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After a $1.15 billion IPO in April 2007, wireless service provider MetroPCS Communications Inc. found itself with a surplus of cash and decided to invest it wisely. It specified to investment adviser Merrill Lynch its interest in low-risk investment vehicles that would preserve capital and provide liquidity while offering modest returns.
In May 2007 Merrill Lynch began purchasing on behalf of MetroPCS nearly $134 million in auction-rate securities, which ostensibly fit the bill. Anyone who's read the financial pages lately knows the turn this story is about to take.
Auction-rate securities (ARS), which have been around since 1984, are generally municipal bonds, although there are other forms such as student loan-backed securities. MetroPCS had cash in 10 ARS, nine of which were subprime mortgage-backed collateralized debt obligations, a rarer category of ARS.
The instruments take their name from the Dutch auctions at which investors buy and sell the instruments and auction agents set an interest rate. Because the auctions take place at regular intervals--typically every seven, 28 or 35 days--these long-term bonds behave more like short-term instruments and became a popular choice among investors for their liquidity, with broker/dealers marketing them as "good as cash" with a better return than money market funds. Issuers liked them too, since the floating interest rate meant they weren't locked in for 30 years. ARS seemed like a win-win proposition.
"When the marketplace is functioning, auction-rate securities provide advantages both ways, and that's why they were so attractive," says Kevin LaCroix, an attorney and a partner in OakBridge Insurance Services in Ohio who has covered the auction-rate debacle on his blog, The D & O Diary. "The embedded risk was it depended on there being an auction-rate market where the interest rate could be set, and the failure of that marketplace is what has stymied everyone."
Auctions first began to fail last summer, as confidence in the credit markets plummeted. Among the first wave of auction failures were the ones for CDOs like MetroPCS held. By fall the crisis began to work its way through the auction-rate market.
Suddenly investors trying to sell through the auction process found there were no takers, demonstrating for the first time that these so-called short-term investments in fact were not--and exposing a truth that changed what investors had come to believe about the $330 billion market.
Few investors were previously aware that the broker/dealers themselves regularly bid on any unwanted instruments at the auction, thereby ensuring liquidity and a robust market. As the auction-rate market began to show its weaknesses and the credit market confronted its own crisis, the broker/dealers stopped supporting the auctions and the marketplace came to a halt.
"The instrument is flawed, but for nearly 30 years it worked well because it had never been stress-tested," says Tony Carfang, partner and director at Treasury Strategies, a consultancy that alerted the Financial Accounting Standards Board to the pitfalls of ARS in January 2007. "Now all the weak links are being exposed."
By February the market was declared dead, and with experts split on whether it can ever be revived, major brokerage firms as well as the companies and individual investors that can't access their cash are facing a financial meltdown.
MetroPCS for its part announced in February an $83 million fourth-quarter loss related to its investments in ARS. And throughout early 2008, others have stepped forward to announce their ARS holdings: Bristol-Myers Squibb cut the value of its ARS from$811 million to $419 million; Best Buy has $417 million; JetBlue has $330 million.
Young tech companies like MetroPCS, which were more likely to have large cash reserves, have been hit especially hard: Earthlink ($60 million), Monster Worldwide ($357 million), Intuit ($328 million) and Palm ($75 million) have all been stuck holding ARS. And financial institutions' losses crept into the billions: Citigroup took a $1.5 billion loss related to ARS. UBS, which as of December 2007 held $5.9 billion in ARS, began marking down the value of its clients' ARS by up to 20 percent, angering investors.
"The question is, if they have to write down significant amounts on their balance sheet, will they be angry enough to sue the investment advisers that put them in those instruments?" LaCroix says.
MetroPCS, whose auctions failed very early in the debacle, certainly is. It sued Merrill Lynch in October for breach of contract, negligent misrepresentation, breaches of fiduciary duties and common law fraud. It seeks disgorgement of fees and actual and punitive damages.
The lawsuit is far from the only legal trouble Merrill Lynch and other financial institutions have faced over ARS.
Filing of ARS suits against brokerage firms, primarily class actions alleging deceptive marketing, picked up in early 2008. By the end of April, 15 ARS-related suits had been filed against 22 brokerage firms--almost all of the big names have been targeted, including Merrill Lynch, Citigroup and UBS.
In addition, regulators from nine states are investigating the ARS market, trying to determine whether allegations against the banks are true. And other parties are angry: Brokers are dealing with compromising whole books of clients, and issuers must pay penalty interest rates as specified by provisions for auction failures. That anger is being directed squarely at the brokerage firms.
The exceptions to the class actions are the MetroPCS lawsuit and an arbitration claim against Merrill Lynch that ASTAR Air Cargo filed with the Financial Industry Regulatory Authority (FINRA) asking for about $36.5 million in compensatory and punitive damages.
"It's the same legal argument for corporations and individuals," says Kirk Smith, a securities fraud lawyer with Shepherd Smith & Edwards, which is representing plaintiffs in class action suits related to ARS. "[The key allegation is that] the broker at the brokerage firm recommended and represented the products as being safe, secure and liquid." Another is that the brokerage firms realized the ARS market was going downhill and began ditching the securities, selling them to their clients when they knew they would soon stop supporting
Still, claims from companies remain a novelty. "One of the reasons you haven't seen corporations filing against the securities dealers is they've just been too busy explaining internally what's going on with these securities within their own company and filing their first-quarter financial reports," Carfang says.
"You may see a change in that pattern. At the same time, a company would have a higher burden to demonstrate that it was misled."
Since individual investors don't face that dilemma, the ARS class action litigation market is booming. But with the suits still in the early stages, at this point there's no telling where they could go.
"There are a lot of issues still in flux because these are essentially bonds and other highly rated instruments, and although the auction market has failed in some instances, the securities have not necessarily lost value," says Gregg Zucker, a partner with DLA Piper.
In other words, ARS investors face a liquidity crisis, not a credit problem. Carfang equates the problem with a house that won't sell: It's not worth nothing, but you have no idea what it is worth. "That's causing a lot of anxiety right now among corporations because they have to value this on their balance sheet," he says.
It also means plaintiffs could face the argument that since they haven't technically lost anything aside from liquidity, they suffered no damages.
"A lot of these instruments are paying interest, will continue to pay interest, haven't defaulted and, if you don't need to sell, they'll just keep right on going until maturity. So it's a funny kind of lawsuit," LaCroix says of the class actions.
For now, according to Smith, plaintiffs seek rescission, or reversal of the transactions. If they can't wait, they can sell on the developing secondary market for a loss and then bring proceedings against the brokerage firm for the loss.
"In time, you're going to see the market become a little clearer as to whether these securities will be redeemed, to what extent there is any damage and, if so, what that amount of damage will be," Zucker says.
Despite the current uncertainty, some experts believe the suits may have merit.
"A lot of things could have been better disclosed here about these instruments," Carfang says. "The operating circulars of some of these are 300-400 pages each, which alone ought to raise a red flag: If it's as good as cash, why does it take 400 pages to say so?"
ARS can confound even the experts. LaCroix didn't know he owned ARS until the market froze up. "It wouldn't surprise me at all that there's probably some truth to the allegations that the investors weren't fully informed of the risks. Just looking at my own circumstances, I had no idea, and I consider myself a reasonably sophisticated investor."