Regional Firms Want ARS Underwriters Investigated

Regional securities firms are launching a major counter offensive against efforts by New York State Attorney General Andrew Cuomo to have more than two dozen brokerage firms repay investors who purchased now illiquid auction rate securities, CNBC has learned.


The brokerage firms, through their trade group, the Regional Bond Dealers Association, have written to both Cuomo, and Chris Cox, chairman of the Securities and Exchange Commission. They're calling on regulators to change the course of their investigation and force the major underwriters of auction-rate securities to repay aggrieved investors, instead of firms that simply sold the securities to their clients, according to a copy of the letter obtained by CNBC.

In their letter, the group's co-CEO's Michael Decker and Mike Nicholas say it is unfair to treat cases as sale-practice abuse because scores of regional firms and discount brokers like Fidelity and Schwab would be forced to make their clients whole, when they played almost no role in the fraud that has prevented tens of thousands of investors from being able to redeem illiquid auction-rate securities. (Click the picture to see who has settled in the auction-rate probe so far.)

The real fraud they say occurred when underwriters of the bonds withheld important information from brokers, namely that they would no longer honor their commitments to hold auctions because of the credit crunch.

“It is clear in part from evidence that you all have published, that lead managers … gave the market a false sense of liquidity when real investor demand was disappearing,” the letter said.

As proof, the letter cited recent settlement against UBS by Cuomo’s office. “According to Attorney General Cuomo’s complaint against UBS,” the letter said, “UBS acted against investors' best interests in part by buying ARS in auctions that otherwise would have failed without disclosing that fact to the market or to its customers. If the allegations in Attorney General Cuomo’s complaint are true and if lead managers other than UBS engaged in similar activity, the violations at the heart of the ARS market downturn stem not from problems with distributing firms at the ‘point of sale’ but in the relatively opaque auction process”.

Video: Gasparino interviews a regional broker

The letter represents the latest twist in the controversy surrounding auction-rate securities, a once obscure investment that has begun to symbolize how the credit crunch affects average investors. In recent years, Wall Street has sold over $300 billion auction rate securities, which are essentially long-term municipal bonds that can be redeemed at weekly or monthly auctions because of guarantees made by the big Wall Street firms that underwrite these securities.

The auction made the bonds look like short-term security, equal to a money market account that is the equivalent of cash. At least that's how Wall Street sold and marketed these securities to hundreds of thousands of small investors who were looking for a cash-equivalent security with both the safety and tax advantages of a municipal bond.

Then came the credit crunch. Wall Street firms no longer honored their commitment to hold auctions, forcing investors who purchased the securities on the basis they could redeem their securities quickly, to keep these securities indefinitely.

In recent weeks, Cuomo has emerged as the lead investigator of auction-rate security fraud. He has reached settlements with the likes of Citigroup, JP Morgan, UBS, Morgan Stanley and Wachovia, forcing these firms to repay investors the par value of their holdings.

Separately, Merrill Lynch continues to negotiate with Cuomo's office, which is seeking a fine of $100 million or more in its ARS case, in addition to repaying investors. Sources inside Merrill and Cuomo's office say progress is being made on a settlement.

As first reported by CNBC on Friday, his investigation has recently widened to include discount brokerage firms Fidelity Investments and Charles Schwab. CNBC has learned that he is also examining the sales practices of many regional brokers like Stifel Nicolaus & Co.

But the investigation has a serious loophole: Because Cuomo is treating this as a sales practice abuse, he has so far covered only a small portion of the auction-rate securities market through his settlements. The Wall Street firms are only agreeing to pay back the bonds they sold, not the billions more they underwrote.

In order to cover every auction-rate security held by investors, he would have to craft settlements with scores of brokerage firms, and many tiny firms, which may be impossible. For that reason, the trade group representing regional bond firms as well as many investors are questioning why Cuomo didn't simply charge the major underwriters of the auction-rate securities with fraud and force them pay back investors.


Then there’s the question of fairness. The regional brokers say they underwrote very few of the bonds. The large Wall Street firms that dominated the market sold the bonds the regional firms and the discount brokers with the promise to hold auctions. The regional firms and the discount brokers say they acted as mere conduits — they sold the bonds to their customers based on promises from the underwriters.

In an interview last Friday, Cuomo told CNBC he doesn’t want to get involved in what could be a dispute between brokers and the big Wall Street firms, over who is culpable for misleading investors. “I represent the investor,” he said, “and that’s why I'm treating this as a sales practice issue.”

Cuomo said he expects to craft settlements with every major broker who sold auction-rate securities to small investors, so while the current amount covered by his settlements is relatively low, it will grow substantially in the near future. “When this is done it will be the largest civil recovery case in history,” he said.

Still, it’s unclear if the SEC will approach the issue as Cuomo has -- as sales pratice abuse.

Cuomo’s office had sought a “global settlement”, with the SEC signing off on his recently announced deals with the big Wall Street firms. That didn't happen. It's also unclear what impact the issues raised by the regional bond dealers association will have with the SEC or with Cuomo as he expands his probe.

The trade group, in its letter to Cox, said regional firms don’t have the resources to do what the big Wall Street firms have recently done and spend tens of billions of dollars by purchasing back the illiquid auction-rate securities from investors at par.

“Firms like Merrill Lynch, Citigroup and Wachovia can buy and hold large volumes of ARS because even though their ARS positions would be significant, they are still small relative to the firms’ total assets, and those firms have sufficient financial resources to carry large securities positions,” the association wrote.

“By contrast, many distributing dealers are much smaller firms with fewer financial resources, and carrying even smaller ARS positions would be excessively burdensome. Holding a significant portfolio of ARS would overwhelm the available capital of many distributing firms. There simply is not sufficient capacity among distributing firms to buy back ARS positions from investors. The only practical solution for making investors whole is to include the ARS customers of distributing firms in the settlements with large lead managers.