When Wall Street Exploits A Charity

Having represented investors who have been wronged by Wall Street for more than three decades, I've seen a lot of scandalous activities. But nothing outrages me more when a brokerage firm seeks to exploit a charitable group. Sadly, I'm dealing with yet another egregious instance, this one involving the peddling of auction rate securities to a charitable foundation in Ohio.

The charity is called the Joffe Foundation, which was founded by Steven N. Joffe, a renowned Cincinnati opthamologist and a pioneer in laser-vision correction surgery. The foundation regularly makes donations and commitments to provide funds on an ongoing basis to support various charities and causes, including low-income patients in the US in need of laser vision correction; AIDS prevention; high school educations; and surgeries to correct cleft palates in children in South Africa and Ghana. Because of its ongoing funding commitments, the Joffe Foundation made clear to its broker at UBS Financial Services that it needed to keep its funds extremely safe and liquid.

But the foundation's UBS broker wasn't content having the organization park its money in a simple money market account. Instead, he encouraged it to purchase auction rate securities, which he assured Dr. Joffe were "the equivalent of cash" and could be liquidated within a few days if necessary.

Auction rate securities are long-term government or corporate bond instruments where the interest rates are set at weekly or monthly auctions. As long as there are investors willing to bid on the bonds, they are indeed liquid investments paying higher rates of interests than money market accounts. The problem is that if there aren't enough investors to buy the bonds, the auctions fail. Investors holding the paper are suddenly stuck with a long-term note with a "penalty" interest rate predefined by the bond's issuer.

Making a market for auction rate securities was a highly lucrative $330 billion market for the big Wall Street firms, including UBS. But the balance sheets of the big firms have been badly impaired because of the collapse of the mortgage-backed securities market (a crisis of their own doing), so they no longer have the wherewithal to support the auction rate market. That's why the market for auction rate securities has dried up.

Acting on his broker's insistence that auction rate securities were as good as cash, Dr. Joffe agreed to allow UBS to invest the foundation's entire $1.35 million. UBS invested all the money in various ARS series or issues of preferred stock in the Eaton Vance Limited Duration Fund, thereby increasing the Joffe Foundation's risk because all its auction rate securities investments were tied to that fund.

The auction for the Joffe Foundation's securities failed on Feb. 15, so all its cash is locked up indefinitely. Although the penalty interest rates of failed auction rate securities can sometimes go as high 17%, the penalty rate on the Joffe Foundation's paper is a measly 4.97%. That makes it incredibly unlikely that anyone will buy the paper before it matures. Moreover, the Eaton Vance fund itself carries enormous potential risk of principal loss.

As a result of this debacle, the Joffe Foundation cannot make a committed $100,000 donation to laser vision correction patients, nor fund its ongoing commitments. The foundation also needs cash to fund the salary of its administrative assistant.

Zamansky & Associates has already filed an arbitration claim on behalf of the Joffe Foundation, but it will take some time before it can be heard. You might think that UBS, which likely earned tens of millions of dollars peddling auction rate securities, would do right for a worthy charity and rescind the fraudulent and unsuitable investments so the foundation can honor its donation commitments, but unfortunately you would be badly mistaken.