For tens of thousands of investors who were trapped in the auction rate securities debacle that started in 2008, finances are getting back to normal. A string of enforcement actions by the Securities and Exchange Commission and state regulators, as well as private litigation and arbitrations by FINRA, has forced large and small brokerages to buy back the securities from clients who were led to believe that the instruments were more liquid — cash-like — than they turned out to be. The SEC last summer said that its settlements with top players — Merrill Lynch, UBS, Citigroup, Wachovia, RBC Capital Markets, Bank of America, Deutsche Bank and TD Ameritrade — alone had returned more than $67 billion in frozen securities to investors who had no access to their funds, in some cases for years. (In the SEC's most recent settlement, Raymond James & Associates and Raymond James Financial Services agreed in June to repurchase ARS from investors and reimburse them for certain costs. For clients who sold ARS below par, for example, the brokerage would pay the difference between par value and the sale price, plus reasonable interest.)
Nearly all the settlements with the SEC came with “without admitting or denying the SEC charges” language, which is common in such settlements. Most of the major brokerages, including Morgan Stanley and Goldman Sachs, also settled cases brought by state agencies under similar terms, albeit with penalties that ran to more than $550 million collectively; some smaller players faced FINRA settlements that called for six-figure penalties as well.
For the advisors who recommended ARS to their clients on the advice of the brokerages with whom they were affiliated, the outcome is more mixed. It's not clear how many advisors faced problems with the securities, although FINRA reports 788 arbitration cases related to the investments from 2008 through August of this year. Complaints by investors have resulted in disclosures on brokers' public records. For many brokers, the sense that they've been wrongly held accountable for the sins of their brokerages is acute; they recommended auction rate securities to their clients, they say, because their B/Ds told them they were suitable investments.
“Rewind the clock back to 2007,” says Eric Branson, a former Raymond James & Associates advisor in St. Petersburg, Fla., whose previously immaculate record was stained after a complaint by a client to whom Branson sold auction rate securities. “Tell me what I should have done differently to know that these were not as liquid a security as we were told they were. There's nothing the advisor could have done.” The disclosure stung after 16 years in the industry, he adds: “This is all just a crock. I haven't had a ding on my license ever.”
For investors whose advisors told them that ARS were a good way to park large sums of money for the short-term — and learned otherwise — the complaint may ring hollow. Indeed, some in the industry say that advisors are ultimately responsible for the recommendations they provide to investors, regardless of what their B/D may have told them.
“Even if a broker/dealer goes through due diligence and says that they approve a mutual fund or a limited partnership, an auction rate security for sale to clients, each individual rep has the additional duty to make sure it's suitable for his or her client and meets the investment objectives of the client,” says Nancy Lininger, whose consultancy, The Consortium, in Camarillo, Calif., provides advice on compliance and marketing. “There may have been problems with auction rate securities where maybe the broker/dealer should have done a better job with due diligence, but that doesn't mean the registered rep is then protected because the broker/dealer didn't do its job.”
Brokers who describe themselves as advisors are wearing a mantle that carries some implied responsibility, says Dan Bernstein, director of professional services and a principal at MarketCounsel, the New Jersey law firm that specializes in compliance issues. “They're trying to say, ‘I represent you. I'm your advisor. I'll provide you with advice. Trust me, call me when you have questions,’” he says. “And in that case, you're holding yourself out as a trusted professional. I do sympathize and I do think that some of the advisors or brokers will get a raw deal because they were told that this stuff was equivalent to cash, and we can't expect everyone to look into every single aspect [of ARS.] They took some of that at face value because the whole industry did. But at the same time, when it didn't work out, then there are consequences to that.”
Auction rate securities are bonds or preferred stock, largely issued by municipalities or closed-end funds, whose interest rates are set periodically, usually at auctions held every seven to 35 days. The yields typically were slightly better than those afforded by money market funds; like money markets, ARS had the appearance of liquidity since investors who wanted to cash out could do so at the next auction. For investors looking to park cash safely with a slight edge on returns, ARS seemed ideal.
That's certainly how brokerages portrayed the securities to their advisors. “We think that the higher rates compensate for the slightly lesser degree of liquidity…We view the unusually high present level of rates as an opportunity rather than a cause for alarm,” a supplement to Merrill Lynch's Fixed Income Digest said in February 2008. (See “Trapped” in the May 2008 issue of Registered Rep. available online.)
