Recent press reports regarding governmental investigations and lawsuits filed by state regulators suggest that the true extent of the potential exposures associated with auction-rate securities (ARS) claims is only now being realized. All signals suggest that in the coming months additional regulatory proceedings will be filed against the main ARS broker-dealers and underwriters. Shareholder litigation against the investment banks and corporate investors in ARS may also be on the horizon as public companies begin to reassess the liquidity of their ARS holdings and write down their value. At this juncture, it is difficult to quantify the likely exposures presented by current and future ARS claims. However, as of May 2008, nearly $330 billion of ARS have become illiquid, leaving investors unable to tap investments that were marketed as liquid cash alternatives. This update provides a brief overview of ARS and the recent collapse of the market for these securities, examines the types and allegations of current ARS claims and discusses the potential implications for professional liability insurers.

Overview of Auction-Rate Securities

What are Auction-Rate Securities?

Auction-rate securities (ARS) are essentially long-term instruments (typically a bond or preferred stock) issued largely by municipalities, school loan lenders and closed-end mutual funds with variable interest rates that reset regularly through auctions, which usually occur every 7, 28, or 35 days. [1] Prior to each auction, broker-dealers survey the market and provide advice to investors as to the range of rates at which the auction is likely to clear. Current investors have three options at every action: (1) they can sell all or some of their ARS holdings; (2) they can decide to hold all or some of their holdings at any clearing rate; or (3) they can hold all or some of their holdings but only if the clearing rate is equal to or greater than a specified rate (otherwise the investor will sell). At each auction, potential investors submit purchase bids that provide for the amount of ARS they will purchase if the clearing rate is equal to or greater than a specified clearing rate. The broker-dealers then collect their investor clients’ bids and submit them to an “auction agent,” who determines whether the auction will succeed or fail. [2]

An auction will succeed and the operative interest rate will reset if the number of “buys” equals or exceeds the number of “sells.” In these auctions, purchase bids with the lowest rate and then successively higher rates are accepted until all of the sell orders are filled. The clearing rate is the highest rate designated in the bids accepted and that rate would then apply to all of the securities purchased and/or held in the auction (even if the buyer designated a lower rate in its bid).

An auction fails, however, when the number of prospective sellers exceeds the number of prospective buyers, in which case the ARS remain with the then-current holders and the interest rate reverts to a “penalty” or “maximum rate” set in the offering documents. [3] The ARS do not go into default upon auction failure because the issuer of the ARS will continue to pay interest to the holders at the defined penalty interest rate. In the case of municipal ARS, this interest rate is comparatively quite high, which benefits the investors but places a strain on the municipal issuers. Accordingly, municipal issuers have a strong incentive to restructure their ARS debt.[4] In the case of closed-end mutual funds, however, the penalty rate is typically much lower, creating a low-yield and long-term investment (rather than a highly liquid cash-equivalent).[5] Thus, closed-end issuers may have little incentive to redeem the notes or restore the auction process absent the threat of litigation. Moreover, while ARS-holders receive a penalty interest rate, they are unable to liquidate their principal investments. The only option is to sell their investments at a deep discount in a secondary market.

ARS were marketed to corporate entities or high net worth individual investors by broker-dealers as more lucrative than cash or money market alternatives because of the higher interest rate and short term liquidity available as a result of the auction process. Issuers used ARS as a source of variable long-term financing at lower rates than traditional bonds.[6] Many of the investment banks involved in ARS served both as broker-dealers and underwriters of ARS for issuer clients, providing the banks with an incentive to keep the ARS market afloat. [7]

As of year end 2007, the ARS market was compromised of four types of securities:

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ARS are backed by insurers that guarantee the securities in the even of a default and thus the value of the ARS is determined, in part, by the creditworthiness of the insurers backing the auction-rate bond or preferred securities. The auction-rate market is considerable in size, estimated in May 2008 at nearly $330 billion in outstanding securities. [11]

Previous Regulatory Scrutiny

Beginning in 2004, the Securities and Exchange Commission (SEC) conducted an investigation of ARS underwriting practices and the bidding process. The investigation culminated in civil proceedings against fifteen ARS broker-dealers. [12] Specifically, the SEC found that the broker-dealers unlawfully intervened in auctions, prevented auctions from failing, submitted or changed orders after auction deadlines, provided certain customers with higher rates of return, and provided inside information to certain investors. [13] According to the SEC, these practices misled investors concerning the true liquidity and credit risks associated with the ARS market. The SEC demanded greater disclosure with respect to the broker-dealers’ ARS practices. Ultimately, the broker-dealers settled in May 2006 with the SEC by collectively agreeing to pay a total of $13.375 million in penalties. Each defendant was censured, ordered to cease and desist these practices, and assessed penalties ranging from $125,000 to $1.5 million. Three other broker-dealers reached a settlement with the SEC in January 2007 in which the government issued cease-and-desist orders in addition to assessing $1.6 million in fines. [14]

The Recent “Collapse” of the Auction-Rate Securities Market

Beginning in late 2007, the number of failed auctions rose tremendously because of a lack of bids and because the four largest broker-dealers (Citigroup, UBS AG, Morgan Stanley, and Merrill Lynch) refused to act as buyers of last resort. Previously, broker-dealers had stepped in with their own capital to prevent auction failures. Having already suffered billions of dollars in losses resulting from the subprime mortgage collapse, the investment firms abruptly ceased their bailout practices. At the same time, demand for ARS dwindled due primarily to turmoil in the credit markets and a loss of confidence in insurers that backed ARS. [15] This lack of confidence led investors to require a higher rate of interest than the maximum rate specified in the offering documents to hold the securities.

