Auction Rate Securities Fraud

My broker told me that auction rate securities were as safe as cash, and paid a better interest rate than money market funds.  But now I can’t access any of my savings, and I’m stuck with tens of thousands of dollars worth of bonds that I can’t resell.

I just sold my home and put the proceeds into auction rate securities until I could close on my next home.  Now my account is frozen, and I won’t be able to close on my new house.

Our business covers payroll checks using the money we had in auction rate securities.  For years we’ve always enjoyed earning a better than average interest rate on our cash savings, and never had a problem with liquidity.  After the latest auction failures though, we may not be able to pay our employees.

The broker at my firm recommended that I invest in a closed-end fund that issues auction rate preferred shares.  I placed a significant portion of my savings in these shares based on what my broker told me about them, and now I’ve found out I can’t sell them without taking a huge loss. 

Complaints such as these are sadly becoming more common as so-called “auction rate securities” (“ARS”) have failed to attract buyers in the market.  Brokers have pitched auction rate securities as liquid, safe investments with interest rates slightly superior to conventional money market funds.  Unwary investors, however, are now finding that their brokers may have misrepresented the risks associated with such investments. 


(This section discusses Auction Rate Securities (“ARS”).  A similar investment, known as Auction Rate Preferred Shares (“ARPS”) is discussed below.)

Auction Rate Securities (“ARS”) are typically municipal bonds, corporate bonds (including bonds issued by student loan lenders) and preferred stocks with long-term maturities (sometimes 30 years or longer).  ARS investors receive interest rates or dividend yields that are periodically reset at each successive auction.  ARS auctions are held in regular intervals, usually every 7, 14, 28 or 35 days.  In an ARS auction, a bidder will submit the lowest interest rate or dividend yield he or she is willing to accept for buying and holding the bond during the next auction interval.  If a bidder “wins” the auction, he or she is required to purchase the bond at par value, and is entitled to receive interest (at the auction’s “clearing rate”) as long as the winning bidder holds the bonds. 

Traditionally, the interest rates available to ARS investors have exceeded the rates available from money market funds.  This is because the periodic auctions provide the opportunity for the bonds’ interest rates to be frequently adjusted to reflect current market conditions.  ARS may provide investors with benefits that in some cases include competitive yields, frequent dividend/interest payments, tax exempt income and some degree of principal protection.  ARS have been promoted by brokerage firms as low risk, highly-liquid investments because bond holders have the option to resell the bonds at the next available auction.  As a result, many brokers have instructed their customers to use ARS as a cash or money market equivalent.


In most cases institutional investors and individuals with high net worth buy ARS.  In some cases unsophisticated investors with low net worth have been placed in ARS by their brokers.


In order to invest in ARS, an investor must submit bids through a broker-dealer firm (for example, Merrill Lynch, Morgan Stanley, UBS, etc.).   The broker-dealer firm processes bids through a “trading desk,” which confirms that all bids include the (1) precise investment amount; (2) specific desired dividend/interest rate; and (3) the name or CUSIP identifier of the security to be purchased.  After the trading desk receives a valid bid, it will submit the bid directly to an auction agent.  The auction agent collects the bids, allocates the ARS among the winning bidders, and determines the auction’s “clearing rate.”  The clearing rate is the rate that will be paid to ARS holders until the next auction.

ARS are auctioned off in large blocks.  The bidders specifying the lowest desired interest/dividend rates will be the first to receive a portion of that block.  The next highest bidders will also be entitled to a portion of the auctioned securities.  The point at which the last available security is allocated to the lowest remaining bidder triggers the clearing rate.  The clearing rate will apply to the entire block of securities, even though the rate may be higher than the lowest bid.

There are several types of bids that investors who hold ARS may place at an auction. 

Buy.  This is a bid by a current holder who wishes to purchase additional securities.

Hold.  An order to continue to hold a security purchased at a previous auction.

