a refund of the purchase price of their ARS from UBS. Furthermore, Judge McKenna’s order noted that Lead Plaintiffs had retained the interest they received from their ARS between February 2008 and the date of the buy-back.

Defendants moved to dismiss the consolidated class action on November 25, 2008. Defendants argued, in relevant part, that because Plaintiffs had received the par value of their ARS, they could no longer allege cognizable damages under §10(b).

In his order, Judge McKenna explained that §28(a) of the Exchange Act limits §10(b) recovery to actual damages. He noted that because §28(a) does not indicate the proper method to measure damages, courts may use discretion to “fashion a measure of damages appropriate for the circumstances.” Judge McKenna recognized, however, that despite the discretion allowed to courts, Plaintiffs are not entitled to receive both rescission and benefit-of-the bargain (or expectation) damages. Rather, Judge McKenna held that the two are alternative measures of recovery.

Plaintiffs claimed that they were entitled to damages because they had received a lower interest rate on their ARS as a result of UBS’s alleged manipulation of the market, and such damages were not dealt with under the regulatory settlement. Judge McKenna, however, held that Plaintiffs could not receive expectation damages after already obtaining rescission and restitution.

Lead Plaintiffs also argued that the case should not be dismissed because some members of the class were excluded from the buy-back because they had purchased their ARS from brokerage firms. Judge McKenna rejected this argument because Second Circuit case law clearly precludes plaintiffs from bringing causes of action based on injuries they have not suffered personally. Accordingly, Judge McKenna granted UBS’s motion to dismiss without prejudice.

This decision represents a significant victory for UBS. It is the first such decision in this line of cases, and it will likely be followed in the putative class actions against other investment banks and broker-dealers, such as Merrill Lynch, Bank of America and JP Morgan Chase & Co. It is important to note, however, that the more recent trend involves cases filed by those investors in ARS who were not included in the terms of the regulatory settlements. For more information on these recent suits, click here, and here.