The Auction-Rate Securities Market Litigation

There has been quite a bit of media coverage these last months on the auction-rate-securities market (ARS) and the ensuing litigation.  It has generated, and will generate, a fair amount of document reviews.  A recent link in Gabe’s Guide gives you an indication of the many major law firms involved (http://gabesguide.com/?p=564).

The major ARS news story these last few days is about the investigation of UBS by Andrew Cuomo, New York state’s Attorney General.  UBS is the world’s largest manager of private wealth assets and the second-largest bank in Europe (Deutsche Bank being #1).   UBS has a major presence in the U.S., with its U.S. headquarters located in NYC and with major locations in New Jersey (Weehawken) and Connecticut (Stamford).  It is a major ARS dealer.  But the first major ARS litigation was launched last week by the Commonwealth of Massachusetts against Merrill Lynch (see details below).

Cuomo charges UBS customers have been left holding more than $25bn in illiquid, long-term paper as a result of the bank’s “fraudulent misrepresentations and illegal conduct”.   Cuomo’s investigation has uncovered evidence, ­including internal emails, that as the securities market started to ­collapse, several of UBS’s top ­executives sold a total of $21m in personal holdings of ARS, while continuing to market the securities to its consumers.

The ARS market is an arcane segment of the municipal securities market.  If you want to understand the details of how auction-rate securities work, the web site Accrued Interest has a good primer which you can find at this link (http://accruedint.blogspot.com/2008/02/you-have-failed-me-for-last-time.html) and the following links will give you more information:

https://www.smithbarney.com/products_services/fixed_income/auction_rate_securities

http://en.wikipedia.org/wiki/Auction_rate_security

As widely reported, the ARS market collapsed following a broker-dealer pullout.  The story of the ARS market collapse, like many others involving the finance industry, is one mired in conflict of interest.  As Joseph Devine of ezinerrticles.com has summarized the crisis:

“For much of the ARS market’s history, broker-dealers like UBS, Merrill Lynch, and Lehman Brothers had “shored up” their auctions by submitting bids on their own behalf. These bids ‘of last resort’ provided extra demand for auction rate stocks and bonds, ensuring that there was a buyer for all shares exposed for sale at auction. For years, this practice appeared immensely successful; the market thrived and investors were attracted by the liquidity of the ARS system.  But by late 2007, major investment firms and broker-dealers were well aware that the ARS market bubble was about to burst, as internal e-mails and reports to state governments show. This was a serious concern to broker-dealers, many of whom had accumulated billions of dollars in auction rate paper. These concerns were swiftly conveyed to several state governments, encouraging municipal borrowers to refinance their debt – a gesture not of broker-dealer goodwill, but of self-interested survival, as evidenced by the fact that such a warning was never given to the countless investors who also held ARS.  However, even such a move was not enough to satisfy executives at major financial institutions; they needed some way to quickly unload ARS that they knew were doomed. But who in their right mind would want to purchase the securities in the months before a market crash? Faced with a conflict of interest between preserving immediate profits and ensuring the well-being of their customers, broker-dealers predictably chose to save their own money. Though they knew that auction rate securities were soon to become illiquid, they aggressively marketed the securities to unsuspecting investors as “safe, liquid, cash-equivalent” investments.

What investors didn’t know:

– The securities they were purchasing were held by broker-dealers who were eager to unload paper whose value and liquidity were due for a fall.

– The liquidity of the ARS market was dependent on the same broker-dealers who were trying hard to exit the market.”

COMMONWEALTH OF MASSACHUSETTS/MERRILL LYNCH CASE

To get a real feel for ARS litigation, go to the Commonwealth of Massachusetts case.  You can find links to the complaint here:  http://dealbook.blogs.nytimes.com/2008/07/31/scenes-from-a-merrill-meltdown/

We love this case because it is filled with “hot docs” and we can well imagine the contract attorneys who found them (assuming it was a CA who found them) must have been ecstatic.  How often do you find an email from a securities firm trading desk that says “come on down and visit us in the vomitorium!!”    (We’ll leave aside what docs were buried or “lost”).

Which brings us to a point.  The “conventional wisdom” is that document reviews are too large/expensive to be done by associates, and the work is “not difficult”.  It’s a funny system that allows document review to be considered not worthy of an associate’s time and yet if someone making $30/35 an hour doesn’t find the bad documents or hot documents it can drastically change the case.   All clients want good lawyers, but balk at the “high price” of things like document review in the age of electronic discovery.  

As far as “difficult”, consider the following comment we received from a Posse List member:  “Reviewing documents can be “difficult” if you define “difficult” to include having the intellect and judgment to appreciate the significance of outcome- determinative facts whose importance may not be obvious at first blush. Or the intellect and judgment to draw a connection between two seemingly unrelated items, one found on Day 9 of the review and the other found 50,000 documents earlier on Day 2.  

We will keep you up-to-date on the ARS litigation.  Our Research Unit has been retained by several agencies to track the issues/potential litigations in anticipation of further document reviews, and we have been contacted by several law firms nationwide about the number/availability of contract attorneys in several areas of the country.