Published: Friday, 9 Oct 2009 | 11:39 AM ET

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The collapse of the auction-rate securities market is a largely forgotten part of the financial crisis, a disaster that was soon overwhelmed by bigger ones — except for the investors who were caught up in it.

The investors thought they were buying safe short-term securities — sort of like a money market fund but with an expectation of a slightly higher return. The securities were supposed to be easy to sell for face value.

Now many of the investors are stuck with securities that pay ridiculously low yields. In some cases, the securities will never mature, so the investors will never get their money back unless they sell them for a fraction of what they paid. Those who thought they were being safe and cautious in fact were taking huge risks.

The biggest losers so far are corporations that bought the paper but now find they are not covered by settlements some Wall Street firms made to reimburse individual investors. But there are still individuals who are stuck with the securities, either because their brokerage firm refused to settle or because they moved from one firm to another and found that neither firm was willing to reimburse them.

Some of those corporate purchasers may recall the old saying, “Be careful what you ask for. You might get it.” Those buyers of this paper are finding they cannot successfully sue because of a 1995 law that was strongly backed by corporate America as a way to curb frivolous lawsuits.

That law, the Private Securities Litigation Reform Act, says that a case, when filed, must be very specific about the fraud that is alleged, or it will be immediately dismissed. In many cases, a plaintiff would need access to inside information to make such a claim with enough detail. Such information could be there in company files, but the plaintiff has no way to get at it before the case is thrown out.

The latest reversal for investors came late last month when a federal judge in Manhattan dismissed a case filed against Raymond James

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[RJF  Loading...      ()   ], a brokerage firm that underwrote and sold auction-rate securities and has refused to settle with regulators.

In that case, a customer claimed that a broker at Raymond James had misled her about the safety of auction-rate securities, and argued that Raymond James, as an underwriter and as a firm that conducted auctions, was involved in a fraud to dump securities before the market for them collapsed.

Judge Lewis A. Kaplan of Federal District Court said that was not enough. The broker, he said, worked for one Raymond James company. The underwriting was done by a different Raymond James company. “There is no evidence in the complaint,” the judge wrote, “from which the court can infer that the Raymond James entities had even the most basic understanding of the others’ business.”

To a nonlawyer, all this sounds like the corporate veil being used to obscure reality. If the plaintiff could prove that one Raymond James subsidiary lied about the securities while another one profited from selling them, that would sound like enough to me.

Proving such a thing might be impossible; Raymond James argues there was no fraud, and that this case relies on “a classic fraud-by-hindsight theory”: since the market failed, there must have been fraud. But if there is no discovery of evidence allowed, we will never know whether such a claim could be proved.

Judge Kaplan gave the plaintiff until Oct. 16 to file an amended complaint that can pass muster under the 1995 law. Jonathan K. Levine, a partner in Girard Gibbs, the San Francisco firm representing the Raymond James customer, says a new complaint will be filed.

Whether or not investors ever get their money back, the auction-rate securities debacle is an example of a good product gone bad.

This could not have happened in the auction-rate market as originally conceived. In the beginning, back in 1984, the first auction-rate securities were preferred shares issued by major companies whose credit was reasonably easy to evaluate. Virtually the only risk for investors was that the issuing company would be unable to meet its obligations. In that regard, it was similar to commercial paper.

What made it different was that auction-rate securities offered companies a way to raise money at short-term interest rates, but to treat it on their balance sheets as long-term capital. There was to be an auction every seven weeks at which a holder could sell the paper at par. That auction would determine the interest rate over the next seven weeks. The rate presumably would rise or fall with market interest rates and with the creditworthiness of the company.

But what if auctions failed? What if there were not enough buyers for the paper?

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