Auction Rate Securities: A Scandal Made Possible by the SEC

The SEC's Division of Enforcement has never been considered a tough minded regulator. But the collapse of the auction rate securities market underscores just how frighteningly ineffective the division really is.

On May 31, 2006, the SEC's Division of Enforcement issued a news release trumpeting that it had settled with 15 broker-dealer firms for what essentially amounted to rigging the auction rate securities market between January 2003 and June 2004. Here's an excerpt from that release:

The SEC order finds that, between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws. The violative conduct included

• allowing customers to place open or market orders in auctions;

• intervening in auctions by bidding for a firm's proprietary account or asking customers to make or change orders in order to


• prevent failed auctions, to set a "market" rate, or to prevent all-hold auctions;


• submitting or changing orders, or allowing customers to submit or change orders, after auction deadlines;


• not requiring certain customers to purchase partially-filled orders even though the orders were supposed to be irrevocable;


• having an express or tacit understanding to provide certain customers with higher returns than the auction clearing rate; and


• providing certain customers with information that gave them an advantage over other customers in determining what rate to bid.

The release also noted:

Some of these practices had the effect of favoring certain customers over others, and some had the effect of favoring the issuer of the securities over customers, or vice versa. In addition, since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities (emphasis mine). By engaging in these practices, the firms violated Section 17(a)(2) of the Securities Act of 1933, which prohibits material misstatements and omissions in any offer or sale of securities.

In justifying the paltry $13 million fine the SEC imposed, a spokesperson said the agency "considered the amount of investor harm and the firms' conduct in the investigation to be factors that mitigated the serious and widespread nature of the violations." In particular, the firms voluntarily disclosed the practices they engaged in to the SEC, upon the staff's request for information, which allowed the SEC to conserve resources.

With the advantage of hindsight, it's clear that the SEC never understood the inherent and significant damage that was created by brokerage firms rigging the auction in the first place. It's also worth noting that if Wall Street firms simply cooperate with the SEC that partially justifies a wrist slap. Finally, if SEC still mistakenly believes that the their "cease and desist" order prompted the big brokerage firms to warn investors of the risks in buying auction rate securities, I have some clients they should definitely meet.