Thousands of investors nationwide are reeling after the collapse of the auction rate securities (ARS) market in early 2008 left their funds frozen and their investments hanging in limbo. Issuers and bond holders alike are suffering from the disintegration of what was once considered a safe market; more ARS auctions have failed in 2008 alone than in the past two decades combined.
The ARS crisis has led to a severe backlash against a number of major investment firms that investors accuse of misrepresenting the nature and reliability of the ARS market. A number of government agencies have launched investigations to determine whether these firms engaged in fraudulent misconduct, while investors have turned to lawsuits and other forms of litigation to recoup their losses.
Causes of the Auction Rate Securities Crisis
In the beginning of 2008, the finance and investment markets were primed for trouble. Investors were skittish and concerned about the credit ratings of the bond insurers behind auction rate securities offerings. Shockwaves from the credit crunch and mortgage/subprime loan crisis made major investment banks wary of anything which could overextend their resources. When numerous broker-dealers pulled their money from the ARS market, declining to act as last-resort bidders, the entire ARS market, valued at over $350 billion, collapsed. Only one issuer had announced plans to buy back the auction-rate debt.
While markets do sometimes collapse due to the business cycle, individual investors in this instance were told they couldn’t access their funds, essentially freezing their investments in unsellable bonds.
Auction Rate Securities Background
Auction rate securities are long-term bonds that act like short-term debt. They can be municipal bonds, corporate bonds, and preferred stocks that can be issued by municipalities (cities, towns, or other districts possessing corporate existence and usually their own local government), tax-exempt institutions, and closed-end mutual funds.
Auction rate securities are known as variable rate debt; that is, their interest rates are periodically reset via Dutch auctions. These are auctions where the auctioneer starts with a high asking price which is lowered until someone buys in. In ARS auctions, interested bidders offer bids to buy a certain number of shares at a proposed interest rate. The lowest interest rate at which all available shares can be sold is known as the clearing rate, and becomes the interest rate during the next period.
If, on the other hand, there are not enough bids to cover all shares being offered for sale, the auction fails. To prevent auction failure, broker-dealers have historically opted to act as bidders of last resort, thus keeping the rate of failed auctions extremely low for the past several decades. When these broker-dealers pulled out of the market in early 2008, the number of failed auctions skyrocketed, leading to market collapse.
Investment Firm ARS Backlash
While auction rate securities are far from illegal, investment firms misrepresented them to investors as safe, liquid, short-term cash equivalents that were an attractive alternative to money market investments. In addition, these securities were frequently sold to investors even if they did not meet the objectives of the individual investor.
In addition to misrepresenting auction rate securities as virtually risk-free, major investment firms also represented them as liquid. Though auction rate securities can be very liquid (i.e. easily bought, sold and converted with minimal value loss) they remain so only as long as the market thrives. When the ARS market fell apart, ARS investments suddenly became almost entirely illiquid and stagnant.
As a result, many investors have sought to hold investment firms responsible for misleading them into the ARS market. Several auction rate securities lawsuits have already been filed against major investment companies. If you have been misled by an investment firm concerning auction rate securities, contact an auction rate securities fraud attorney to discuss your situation and to determine your legal options.