What are Auction Rate Securities

An auction rate security (ARS) typically refers to a debt instrument with a long-term nominal maturity (20 or 30 years) for which the interest rate is reset through a Dutch auction. It could also refer to preferred stocks for which the dividend is reset through the same process; notably preferred stocks have no maturity date. In a Dutch auction, a broker-dealer submits bids to the auction-agent on behalf of current and prospective investors. Based on the submitted bids, the auction agent will set the next interest rate by determining the lowest rate to clear the total outstanding amount of ARS.

Auction-rate securities were invented in 1988; and, until 2004, were classified as cash equivalents, since investors could redeem their securities at auctions held every seven, 28, or 35 days. In the beginning, ARS auction failure was rare, with most underlying bonds being issued by municipal and corporate entities rated at AAA or AA. (Auction failure occurs when supply of ARS outstrips demand.)

However, the ARS market, which had grown to well over $330 billion in 2007, had become more risky with the rise of preferred stock auction-rate securities issued by closed-end funds; these issues had reached 20% of the ARS market. At the same time (in late 2007), auction-rate securities had morphed from a product sold mainly to corporations to one marketed heavily to retail investors; minimum investments were dropped to $25,000 (with the average retail investment at $300,000). By the start of 2008, corporate investment had dropped to less than 30 percent of the ARS market.

Why are Auction Rate Securities Relevant

The ARS market worked relatively smoothly until February 2008, when the credit crisis caused supply of ARS to greatly outstrip demand, and investors could no longer sell their securities. Now, many corporate and retail investors no longer have access to assets held in ARS. Retail investors say their brokers put them into these securities at the same time corporations were dumping their stakes. Furthermore, these investors assert that they were never informed of the risks associated with ARS. (Investors are not provided with prospectuses because ARS are considered secondary market issues.) Investors argue foul-play, claiming that auction-rate securities were marketed as a risk-free cash equivalent; some investors are now holding their ARS indefinitely.

Wall Street firms have little interest in resolving the problem of failed auctions, where they earn money at least twice. First, they receive 1.5 percent of the amount of money raised as a fee for underwriting the shares; then they receive 0.25 percent annually for conducting the auctions. And, these fees are earned even when the auctions fail, so the firms have no incentive to help revive this market.

Now, the Securities Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) are investigating whether brokerage firms and banks marketed ARS as cash equivalents, knowing that they are not. Also, regulators are investigating whether Wall Street firms hid the true demand for ARS, where investment banks would often add capital to smooth out the auction process. The ARS market began to fail when credit became scarce, and these firms could no longer hide any market imbalances.

Beyond the woes of retail investors, some corporate investors have also been burned by the fallout in the market. For example, about $80 billion of the ARS market is made up of bundles of student loans. And, with distress in the market, 46 student lenders, accounting for 12% of the student loan market, have stopped making federally guaranteed student loans. Also, airlines, like ASTAR Air Cargo (a sub-service operator for DHL), have had their cash reserves tied up in ARS. In a complaint filed with FINRA, ASTAR is asking for $9.1 million in compensation and $27.4 million in punitive damages from Merrill Lynch for failure to warn of the risks associated with ARS.

Finding Relevant Information

Investors, corporations, regulators and other lawyers may have an interest in researching Auction Rate Securities; many players have been impacted by the fallout from the ARS market. For example, retail and corporate investors may now hold ARS as long-term assets, instead of as cash equivalents, which disrupts their access to cash necessary for funding daily operations. Relatedly, brokers who marketed and sold ARS product are now under investigation by the SEC, and are exposed to investor lawsuits.

Legal Sources

There are various relevant legal sources for finding information on Auction Rate Securities. First, the authority to regulate securities transactions comes from eight principal federal statutes found in Title 15 of the USC, Commerce and Trade. Next, regulations under these eight federal securities statutes are codified largely in Title 17 of the Code of Federal Regulation (CFR). And, at the time that Auction Rate Securities claims have been litigated, there may be some case law. In the meantime, the SEC, as the agency charged with administering federal securities law, has Congressional authorization to promulgate rules and regulation on ARS. Finally, brokers who sell securities are also regulated by the Financial Industry Regulatory Agency (FINRA).

