Summit News

Marketing of auction rates may bring lawsuits

NEW YORK (Reuters) - Banks and brokers could face a wave of lawsuits from clients who claim they were not properly told about risks in the now nearly frozen auction rate securities market.

Salvatore Graziano from Bernstein Litowitz Berger & Grossmann answers questions during the Reuters Housing Summit in New York, February 19, 2008. REUTERS/Chip East

Auction rate securities -- debt instruments once touted as a highly liquid, short-term cash management strategy -- have been caught in the credit crunch and are failing to attract bidders. As a result investors, including institutions, high net worth individuals and corporate treasurers, are discovering that their cash may be tied up indefinitely.

If so, many brokerage clients may decide to sue to resolve how an investment they thought functioned like cash has soured so quickly.

“If the marketing is deceptive that would be the key argument,” Sal Graziano, a securities class action attorney at Bernstein, Litowitz, Berger & Grossman LLP, said at the Reuters Housing Summit on Tuesday.

Auction-rate securities are municipal bonds, corporate bonds, and preferred stock, with their rates, or dividend yields, reset through periodic “Dutch auctions” allowing the current holders to liquidate for cash.

In marketing materials on its Web site, for example, Merrill Lynch & Co Inc MER.N described auction rate securities as "money market-type instruments."

But, Graziano cautioned, it pays for investors to have read the fine print.

“The questions will be, what did the banks tell the investors? What was in the written materials?,” Graziano said.

Merrill also disclosed in documents on its Web site that as the broker, the firm may have different interests than its clients in marketing the auction rates, that clients may not be able to sell their securities if an auction fails, and that the firm provides no assurance on the ultimate outcome of the auctions.

Graziano said he had heard concerns from institutional investors that funds invested in auction rate securities carried an inappropriate level of risk for the kind of investments they authorized brokers to make.

Such claims could go to arbitration in front of the Financial Industry Regulatory Authority, but class action lawyers have begun to circle.

Miami-based class action law firm Dimond Kaplan & Rothstein said on Friday it was investigating claims of investment losses in auction rate securities and was seeking to represent investors with claims.

Also, in Texas state court, MetroPCS Communications Inc PCS.N has sued Merrill, claiming the brokerage invested the company's money in the securities without the appropriate authorization and that it misrepresented their risk.

Another area for possible litigation is whether clients had an implicit expectation that brokers would bail them out if an auction failed, Graziano said.

While brokers do not have a legal obligation to do so, what matters is whether investors thought they would, he said.

“The investors in these securities expected the banks to sort of buy them out if there were no buyers because these things turn over very quickly,” Graziano said. “There’s a question about what was said to the investors in their communications with the banks.”

However, the fine print could be the key for many banks. In 2006, the Bond Market Association, issued a white paper with best practices for brokers of auction rate securities, which were widely adopted in broker disclosures.

One of the association’s recommended disclosures reads: “Auction failures are possible, especially if ... credit were to deteriorate, if a market disruption were to occur, or if, for any reason, the broker-dealer were unable or unwilling to bid.”

(For summit blog:

Reporting by Emily Chasan; Editing by Jeffrey Benkoe