Three recent auction rate securities cases provide an interesting glimpse into the events which lead to the market crisis and the difficulties of litigating claims relating to it. Each centers in 2007 and 2008 as the market for these securities began to show cracks and eventually crashed. Each is concerned with what investors were told about the market, its risks and the viability of the market that Wall Street created to turn long term investments into short term apparently liquid ones.

The market: Long term instruments become short term, liquid investments

Auction rate securities consisted primarily of long term bonds issued by municipalities and student loan entities and preferred stock issued by close end funds. They had variable interest rates or dividend yields which were periodically reset through auctions. Most of the bonds had maturity terms which ran for as long as 30 years. The student loans were backed by a government guarantee. The securities offered issuers an alternative variable rate financing vehicle and investors a highly liquid investment through the auctions. The yield to the investor and the cost of financing for the issuer was determined by the interest or clearing rate established through the periodic auctions. The clearing rate was the lowest bid sufficient to cover all of the securities in the auction.

The issuer typically selected a broker dealer to serve as the underwriter of the securities. Other brokers were designated as co-brokers. The lead broker typically placed bids in the auction for their own account but not the co-brokers. Investors could only submit bids through the selected broker dealers. The issuer paid an annual fee for the broker dealer to manage the auction process.

Those auctions began in the mid-1980s and prior to 2007 never failed. In 2007 they began to fail. By mid-February 2008 there were wide spread failures. Underwriters withdrew from the market. In the end customers were left holding billions of dollars in illiquid auction rate securities. While the underlying bonds would mature in a period of years, the investors had purchased the securities for their favorable rate of return and liquidity which ended with the collapse of the auctions.

Case 1: Raymond James

Broker dealer Raymond James settled claims related to ARS with the SEC. In the Matter of Raymond James & Associates, Inc., Adm. Proc. File No. 3-14445 (June 29, 2011). According to the findings of fact in the Order for Proceedings, the firm acted as an underwriter of single issuer municipal auction rate securities known as MARS. It managed the auction and submitted bids to prevent them from failing, to maintain an orderly market, or to set a clearing rate. The firm also acted as agents on a solicited and unsolicited basis for their customers by submitting order to purchase and sell other ARS products. The firm did not submit bids in these auctions.

Prior to the middle of February 2008 firm representatives sold ARS to customers. In some instances those representatives misrepresented the risks of the securities calling them “the same as cash” or “highly liquid” or using similar descriptions. Post sale trade confirmations sent to these customers disclosed the risks of the auctions noting that they could fail and that the firm was not obligated to ensure their success.

The disclosures were inadequate according to the SEC: “Respondents did not provide customers with adequate and complete disclosures regarding the complexity of the auction process including failing to adequately disclose to customers that Respondent . . .managed the auctions of the MARS and . . . routinely bid in MARS auctions to prevent a failed auction, maintain an orderly market, or set a particular clearing rate.” This violated Section 17(a)(2) of the Securities Act according to the Commission. The firm settled these charges by agreeing to implement certain undertakings which include the repurchase of certain ARS and to the entry of a cease and desist order.

Case 2: Merrill Lynch & Co.

This is a class action on behalf of all ASR investors who purchased securities for which Merrill Lynch served as the sole auction dealer, lead auction dealer, co-lead auction dealer or joint lead auction dealer between March 25, 2003 and February 13, 2008. The complaint alleges market manipulation in violation of Exchange Act Section 10(b) and Rule 10(b)-5. Colin Wilson v. Merrill Lynch & Co. No 10-1528 (2nd Cir.)

The allegations here are similar to those in Raymond James but more explicit. According to the complaint Merrill engaged in a scheme to manipulate the market by creating the appearance that the securities were traded at arm’s length when in fact the available supply well exceeded the demand for the securities. Merrill had a policy of routinely placing support bids in every auction through which it acquired ARS for its own account to mask a lack of demand and prevent auction failure. The complaint also claims that Merrill executives knew that the ARS market was unsustainable by the fall of 2007 and that it was only through the conduct of Merrill and other auction dealers in artificially supporting the auction and acting as buyers of last resort, that the market for Merrill ARS was able to exist during the class period. In essence the market was an illusion according to the complaint.