Hold-at-Rate.  This allows a current holder to keep a previously purchased security as long as the new clearing rate is at or above the current rate.  Note that if the auction’s new clearing rate resets to a lower rate, the holder becomes obligated to sell the security at the auction.

Sell.  This is the normal method of reselling a security purchased at a previous auction.

If a current holder chooses not to participate in a subsequent auction, or fails to timely submit a proper bid, most auction procedures provide that the holder will be deemed to have submitted a “hold” bid.


First off, an auction failure is not the same thing as a bond default.  Failed auctions occur when there are too few bidding buyers to take possession of the entire block of ARS offered at the auction.  For example, if a block of 1,000 bonds is offered at auction, but the auction agent only receives bids for 500 bonds, the auction will fail.  If an auction fails, those currently holding ARS will be unable to sell some (or all) of the securities in the auction.  To compensate these holders for the diminished liquidity, the interest/dividend rate of their securities will reset to a (usually) higher, predetermined maximum rate until the next auction.  Holders can either wait for the next auction to sell their ARS, or attempt to find buyers on the secondary market.

It’s worth noting that as a matter of practice, brokerage firms have traditionally stepped in to prevent auction failures by bidding on enough securities to complete the auction.  However, firms are not obligated or required by law to do so. 

An auction failure may be devastating to both the issuer and the investor.  The issuer will often be saddled with crushing interest payments (sometimes 20% or more) that must be paid until the securities are sold at a successful auction or called in.  The investor may find that he or she is left holding an enormous position in securities that cannot be sold without a substantial discount.  This is especially true in cases in which the ARS are downgraded because of increased credit risk of the issuer or the issuer’s insurer.  Securities that are comprised of sub-prime mortgages, CMOs, or other similar investments have been particularly at risk for auction failure.  Investors who have placed a significant portion of their savings in ARS with the expectation of high liquidity may find themselves unable to use their cash for its intended purposes.  Sadly, many investors are now holding sub-investment grade long-term bonds paying paltry interest rates.  These investors must either hold the bonds to maturity (perhaps for decades) or sell the bonds to someone on the secondary market at a steep loss.


An auction may fail for several reasons, all of which are evidenced by a lack of willing bidders at the auction.  An issuer’s credit may deteriorate to the point that the ability of the issuer to continue making interest payments is placed in doubt.  An issuer’s insurer may be downgraded, signifying that the security of the bond is compromised.  More recently, auctions have failed because brokerage firms have chosen not to step in to save the auction from failure.  In the past, these firms have taken the initiative to intervene in potentially failing auctions in order to protect the interests of the issuer, which pays the brokerage firm substantial fees for taking the ARS to auction, from having to pay higher interest rates to investors.  In some cases the brokerage firms have bid on ARS because they can do so with the benefit of knowing what the other bids are going for, and can make a profit by underbidding.  Brokerage firms that have taken large positions in debt secured with sub-prime mortgages are now reluctant to add more questionable debt to their balance sheets, and as a result, are increasingly more willing to leave ARS investors holding the bag.


Auction Rate Preferred Shares (“ARPS”) are similar to the ARS discussed above.  ARPS are issued by closed-end funds and sold at auctions.  The closed-end fund uses the proceeds from the auction sales to invest in long-term debt securities.  Just like ARS auctions, ARPS auctions are held in regular intervals, and intended to provide investors with short-term investments.  Investing in ARPS can be risky if the supply of available shares exceeds the demand, as has been the case in recent weeks.  Investors may face significant liquidity problems and be forced to sell ARPS at a steep discount to free up their invested capital.


You should consider consulting a law firm that is familiar with securities fraud.  Shepherd Smith Edwards & Kantas LTD LLP is a law firm that almost exclusively represents investors that wish to recover money they have lost because of the misconduct or negligence of an investment adviser, broker, or firm. One of our lawyers would be happy to speak with you during a free consultation.

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