By February 2008 the demand for ARS evaporated, and auction failures soared to over 1,000 failed auctions in a three-day period. The broker-dealers maintain that the collapse of the market and subsequent freeze of ARS sales occurred precipitously as the result of unprecedented instability in the markets. However, recent lawsuits filed by state regulators (discussed below) suggest that at least some of the broker-dealers were aware of problems with ARS and lack of demand as early as 2006.

Current Auction-Rate Securities Claims

The recent ARS meltdown has spawned a wave of customer arbitrations [16] and securities class-action lawsuits, in which investors allege that ARS were marketed as short-term, cash-like instruments and not the long-term, illiquid investments they have become. In addition, state regulators, the SEC and the Financial Industry Regulatory Authority (FINRA) have launched investigations into ARS market practices, resulting in regulatory proceedings against several of the principal ARS broker-dealers and the threat of additional such proceedings to come.

Litigation Against ARS Broker-Dealers

To date, over thirty ARS securities class action lawsuits have been filed against sixteen broker-dealers and one mutual fund issuer by ARS investors. The majority of these suits are pending in the Southern District of New York. [17] The suits have not advanced beyond the initial stages. A motion for coordination of certain of the suits currently is pending before the Judicial Panel on Multidistrict Litigation.

All but one of the complaints allege violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Most of the suits are identical in their allegations and name both the parent corporations and their wholly owned broker-dealer subsidiaries as defendants. Specifically, the suits allege that the defendants marketed ARS to investors as short-term, liquid, cash equivalent investments rather than revealing their true nature as long-term instruments whose liquidity depended on the existence of an auction market. In addition, the suits claim that the broker-dealers failed to disclose that the broker-dealers themselves were artificially supporting and manipulating the ARS market.

Specifically, the complaints assert that the broker-dealers would prevent auction failures in order to set market rates, provide certain customers with inside information about auction bids, submit or change orders after auction deadlines, allow customers to place open orders, and provide certain customers with higher returns than the auction clearing rate. The complaints also allege that investment banks acted as principals and used access to inside information to buy and sell ARS for their own accounts. The suits further maintain that the defendants knew the market would become illiquid as soon as they stopped propping up the market.

One investor lawsuit, Miller v. Calamos Global Dynamic Income Fund, et al., Civ. No. 3756 (S.D.N.Y. Apr. 21, 2008), alleges only violations of Sections 11 and 12(a)(2) of the Securities Act of 1933 by a closed-end mutual fund issuer and two underwriters. The suit alleges that the issuer’s registration statement was materially false or misleading because it failed to disclose the likelihood and true risk of auction failures and that purchasers of its securities would fare worse in the event of auction failures than would purchasers of municipal auction rate securities. [18]

Governmental Investigations and Regulatory Proceedings

According to recent press reports, most of the large investment banks involved in the ARS market are being investigated by the SEC, FINRA and/or several state regulators. Indeed, nine members of the North American Securities Administrators Association (NASAA) – Florida, Georgia, Illinois, Massachusetts, Missouri, New Hampshire, New Jersey, Texas and Washington – have formed an ARS Taskforce to coordinate their ongoing ARS investigations. [19] In addition, the U.S. Attorney for the Eastern District of New York reportedly is conducting a criminal investigation of two former Credit Suisse Group brokers for allegedly lying to investors about placing their money in ARS. Congress is also getting in on the act with the House Financial Services Committee recently announcing a September 18, 2008 hearing into the problems with the ARS market. [20]

To date, the following companies have reportedly received subpoenas from one or more state regulators: AG Edwards, Bank of America, Citigroup, Deutsche Bank, Edward Jones, E*Trade Financial, First Albany, Goldman Sachs, JP Morgan Chase, Lehman Brothers Holdings, Merrill Lynch, Morgan Keegan, Morgan Stanley, Oppenheimer Holdings, Piper Jaffray, Raymond James Financial, RBC Dain Rauscher, Scottrade, Stifel Nicolaus & Co., SunTrust Banks, TD Ameritrade, UBS AG, Wachovia and Wells Fargo. [21] In addition, Citigroup recently announced that it is the subject of an SEC formal investigation concerning the company’s handling of ARS. [22]

