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Auction Rate Securities Crash Yields Lawsuits

Mar 26, 2008 | Parker Waichman Alonso LLP

Investors in auction rate securities have filed  lawsuits against Morgan Stanley and Merrill Lynch, alleging those brokerages deceptively marketed the investment vehicles and took actions that made auction rate securities all-but-impossible to sell.  Both lawsuits, filed in federal court in Manhattan, are seeking class action status.

Auction rate securities are long-term corporate bonds, municipal bonds and preferred stock on which the interest rates are reset periodically based on bids submitted through securities firms. Generally, rates are reset every  seven, 14, 28 or 35 days. Because they can be sold during weekly or monthly auctions, banks and brokerages often touted auction rate securities as short-term investments or cash equivalents.  

Unfortunately, because of the crisis in the credit markets,  auctions of these securities haven’t been successful because of worries that bond insurers guaranteeing many of the $330 billion in outstanding auction bonds would be downgraded. Bloomberg.com has also reported that brokers such as Goldman Sachs Group Inc. and Citigroup Inc. also purposely permitted the auctions for preferred securities, which aren’t insured, to fail by not committing their own capital to sales when there weren’t enough bidders.  As a result, the market for auction rate bonds has pretty much vanished, leaving a lot of small investors holding auction rate securities they once thought were safe vehicles with no way to sell them.  Some legal experts have asserted that  banks or brokers could be held liable for investors' auction rate securities loses if the vehicles were represented as short-term investments or cash equivalents.

According to Reuters, the auction rate securities lawsuits filed against Morgan Stanley and Merrill Lynch claim the brokers had artificially supported the auction rate securities market, causing their investments to become illiquid. They also claimed that the firms had recklessly misrepresented the risks of such investments.

Investor Gary Miller, who filed suit against Morgan Stanley, is seeking an injunction that would force the broker to rescind millions of dollars it executed in auction rate transactions from March 2003 through February 2008, and compensatory damages for himself and other investors in those securities.  The other suit, filed against Merrill Lynch by Frederick Burton, alleges the company deceived the investing public and issued misleading information to clients in violation of the Exchange Act. He is also seeking compensatory damages.