FINRA Arbitrations on the Increase?

In the aftermath of the tech wreck earlier this decade, investors filed record numbers of securities arbitrations against broker dealers. These “customer” cases alleged a panoply of misconduct by Wall Street firms, ranging from garden variety issues such as suitability and over-concentration to more unusual causes of action, including the well publicized, but generally poorly received, research fraud cases. The return of the bull market in 2003, however, led to a steep drop off in the number of cases filed. FINRA arbitrations peaked in 2004 at 8,945, and dropped to 3,238 in 2007.

While the bursting of the housing bubble has affected retail securities investors more indirectly than the tech meltdown, the contemporaneous credit crunch associated with it may nevertheless lead to a massive increase in customer FINRA arbitrations. That’s because investors are in an uproar over Auction Rate Securities, a previously innocuous class of securities marketed over the last few decades by Wall Street firms as a cash equivalent.

Increasingly over the last two decades, brokers across the street have advised their clients that auction rate securities provided marginally better returns on cash than standard money market funds. Wall Street Firms regularly touted these securities as risk-free cash equivalents that were, by and large, completely liquid.

Auction Rate Securities are either debt instruments with long-term maturity (corporate or municipal bonds), or preferred shares of closed-end funds holding municipal bonds (also known as “auction rate preferred stock”), for which the interest rate or dividend is reset on a periodic basis through a Dutch auction.

Typically, auctions for the securities are held every 7, 28, or 35 days, and interest or dividends on the securities is paid at the end of each auction period. When an auction fails, i.e., there are not enough buyers to match with sellers at any price or yield – or, alternatively, when a broker-dealer makes only a “hold” bid in an auction that also fails – Auction Rate Securities investors cannot sell their positions until and unless a subsequent auction is successful.

Until recently, broker-dealers had bid on their own behalf to support the auctions. In other words, broker-dealers historically had invested their own capital to avoid auction failures. That historical commitment by broker-dealers made failed auctions extremely rare. Simply, broker-dealers often controlled the liquidity of the market, and because of this artificial liquidity, firms routinely marketed and sold Auction Rate Securities as liquid, cash-equivalent investments.

But beginning in about August 2007, broker-dealers increasingly became unwilling to invest more of their own capital in Auction Rate Securities, and they no longer supported the auctions by buying the excess securities themselves. That decision led to a dramatic increase in auction failures. In the first four months of 2008 alone, there have been thousands of auction failures, causing a near total collapse of certain areas of the Auction Rate Securities market. In turn, the liquidity of those sectors of the Auction Rate market has almost entirely evaporated, leaving many investors in the $330 billion Auction Rate Securities market with no way to sell their securities.

At present, there is no certainty as to when, if ever, Auction Rate Securities preferred holders, who do not have the right to put their securities back to the issuer, will be able to sell their investments. Further, there is currently no reliable or liquid secondary market for Auction Rate Securities.

For many investors, this lack of liquidity has eviscerated the advantages provided by the marginally increased return associated with Auction Rate Securities, and left them feeling like they’ve been sold a bill of goods. Suddenly, despite the representations of their brokers, their “cash” is no longer cash. The problem, however, is particularly magnified for those who invested their cash in Auction Rate Securities only on a short-term basis, perhaps with the idea of using the funds for a house closing or an April 15th tax payment, as was the case with many individual investors, or for use as short-term working capital, as was the case with many institutional Auction Rate Securities investors. Without access to the funds, investors have been forced to seek alternate financing sources, often at considerable cost.

Additionally, and in what appears to be increasing numbers, investors have resorted to filing arbitrations against the brokerage firms that recommended and sold them the Auction Rate instruments, with the representations that the securities were liquid, cash-equivalent products.

Just this week, UBS (UBS) agreed to return $37 million to Massachusetts municipalities and the Massachusetts Turnpike Authority in a settlement related to the sale of Auction Rate Securities. In another development, a task force of state securities regulators recently opened an investigation into the Auction Rate Securities market in cooperation with the North American Securities Administrators Association. If their inquiries uncover misrepresentations by broker-dealers in connection with their marketing and sale of these securities, investors involved in FINRA arbitrations would have a powerful tool to help prove their cases, the results of which could lead to rescission of Auction Rate Securities investments, together with other potential damages.

On the other hand, if the auctions start functioning again over the next few months, or if the issuers of the securities purchase the auction rate securities back from the investors, most investors will have a difficult time proving damages, since the securities have continued to pay interest, often at increased rates. In the short term, however, FINRA Dispute Resolution may want to prepare for a deluge of claims.

Comments

[Serge Birbrair]

Oh yeah, the number of people filing for arbitration is on the rise and while the holders of the preferred stocks have hope as some of the funds redeem rather than being sued, the holders of Student Loan ARC's have no prayer.

You can find heart wrecking stories of Auction Rate Securities victims at
www.nothingcontroversial.com/forum/showt...
and feel free to add your own.

While some ARS Victims look at Arbitration as the last resort
www.nothingcontroversial.com/forum/showt...
some investors found that they do NOT have arbitration agreements signed with the broker and they will be suing in courts, with treble damages and all other remedies available to those lucky ones.

The defending banks and brokerage firms are in violation, in my humble opinion, of

SEC Rule 10b-5 is one of the most important rules promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under the Securities Exchange Act of 1934. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security, including insider trading.
The rule itself is relatively short, and to the point. The formal title is "Rule 10b-5: Employment of Manipulative and Deceptive Practices", and the complete text reads:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

In the case of TSC Industries, Inc. v. Northway, Inc., the word "material" was defined by the U.S. Supreme Court - "an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote." 426 U.S. 438, 449.

and I feel cautiosly optimistic that arbitrators and juros see it this way.

[Richard Schweitzer]

In the words of the sage of Omaha:

"There is no limit to the amount of money you can lose by investing in something you do not understand."

Similar to these has been the entire Muni Market.
Assume one had an account with the trust department of a bank. With your ok they buy for your account 200K of City XX, yield of 3.3%, YY maturity. In reporting the assets in your account, they give it a purported value as part of the total assets (on which their trustee fee is based), but, if you give an order to sell at any point, the purported value is not what you get - they do not "mark to market" for account valuations.

[User 191974]

I am in arbitration against Smith Barney on ARS securities that I had to liquidate in a secondary mkt. The broker sold me these securities as cash/money mkt equivalent. They were willing to give me a margin loan which will risk the rest of my securities. Also, when I was about to sell on the secondary mkt, they were willing to match the price I was getting if I will sign a release. The whole thing is a racket where tails I lose, heads they win.

Any help on principles or rules on the Arbitration will be appreciated

Mohan