Auction Rate Securities and Their Impact on Municipality Issuers
The news has been inundated with stories about the failure of auction rate securities (“ARS”) and the financial havoc they have caused to individual and institutional purchasers. Investors weren't the only ones hurt by the ARS debacle, however. The municipalities that issued these securities have been forced to pay default rates of interest—up to 10 points higher than expected—on debt that was presented to them as inexpensive, safe, and stable.
At its peak, the market for auction rate securities was approximately $330 billion. That all changed in February 2008 when auction rate securities fell prey to tightening credit markets. Investors failed to bid in the auctions, and the large investment banks declined to purchase the excess, as they had done in the past. This, in turn, caused the auctions to fail. Following their invention in 1984, the ARS market had experienced only 44 failed auctions. In contrast, hundreds of these auctions were failing daily in mid-February 2008.
The main problem for municipality issuers is that when auctions failed, the issuer is often subject to a “fail rate.” For example, The Port Authority of New York and New Jersey was forced to pay a fail rate of 20%, causing its weekly interest payments to jump from $83,600 to $389,000. The advice provided to the issuers stated that this would never happen. The underwriters touted the fact that none of their auctions had ever failed, and that the market for these securities was extremely liquid, robust and organic. They claimed these were “pure” markets established by arms-length transactions by independent purchasers.
In reality, the banks were usually the primary purchasers, providing the support needed to keep these auctions from failing.
An auction rate security is combined with a swap agreement. These swaps work by having one party (the issuer) pay a fixed rate, with the other party (the underwriter) paying variable rate that closely follows the ARS rates. When interest rates are high, the underwriter makes payments to the issuer. When rates are low, the issuer makes payments to the underwriters. The swap effectively allows the issuer to pay a fixed amount of interest on variable-interest debt.
The problem with swaps is that when the ARS market failed, the swaps were still in effect. Low interest rates meant that issuers were making payments on swaps that were no longer offset by lower ARS payments. The swap agreement effectively turned into a second penalty for the issuers of the failed auctions. Making matters worse, swaps typically have millions of dollars in termination fees attached. Refinancing the ARS generally invokes these fees, further increasing the financial burden of the failed auctions.
Maddox Hargett & Caruso, P.C. is focused on bringing cases on behalf of municipality issuers against broker/dealers (typically, major investment banks) that underwrote their auction rate securities. While litigation is feasible, our preferred action is to file for arbitration with the Financial Industry Regulatory Authority (FINRA). FINRA arbitration typically is scheduled within nine months after a demand has been filed. Not only are funds generally available sooner, but FINRA arbitration awards are final and binding on all parties. Rarely will a FINRA arbitration award be challenged in state or federal court.
Maddox Hargett & Caruso has extensive experience dealing with investment and securities litigation and arbitration. We have represented thousands of investors throughout the securities dispute resolution process. This includes FINRA arbitration proceedings, state and federal court proceedings, and, when appropriate, mediation. Our team of attorneys includes a former state securities commissioner, a former and a current Chairman of the National Arbitration and Mediation Committee of FINRA, former presidents and board members of the Public Investors Arbitration Bar Association, regular contributors to regional and national publications, and providers of legal interpretation for broadcast news, cable, and radio networks.
If you are an institutional or retail investor and were misled about auction rate securities, please contact us. You may have a viable claim for recovery of your investment losses.