• LexisNexis

LexisNexis provides statutes, regulations, and administrative materials related to securities law. Browse for sources in the LexisNexis database: FEDSEC. LexisNexis also provides useful secondary sources, including general news and Company & Financial news.

http://www.lexisnexis.com/lawschool/

• Westlaw

Westlaw provides, among other information, statutes, regulations, and administrative materials related to securities law. Browse for sources in the Westlaw database: FSEC-ALL. Westlaw provides many secondary sources databases, including the Law of Securities Regulation (LAWSECREG) and Securities Law Reference Books Multibase (PLIREF-SEC).

http://lawschool.westlaw.com/

• Securities Exchange Commission

The SEC website provides information on agency public statements, proposed and final rules, enforcement actions, educational materials, and other SEC documents.

http://www.sec.gov/search/search.htm

• Financial Industry Regulatory Authority

The Financial Industry Regulatory Authority (FINRA) is a self-regulatory organization under the Securities Exchange Act of 1934, successor to the National Association of Securities Dealers, Inc. (NASD). FINRA is responsible for regulatory oversight of all securities firms that do business with the public; professional training, testing and licensing of registered persons; arbitration and mediation; and market regulation by contract. FINRA was formed in 2007 by a consolidation of the enforcement arm of the New York Stock Exchange, NYSE Regulation, Inc., and the NASD. The FINRA website provides information on Auction Rate Securities, and on ARS Regulatory Notices.

http://www.finra.org/index.htm

Business Sources

In addition to legal sources, relevant information on Auction Rate Securities will be found in the filings of various publicly traded corporations. For example, information found in a company’s financial statements may provide insight into how fallout from the ARS market affects its asset holdings and shareholder’s equity, earnings and earnings-per-share, along with potential disruptions to operational cash flow. Companies are required to provide the SEC with specific information regarding their operations and offerings of securities, along with quarterly and annual filings.

• Securities Exchange Commission

The SEC website allows for a full-text search of its Electronic Data Gathering Analysis and Retrieval system (EDGAR), which contains filings from the last four years. The full text of a filing includes all data in the filing as well as all attachments to the filing.

http://www.sec.gov/edgar/searchedgar/webusers.htm

• Investment Bank and Other Corporate Websites

Each publicly traded company will provide information about its financing, investments and operations on its website, usually in a link entitled investor relations.

In addition, investment banks, which have been negatively impacted on many levels by fallout in the ARS market, have produced reports or white papers on the topic. Most notably:

Goldman Sachs: http://www2.goldmansachs.com/

Morgan Stanley: http://www.morganstanley.com

• Financial Accounting Standards Board

The Financial Accounting Standards Board (FASB) is the designated private sector organization in the U.S. that establishes financial accounting and reporting standards. FASB standards are recognized as authoritative by the SEC and the American Institute of Certified Public Accountants. The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.

http://www.fasb.org/

Additional Sources

Articles

Magazine and newspaper articles are a great source of information on securities issues, especially on hot issues like the ARS market.

• Factiva

Factiva is a global news and business information service that combines the content sets of Dow Jones Interactive and Reuters Business Briefing.

• ABI/Inform-ProQuest

ABI/Inform-ProQuest provides citations to and full-text of articles in academic business, marketing, and management academic journals from 1971.

• Other

In addition, materials may be found directly at the following news sources:

The Economist: http://www.economist.com/

Financial Times: http://www.ft.com/home/us/

The New York Times: http://www.nytimes.com/

Wall Street Journal: http://www.wsj.com/

Book

Frank Fabozzi, The Handbook of Fixed Income Securities 263-64 (2005), available at http://tinyurl.com/3uugb6.

This comprehensive survey features contributions from leading business academics and practitioners. The revised and updated seventh edition gives finance professionals the facts and formulas they need to compete in today's transformed marketplace

Blog

SEClaw.com provides news, commentary and analysis on securities and derivative investment instruments; includes commentary on auction-rate securities.

http://www.seclaw.com/Welcome.shtml

Research Guides

For a more complete securities law research guide, see the HLS Law Library guide, at http://tinyurl.com/4x8oks.

Also, note that here the focus is on publicly traded companies. However, there are additional resources available for researching privately held companies; see, for example, the HBS Baker Library company guide, at http://tinyurl.com/3o9wtj.