But as the credit bubble popped in 2008, the auctions at which the ARS rates were set failed — a rare occurrence in the securities' history, but one that effectively froze the investors' funds. In fact, there were only a few so-called busted auctions in the securities' 20-plus years of existence. FAs interviewed by reporters of this magazine over the last few years couldn't ever recall a busted auction. And so it is somewhat understandable that FAs and their clients grew comfortable with the higher-yielding securities.
Attorney Barry Lax has brought a number of lawsuits against broker/dealers over ARS. “We found uniformly they were misrepresented to clients based on the fact that the broker/dealers uniformly misrepresented the products to their brokers,” he says. In some cases, the ARS in the clients' account statements fell under the heading, “Cash equivalent.” Lax has heard the argument that brokers, in the end, are responsible for what they tell their clients. He's not persuaded. “It is a broker's responsibility. But the broker is part of the brokerage firm. So my position is, it's the brokerage firm's responsibility to provide the due diligence,” Lax says. “You're selling [ARS] the way you're told they should be sold. How would you, then, be responsible individually?”
Brokerage firms want their FAs to rely on their research, and brokers are paying for the service, adds Marc S. Dobin, an attorney in Jupiter, Fla., who has handled expungement cases. “An average broker gets a 35 percent payout on the commissions. The firm gets 65 percent of those commissions. That firm gets paid to do something. And that something, in part, is to provide research and market knowledge.”
In arbitrations over customer complaints about failed auction rate securities, arbitrators review both the brokers' actions as well as the product itself, Dobin says. “If arbitrators feel that the broker lied to the customer, that's a point of sale problem and the brokers can be held responsible. If the arbitrators decide that the broker merely said to the customer what they were being told by their firm and then the product failed, then it becomes a firm problem,” he says. “The irony of that, of course, is that unless there's an expungement granted, it still ends up on the broker's CRD report.”
Ignorance Is Not Bliss
Some advisors appeared to lack a full understanding of how the product worked. A 2008 FINRA arbitration between an investor and Raymond James Financial Services held that the broker who sold the ARS to a personal financial advisor to the investor was “poorly trained” in the instruments, alternately describing them as “unit trusts,” “short-term paper,” and “short-term stuff.” (The arbitrators ruled against the investor, however, arguing that he was aware of the risks involved in ARS and that Raymond James didn't know about the imminent wholesale failure of the auctions.)
Branson, who now practices with Morgan Stanley Smith Barney, agrees with Lax that the brokerage bears responsibility. “Everybody in the industry who was an advisor at the time will tell you these were supposed to be cash equivalent vehicles,” he says. “I don't even know how I could have done more … If you're going to hang your license somewhere, do business through that firm, you should be able to trust the information coming to you. Because if you act on that information, it should protect you — and it doesn't.”
Officials at Raymond James and other brokerages either declined to comment on their handling of auction rate, or didn't return calls for comment. For Branson and other advisors who are considering whether to attempt to have their records expunged of complaints about ARS, the decision can be a costly one. If a firm or a client challenges the effort, the legal fees can run up to $50,000 to $75,000, Dobin says. But if the client is satisfied because the firm has repurchased his securities, he may not quarrel with the expungement request; such cases can be settled in less than a year for perhaps as little at $5,000, Dobin says.
Product problems come in cycles; recall the limited partnerships in the 1980s and the Lehman structured notes that failed following the Wall Street firm's bankruptcy, Dobin says. He expects advisors will face more investor complaints in the future with fixed income products. “The credit markets are drum-tight right now,” he says. “As soon as interest rates go up, the bonds are going to be worth less. People are going to complain about that.”
Auction Rate Settlements
The Securities and Exchange Commission has struck settlements with major brokerages that returned $67 billion to investors whose stakes in auction rate securities were frozen when the auctions failed. Here are some common terms of the settlements with Bank of America, UBS, Wachovia, RBC, Deutsche Bank, Merrill Lynch, Citigroup, TD Ameritrade and Raymond James. The brokerages will:
- Offer to repurchase the ARS at par from clients, even if the clients moved their accounts.
- Pay eligible clients, who sold their ARS below par, the difference between the par and sale price.
- Take part in special FINRA arbitrations brought by eligible clients who believe they sustained additional damages.
- In some cases reimburse clients for excess interest costs incurred when clients used the brokerage's ARS loan programs.
- Neither admit nor deny the SEC's charges.