Following the crash of the market for auction rate securities in early 2008, regulators as well as private litigants brought a series of suits against the brokerage houses which sold the securities. Typically the suits claimed that sells had misrepresented the risks in the market claiming, for example, that the securities were “the same as a money market fund” without describing the risks or telling investors that in the fall of 2007 cracks began to appear in the markets as they spiraled to a crash. The SEC and the NY AG settled a series of enforcement actions tied to the sale of these markets.
In litigation regulators and private plaintiffs have not been as successful. The SEC lost an ARS case against Morgan Keegan & Co. on summary judgment. SEC v. Morgan Keegan & Co., Inc., Civil Action No. 1:09-cv-1965 (N.D. Ga. Opinion dated June 28, 2011)(here). The New York AG lost an action against Charles Schwab & Co. on a motion to dismiss. The People of the State of New York v. Charles Schwab & Co., Index No. 453388/2209 (N.Y. Sup. Ct.)(here). Private plaintiffs such as Ashland, Inc. also failed. could not sustain claims centered on the ARS market. Ashland, Inc. v. Oppenheimer & Co., No. 10-5305 (6th Cir. July 28, 2011)(here)(affirming dismissal but describing narrow class of cases that have been successful).
Even when private plaintiffs are backed by the SEC, as in Wilson v. Merrill Lynch & Co., No. 10-1528 (2nd Cir. Decided Nov. 14, 2011), the claims have not been sustained. In that case Colin Wilson brought a class action against Merrill Lynch for those who purchased auction rate securities between March 25, 2003 and February 13, 2008. The complaint centered on allegations of market manipulation rather than nondisclosures. Plaintiffs claimed that Merrill manipulated the clearing rates — the rate set at the periodic auctions –through its supporting bids which sent a false signal to the market about the price and liquidity of the securities. As the markets began to deteriorate in the summer of 2007 Merrill prevented auction failure with its bids. By the fall however the broker began withdrawing its support from some auctions. On February 13, 2008 Merrill and all other major dealers withdrew from the ARS markets which subsequently collapsed. Prior to that time Merrill had described the markets as safe and liquid, according to the complaint.
The district court dismissed the case. That court concluded that the disclosures Merrill made regarding the markets were adequate, although Mr. Wilson purchased his securities on-line. On appeal the Second Circuit requested the views of the SEC. The agency filed a letter brief supporting reversal of the district court’s decision (here). The Circuit Court affirmed the ruling of dismissal.
Plaintiffs told the Second Circuit that Merrill’s disclosures were false and misleading because they stated that the firm may routinely submit support for individual auctions when, in fact, the broker supported every auction. In addition, the firm knew that there was insufficient investor demand and that the bids were submitted to create a false impression of demand.
The Second Circuit found there was no dispute that Merrill disclosed it routinely placed orders in the market for several purposes including too prevent auction failure. Those disclosures also stated that “the fact that an auction clears successfully does not mean that an investment in the securities involves no significant liquidity or credit risk . . “ While plaintiffs argue that in reality Merrill had a policy of placing support bids in every auction to prevent failure, the complaint is inconsistent in the view of the Second Circuit. Some allegations in the complaint support plaintiffs’ contention. Others are much more limited and qualified. These inconsistencies on this central point are critical and undercut plaintiffs’ arguments on appeal.
While plaintiffs’ also claim that Merrill knew the market was “unsustainable,” that knowledge post dates the purchase by Mr. Wilson. When read together, the allegations of the complaint “do not support the inference that Merrill knew, at the time of Wilson’s purchase, that the ARS market was certain to fail in the absence of intervention.” (emphasis original).
The fact that the SEC supported plaintiffs claims did not persuade the Circuit Court to reverse the dismissal. The Commission presented two key legal propositions. First, in some circumstances disclosure can prevent a false signal from being sent to the market, thereby undercutting a market manipulation claim. Second, disclosure of a potential risk is insufficient when in fact the risk is much greater and/or is a known certainty. The Court agreed with each point. Nevertheless, it did not agree with the Commission’s conclusions. While the parties disputed the amount of deference that should be given to the views of the agency, the Second Circuit held that “we are unable to agree with the SEC’s application of the legal principles governing Merrill’s disclosures even under the generous standard of deference that Wilson urges . .. we find the complaint to be inconsistent as to how Merrill placed support bids . .. and view other allegations of the complaint as incompatible with the notions that every auction would fail in the absence of Merrill’s intervention or that Merrill knew by July 2007 that the ARS market was unsustainable.”