The firm provided investors with written warnings regarding the risks of the ARS market. Those materials discussed the possibility of auction failure. They also noted that Merrill may bid in the auctions, that it may routinely place bids and that those bids are likely to affect the clearing rate. The warnings also state that Merrill might place bids to keep the auctions from failing.

The district court dismissed the complaint for failing to state a claim upon which relief can be granted. That court concluded in part that the warnings furnished to investors negated a claim of fraud. Plaintiffs appealed. The case has been briefed and argued before the Second Circuit.

Recently the Court requested the SEC to provide its views on certain issues including the adequacy of the warnings. The Commission told the Court of Appeals that Merrill’s warnings are inadequate. In some instances disclosure can prevent a “false signal from being sent to the market, thereby undermining a claim of manipulation . . . “ the SEC stated in a letter to the Court. The letter goes on to note that courts have “long recognized .. . that disclosure of a potential risk is insufficient when, in fact, the risk is much greater and it a known certainty. . . Here, by stating that, in the absence of its bidding, there ‘may not always’ be enough bidders to prevent auction failure, and that therefore auction failure was ‘possible’ if Merrill failed to bid . . [the]disclosures imply that some auctions have sufficient independent demand to prevent failure.” In view of the allegations in the complaint that the firm knew there was no such demand, Merrill concealed this material fact from investors. The warnings were thus inadequate.

A decision from the court should be issued later this year.

Case 3: Morgan Keegan

The SEC litigated an enforcement action against the firm centered on claims similar to those in the Raymond James and Merrill Lynch cases. SEC v. Morgan Keegan & Co., Inc., Civil Action No. 1:09-cv-1965 (N.D. Ga. Opinion and Order dated June 28, 2011). AS in Merrill Lynch, the court here found the warnings adequate. Morgan Keegan prevailed on a motion for summary judgment in this action.

The Commission claimed in its complaint that as the auction rate securities market was collapsing the firm continued to sell the securities to customers based on misrepresentations. Between 2002 and February 27, 2008 Morgan Keegan placed bids for its own account in a majority of the auctions for which the firm served as the lead broker deale,r according to the complaint. A majority of those auctions would have failed but for those bids. After an auction failed on February 12, 2008 which was underwritten by others “Morgan Keegan declined to place bids in most of the auctions for which it served as lead broker dealer and in which the bids of other market participants were insufficient to satisfy all the sell orders.” As a result Morgan Keegan customers were left holding about $1.2 billion of illiquid ARS.

At summary judgment the issues focused not on the adequacy of the disclosures or on proof of the SEC’s claims that essentially the ARS market in which Morgan Keegan customers traded was artificial, but on the Commission’s evidence regarding misrepresentations made to four investors and the disclosures available. The four investors were told that ARS are “as good as cash,” or the product is “cash equivalents to CDs and money market” or similar statements. The firm however furnished or made available five written disclosures which detailed the risks of ARS including the prospect of market failure. Those disclosures also told investors that the firm submited bids in the auctions. The warnings did not state that most of the auctions where the firm was the lead would have failed but for the participation of Morgan Keegan.

On this record the court granted summary judgment in favor of Morgan Keegan. The SEC claimed that the oral misrepresentations were sufficient to support its claims under Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(c). In making this argument the Commission argued that the firm did not do enough to ensure that customers read the written materials or to adequately distribute them. The court rejected this argument noting that Morgan Keegan does not have a duty to give each customer a copy of the disclosures and ensure that they are read as contended by the SEC. In any event the confirmations notified the customer that the transaction could be rescinded which is sufficient the court found.

There is no reference in the court’s opinion to the claims made in the SEC’s complaint regarding the liquidity of the market. There is no indication that the Commission offered evidence to support the claims. Likewise, there is no reference to the Commission’s claim that the disclosures of the firm were inadequate for failing to tell customers that without the participation of Morgan Keegan the auctions would likely fail. Again there is no reference to the submission of any evidence on this point by the SEC.