Beyond these investigations, regulatory proceedings have been initiated by state regulators against UBS AG and Merrill Lynch. In the last few months, Massachusetts regulators have filed securities fraud suits against UBS and Merrill Lynch, the New York Attorney General has filed suit against UBS and threatened to bring suit against Citigroup and Texas regulators have sued UBS. Moreover, according to recent press reports, Citigroup reportedly is close to reaching a settlement with state and federal regulators that could result in Citigroup buying back more than $5 billion of its customers’ ARS and paying up to a $100 million fine. [23]

Broadly speaking, the regulators maintain that UBS and Merrill misrepresented the risks associated with ARS and the conflicts of interest created as a result of their dual role in underwriting ARS and selling them to clients. In particular, UBS and Merrill assertedly failed to disclose to investors that the ARS auctions were not true actions. According to the regulators, UBS and Merrill submitted a “support bid” for every auction for which they served as the lead or sole broker-dealer to avoid auction failures. Those “bids” allegedly masked the decreasing demand for ARS. UBS and Merrill also purportedly manipulated the clearing rate for most auctions, selecting a rate that was high enough to sell the ARS it had unwritten but not so high as to upset the issuers (i.e., their underwriting clients).

The regulators further contend, citing numerous internal communications, that in the second half of 2007 and early 2008, UBS’s and Merrill’s internal risk management departments insisted that the banks reduce their ARS inventory. Internal emails cited in the complaints also allegedly suggest that the banks were aware that the auction process was flawed and that the ARS market would eventually fail. At the same time, as the credit market continued to worsen, demand for ARS evaporated and allegedly caused UBS and Merrill to step in with more of their capital to purchase ARS to ensure that auctions cleared and to maintain their profitable ARS underwriting business. As a result, according to the regulators, UBS and Merrill engaged in a “campaign to unload” their own ARS holdings on their retail investment clients through purportedly deceptive marketing practices to reduce the growing credit exposure associated with their ARS holdings. In addition, during this time, several high-ranking UBS insiders, who were assertedly aware of the internal, non-public communications regarding the problems with ARS, allegedly sold approximately $21 million of their personal ARS holdings.

Moreover, the regulators maintain that Merrill enlisted the assistance of its assertedly independent research analysts to help the bank promote ARS and market them to its customers. By February 2008, UBS and Merrill, along with all of the other broker-dealers, purportedly ceased supporting the ARS auctions, which caused the market to collapse.

The regulators seek cease and desist orders, censures, administrative fines and orders requiring UBS and Merrill to offer rescission of sales of ARS at par value or restitution to investors who have already sold ARS at below par. The New York Attorney General is also seeking an order requiring UBS to pay back its ARS-related profits.

Potential Implications for Professional Liability Insurers

Regulatory investigations of many broker-dealers are ongoing. The investigations may uncover additional information regarding broker-dealer practices with respect to ARS and result in additional regulatory proceedings and ultimately the imposition of fines and penalties. In addition, while the ARS securities fraud lawsuits thus far have seen little activity, we expect that the recent regulatory investigations and proceedings will reinvigorate civil lawsuits as plaintiffs seek to amend their complaints with specific allegations drawn from the information uncovered by the regulators.

Existing and future ARS claims may raise a number of coverage issues. Currently, the ARS investigations, proceedings, lawsuits and arbitrations appear to represent primarily E&O coverage exposures, as the claims largely concern the defendants’ practices and services as broker-dealers and/or underwriters. We are not presently aware of any ARS lawsuits that have been filed against investment banks or corporate holders of ARS by their own shareholders. However, as in the subprime litigation, shareholders may ultimately bring securities suits against the investment banks and corporate ARS investors as they write down the value of their own ARS holdings or refinance their holdings at a loss. [24] Accordingly, future claims may implicate D&O coverage as well.

The ARS investigations and regulatory proceedings seek orders requiring the defendant broker-dealers to rescind their ARS sales or otherwise buy back their customers’ securities. In addition, the New York Attorney General is seeking to compel UBS to disgorge its ARS-related profits. To the extent that the investment banks buy back or rescind their customers’ ARS, thereby receiving the securities in return for paying par value, issues exist regarding whether the banks have suffered a covered loss. In addition, “no loss” issues may arise with respect to ARS arbitrations and litigation depending on the nature of relief sought by the claimants.

The claims also may raise issues concerning the scope and definition of “professional services.” E&O policies commonly define “Wrongful Acts” as errors and omissions committed “solely” in performing or failing to perform professional services. However, many of the claims concern trading by broker-dealers in their own proprietary accounts. Moreover, the allegations of fraud and, in some instances, insider trading raise issues potentially implicating exclusions for fraud, intentional acts and profit or advantage. Further, many of the ARS lawsuits allege class periods dating back to 2003 and specifically cite the previous SEC investigations and settlements. Accordingly, insurers presented with these claims may wish to examine relevant related claims, prior knowledge, prior notice, prior litigation and/or prior acts provisions.