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Tuesday, February 19, 2008

Auction Rate Securities: An Investor Scandal of Significant Proportions

Our office has been flooded in recent days with inquiries from panicked investors who have suffered incredible harm because of the collapse of the auction rate securities market. All these investors vehemently insist they acquired auction rate securities because their brokers advised them they were as good as cash but would pay higher interest rates than government treasury bills or FDIC-insured savings accounts. Firsthand accounts from investors are posted on Dealbreaker, available here. Now that the market for auction rate securities has all but dried up, these investors can no longer make good on routine financial commitments such as monthly mortgage and credit card payments.

Although we are still sifting through mounds of evidence in preparation of filing our first claims, here is what we have already determined:

The investors we represent have provided irrefutable evidence that their brokers assured them that auction rate securities were as good as cash. Although Wall Street firms can cite some boilerplate warnings in their offering materials, they clearly marketed auction rate securities as being risk free, liquid investments. And indeed they were risk free, as long as Wall Street firms were willing to provide liquidity to prop up the market.

And therein lays the magnitude of this scandal.

One of the egregious blind spots of individual investors is they rarely take the time to understand the financial incentives behind the products Wall Street sells them. Underwriting or serving as a broker-dealer for auction rate securities was a hugely profitable business for the big brokerage firms, garnering them millions of dollars in fees. In addition to peddling auction rate securities to individual investors, the brokerage firms also bought these securities for their own proprietary accounts, yet another whopping conflict of interest.

And true to form, the big brokerage firms got caught manipulating the market. In May 2006, the big brokerage firms agreed to pay more than $13 million to settle SEC charges they were sharing confidential information between January 2003 and June 2004. The SEC said the violations were "serious and widespread."

The Big Four accounting firms clearly understood the inherent risks of auction rate securities. A year after the SEC settlement, the Big Four accounting firms warned their corporate clients to classify auction rate securities in their portfolios as "investments" rather than "cash equivalents." As of yet, we have found no evidence of any brokerage firm offering similar counsel or warnings to their clients.

The credit crunch that was sparked by the sub-prime mortgage mess – for which investors can also thank the big brokerage firms – has impaired the balance sheets of the big brokerage firms, so they no longer have the flexibility to provide liquidity and support for the $350 billion auction rate securities market. (Note to individual and corporate investors: the interests of a brokerage firm always take precedent over yours.) The repercussions and the extent of the fallout is not yet fully understood; in addition to individual investors that have been impaired, an untold number of corporations will likely be forced to join Bristol-Meyers Squibb ($270 million write-down) in taking massive write-downs relating to the auction rate securities on their books.

Merrill Lynch already has been sued by one of its corporate clients for peddling auction rate securities. Rest assured, when all the facts about the auction rates securities market are known and understood, the legal fallout could quite possibly be more formidable and damaging than Wall Street has ever before experienced.

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