When Law Obscures the Facts

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.

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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 , 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?

Salesmen who didn't understand what they were selling

Then the current holders were stuck with it until the next auction. But the issuer would have to pay a penalty interest rate that was well above the rate it would normally have to pay. Any issuer that could borrow money — that is, any issuer whose credit had not vanished — presumably would redeem the paper instead of paying that punitive rate for more than one or two auction cycles.

But as the market grew, things changed. The first deals had minimum investments of $500,000. By the end, the standard was $25,000. Differing types of auction-rate securities were issued, often by issuers whose credit was not as easy to evaluate, and auctions came as frequently as weekly.

Most important, those “penalty rates” were set by formulas that became less and less generous to investors. In some cases, involving paper backed by student loans, the penalty rate can fall to zero for a month or two.

One allegation in the Raymond James suit is that underwriters reduced those rates to attract issuers, and investors did not understand what was happening. The early auction-rate issues required that prospectuses be given to all buyers, including those in subsequent auctions, but that provision was later dropped.

Providing prospectuses might not have done much good anyway. The documents were confusing when it came to explaining how penalty rates would be set, and sometimes did not even mention as a risk the possibility of an auction failure.

By the summer of 2007, many people knew that auctions were succeeding only because underwriters were taking paper no one else wanted. What we don’t know is how much paper ended up in Wall Street vaults, and how much was sold to corporate investors before the whole market collapsed in February 2008.

The auction-rate securities that did have good penalty rates have been redeemed. But in some cases investors are stuck with tax-exempt securities that are perpetual and currently pay less than 1 percent a year. Those securities may never be redeemed.

Ron Gallatin is a retired partner of Lehman Brothers and the man who invented auction-rate securities. He is critical of changes in the product, including the withering of penalty rates.

“I cannot comprehend how any broker could have had any client bid at an auction by October 2007,” he said this week, pointing to the talk of auction problems that had spread around Wall Street and been reported.

Actually, he says he thinks he does comprehend what was going on: “The reason is that the salesmen did not understand it. They thought it was a cash equivalent that paid them a fee. And in most cases, firms did not do anything to educate them.”

If there ever is a wide-ranging trial, we might get to see which issues of auction-rate securities were owned by Wall Street firms in the summer and fall of 2007, and how much they sold before the collapse. We might learn if the firms understood risks they did not mention to customers.

But that will not happen if judges continue to prevent such cases from proceeding even to the discovery process. Corporations that cheered the 1995 law may discover it keeps them from having a chance to recover their own losses.