Securities Law Blog

In the midst of all the horrible economic news of the last few months—Madoff, Stanford, the plummeting economy in general and financials in particular—the Auction Rate Securities (ARS) woes seem to have fallen off the media radar screen. If you recall, in 2008, many firms reached regulatory settlements of many millions of dollars to help make clients liquid in a suddenly illiquid world. The litigation is now catching up with the prior regulatory ARS settlements.

As Dan Jamieson writes in the current issue of Investment News more litigation is likely:

Despite having settled regulatory actions involving auction rate securities, the big Wall Street firms aren't out of the woods yet.

Citigroup Inc., Merrill Lynch & Co. Inc. and UBS Financial Services Inc., all of New York, and St. Louis-based Wachovia Securities LLC are facing a number of individual lawsuits from institutional investors who still have huge sums locked up in the illiquid securities.

What's more, last month, the first so-called downstream brokerage firm case was filed, when Amegy Bank NA of Houston and its broker-dealer affiliate Amegy Investments Inc. filed an arbitration claim against Merrill Lynch.

Amegy claims it purchased more than $240 million of ARS from Merrill, which it said it then sold to its clients. Amegy's suit seeks rescission of the remaining $140 million that its clients still hold, plus unspecified damages.

In a statement, Merrill Lynch spokesman Mark Herr said the suit has no merit.
The downstream firms, as well as institutional and wealthier individual investors, weren't part of the ARS buyback agreements announced last year. Those settlements with regulators cover only retail investors at the major firms.

The underwriting firms "got regulators to believe [that the ARS mess was] a point-of-sale problem" rather than fraud by the underwriters, said an executive with a regional firm who asked not to be identified.

The market for ARS froze a year ago after all the major underwriters stopped supporting auctions for the securities.

More claims from downstream firms are coming, said Paul Yetter, a partner at Yetter Warden & Coleman LLP in Houston, which represents Amegy Bank.

He said he has more such cases but could not yet comment on those claims.

"It wouldn't surprise me if other [downstream firms] took action like this, especially if Amegy is able to get some traction ... and get money back for its clients," said Michael Decker, co-chief executive of the Regional Bond Dealers Association in Alexandria, Va.

He estimated that $30 billion to $40 billion worth of ARS are still held by downstream firms.
The major firms are "leaving innocent [investors and downstream firms] with no other option" but to sue, Mr. Yetter said.

And that's what they're doing. Some of the claims filed so far:

• American Eagle Outfitters Inc., a Pittsburgh-based specialty retailer, this month filed a lawsuit in federal court seeking to force Citigroup to take back the $258 million worth of illiquid ARS the bank sold to it.

• Another suit against Citigroup, filed in federal court in November by Hutchinson (Minn.) Technology Inc., is pending in arbitration.

  Hutchinson said it is stuck with $31 million of ARS it bought from Citigroup.

  A separate claim against UBS by Hutchinson Technology for rescission of $70 million of ARS was settled in December, with UBS providing a no-net-cost $59.5 million line of credit.

• A federal lawsuit filed against UBS by Plug Power Inc. was settled in December, with UBS providing a no-net-cost line of $62.9 million, equal to the value of Plug Power's frozen ARS, according to an SEC filing by the Latham, N.Y.-based energy company. UBS also agreed to repurchase the securities at any time from June 30, 2010, to July 2, 2012.
• In December, Hanna Steel Corp., a Fairfield, Ala.-based tube manufacturer, sued Charlotte, N.C.-based Wachovia Corp. and its broker-dealer units in federal court seeking rescission of $12.9 million worth of ARS.
• TGS-NOPEC Geophysical Co. ASA of Asker, Norway, filed an arbitration in November against Merrill
  Lynch seeking the repurchase of $64.5 million in frozen ARS.

Citigroup spokeswoman Danielle Romero-Apsilos declined to comment.

UBS and Wachovia had not responded to questions by press time.

The fights among the heavyweight investors and Wall Street firms could get nasty.
Claimants of all stripes said the big underwriting firms knew by late 2007 that auction failures were imminent and were reducing their inventories, but never disclosed any impending problems to their
clients.

Lawsuits by institutional clients cite many of the charges previously made by regulators.
But unlike many retail investors, some institutional clients say they had warning of ARS problems and specifically raised concerns late last year with their brokerage firms but got reassurance that all was well.

Several claim that their brokers violated written investment policy statements for cash reserves that prohibited investments in long-term securities or anything with limited liquidity.
Amegy Bank's claim says it "bought the securities from Merrill at the same informational disadvantage as Merrill's direct retail customers."

Mr. Herr begs to differ.

"Amegy began selling ARS it purchased from Merrill Lynch in 2004, and it is unfathomable that it would now claim that when it sold these products to its clients, it didn't know or understand what it was selling," the Merrill spokesman said in his statement. "It appears Amegy failed to do even the most routine due diligence."

Amegy's claim said it performed an exhaustive analysis of the credit quality of ARS in the summer and fall of 2007, "but no amount of research or analysis could have led Amegy to learn of Merrill's deceptive marketing and support of the ARS market."

Mr. Herr said Merrill Lynch did disclose its role in the auction process and informed purchasers that auctions could fail.