When the auction rate securities market froze up in February 2008, angry clients blamed their financial advisors; financial advisors blamed their firms. Today, the SEC announced finalized settlements with Bank of America, RBC Capital Markets and Deutsche Bank, “resolving SEC charges that the firms misled investors regarding the liquidity risks associated with auction rate securities (ARS) that they underwrote, marketed or sold,” the SEC said in a statement today.
According to the SEC’s complaints, filed in federal court in New York City, Bank of America, RBC and Deutsche Bank misrepresented to certain customers that ARS were safe, highly liquid investments that were comparable to money markets. The SEC alleges that in late 2007 and early 2008, the firms knew that the ARS market was deteriorating, causing the firms to purchase additional inventory to prevent failed auctions. At the same time, however, the firms knew that their ability to support auctions by purchasing more ARS had been reduced, as the credit crisis stressed the firms’ balance sheets.
Even firms’ own analysts didn’t know Wall Street firms, who were cash constrained at the time, were pulling out of the auctions, which, by and large, had run smoothly for decades, with only a handful of “busted” auctions during that time. On February 4, 2008—just as firms were abandoning their seats at the ARS table—Merrill analysts infamously wrote in a report to Merrill advisors:
“Are closed-end fund preferred-auction securities safe? We consider CFPs to be the conservative's conservative security.”
“Defaults are even rarer than failed auctions.”
“We are comfortable with the safety of auction securities from closed-end funds, municipals with an underlying credit rating of at least single-A and guaranteed student-loan issuers.”
This caused great havoc on advisor/client relationships, just as tax time was approaching when clients need liquidity to pay taxes. ARS products weren’t advisors’ only headache. The Lehman Bros. collapse also affected other products that were deemed to be “guaranteed.”
The SEC noted that its Division of Enforcement previously announced preliminary settlements with Bank of America and RBC on October 8, 2008. According to the SEC, today’s finalized settlements with those two firms, as well as Deutsche Bank, provide nearly $6.7 billion to approximately 9,600 customers who invested in ARS before the market for those securities froze in February 2008.
Wachovia settled in February 2009; UBS and Citigroup settled in December 2008 and Merril settled in August 2008.
“Through these latest settlements and prior ARS settlements with other firms entered into by the Commission, more than $50 billion in liquidity is being made available to tens of thousands of customers so they can get back all of the money they invested in auction rate securities,” said Scott Friestad, Deputy Director of the SEC’s Division of Enforcement.
The SEC’s complaints allege that Bank of America, RBC, and Deutsche Bank “failed to make their customers aware of these risks. In mid-February 2008, Bank of America, RBC, and Deutsche Bank decided to stop supporting the ARS market, leaving their customers holding billions in illiquid ARS.”
The SEC said in a statement that “the settlements, which are subject to court approval, will restore approximately $4.5 billion in liquidity to Bank of America customers, $800 million in liquidity to RBC customers, and $1.3 billion in liquidity to Deutsche Bank customers.”
The firms settled without admitting or denying the SEC’s allegations; Bank of America, RBC and Deutsche Bank agreed to be “permanently enjoined from violations of the broker/dealer fraud provisions and to comply with a number of undertakings,” such as purchasing ARS at par, even if the clients moved their accounts and will make up the difference for those that sold ARS below par. Third-party markets popped up to handle such transactions.
The SEC also said, somewhat ominously, that its “investigation of the auction rate securities market is continuing.”