SEC ‘Missed Opportunity’ to Save Auction-Rate Market Investors

  The U.S. Securities and Exchange Commission missed a chance to protect investors from the collapse of the $330 billion auction-rate market by failing to police how banks sold the bonds to customers. Federal regulators didn't stop brokers from selling the long-term securities to individuals as alternatives to cash late last year when credit markets seized up, though they knew dealers routinely propped up the bonds. The SEC ended a probe of bid-rigging in May 2006 by permitting 15 banks to take part in auctions as long as they disclosed it on the Internet. It was only after firms abandoned the market in February, leaving investors stranded with bonds they didn't want and borrowers with interest rates as high as 20 percent, that state and U.S. regulators tackled Wall Street's sales practices. In the past month, eight banks settled with officials, agreeing to pay more than $520 million in fines and promising to buy back more than $40 billion of the debt. "It's obvious they missed an opportunity,'' said Massachusetts Secretary of State William Galvin, who filed complaints against UBS AG, the biggest Swiss bank, and Merrill Lynch & Co., the third-largest brokerage firm, in June and July. "They could have raised a red flag.'' The collapse left investors who thought they were holding something similar to money-market funds with long-term securities they could only sell at losses of as much as 40 percent, according to data compiled by New York-based Restricted Stock Partners, which trades auction-rate bonds. Hearings Planned A total of 281 companies have also written down the value of $32.3 billion they hold by $2.1 billion, Pluris Valuation Advisors LLC, a New York-based firm that helps companies value hard-to-trade securities, said last month. The SEC, already under scrutiny by Congress for its handling of the credit crisis that led to the collapse of New York-based Bear Stearns Cos. in March, may face questions about its role in the auction-rate market. U.S. House Financial Services Committee Chairman Barney Frank, a Democrat from Massachusetts, will hold a hearing on Sept. 18 to examine regulators and firms. Christopher Cox, the 55-year-old SEC chairman appointed by President George W. Bush in 2005, declined to be interviewed. On Aug. 19, he told reporters the agency has more than a dozen pending investigations into the auction-rate market and that "nobody is getting a pass'' for misconduct. Increased Risk "The securities laws don't permit us to bring enforcement actions for violations that haven't yet occurred,'' Linda Thomsen, the SEC's enforcement chief, said. Banks used their capital to keep auctions from failing for years, she said. The risk of investors getting stuck with the securities "dramatically increased beginning in the latter part of 2007,'' Thomsen said, at which point "the firms were legally obligated to disclose the increased liquidity risks.'' Mary Schapiro, the chief executive officer of the Financial Industry Regulatory Authority, which monitors the sales practices at almost 5,000 brokerages, declined to be interviewed. The Washington-based group notified about 40 brokerages last month that it would start on-site inspections as part of an inquiry into the market, a person familiar with the matter said. Fines, Buybacks Citigroup Inc. and Goldman Sachs Group Inc., both based in New York, Zurich-based UBS and five more firms agreed to redeem bonds and preferred shares from individuals, nonprofit organizations and small businesses in their settlements. New York State Attorney General Andrew Cuomo and other regulators are targeting underwriters such as Bank of America Corp., and resellers including the brokerage arm of Boston-based Fidelity Investments. Bank of America, the second-largest U.S. bank, said Sept. 4 it's ready to settle on terms similar to previously announced agreements. Cuomo subpoenaed eight executives at the Charlotte, North Carolina-based bank, according to a person familiar with the matter. For more than 20 years, the securities allowed municipalities, student loan organizations and closed-end mutual funds to sell long-term bonds with interest rates that reset every week or month at auctions run by brokers. The market began deteriorating last year as losses tied to the subprime mortgage crisis raised concern among investors that MBIA Inc. and Ambac Financial Group Inc., the largest insurers of the securities, might lose their AAA ratings. 'Mobilize the Troops' Banks, facing writedowns and credit losses of their own, increased marketing of the bonds to individuals and continued to label the debt as cash equivalents while they faltered, state regulators allege. "The fact that auction-rate securities were misrepresented on an industry-wide basis for several years and that nothing was done to address the question until the market froze raises a question as to whether investor protection by the regulator is really effective,'' said Laurence Schultz, founding shareholder of Driggers, Schultz & Herbst in Troy, Michigan, and president of the Public Investors Arbitration Bar Association. UBS ratcheted up the effort to "move inventory'' even as it considered pulling out last year, Galvin alleged in a June 26 complaint. While executives identified auction-rate hazards in August, they began to "mobilize the troops'' to sell them, according to e-mails from David Shulman, the former head of UBS's municipal securities group, cited in Galvin's report. The bank held more than a dozen conference calls with salesmen and provided new marketing materials to promote the bonds, the report said. Executives Sell Galvin's complaint also showed that UBS executives, including Shulman, sold their personal holdings while the company promoted the products to investors. Shulman, who hasn't been accused of wrongdoing, was put on administrative leave in July and left the bank last month. Robert Anello, an attorney for Shulman, declined to comment. Merrill salesmen urged analysts to publish upbeat notes recommending clients buy auction-rate securities until days before the market collapsed, Galvin said in a separate complaint. New York-based American Express Co. sold the first of the securities in 1984, in a $350 million issue of money-market preferred shares with dividends reset every 49 days. At the time, the minimum purchase was $500,000, so buyers were mostly corporate treasurers, said Ronald Gallatin, the former Lehman Brothers Holdings Inc. managing director who invented the market, in an interview earlier this year. Lehman Settlement The SEC has been accusing banks of manipulation since 1995, when Lehman settled allegations that it improperly bid at some American Express auctions. The New York-based firm paid an $850,000 fine without admitting or denying wrongdoing after the SEC said it rigged bids 13 times and prevented two auctions from failing. In 2004, the SEC asked 25 firms to review their practices and provide reports "detailing any potentially deceptive, dishonest or unfair practices,'' according to a memo from the Bond Market Association, the Securities Industry Association and the American Bar Association. The probe ended two years later, with the SEC fining Citigroup, Goldman and the 13 other firms a total of $13 million. The banks settled claims they violated securities laws between January 2003 and June 2004 by letting customers change orders in the supposedly blind auctions. They also stepped in to bid for their own accounts to influence results, the SEC said. Banks created the illusion that the bonds were almost as liquid as cash, said Ken Lench, an SEC enforcement attorney at the time. Dealers weren't required to stop bidding at their auctions. Instead, they had to disclose their practices and ensure they stuck to them. None of the firms admitted or denied wrongdoing. Don't Dance Martha Haines, head of municipal finance at the SEC, suggested in a September 2006 speech that more steps were needed to bolster investor understanding and confidence. The industry, for instance, should have considered changing the products' names to better reflect their firms' involvement in setting rates, she said. "Do not dance around this issue: Describe what really happens flat out,'' Haines said in the speech. The SEC was engaged in efforts to increase the market's transparency as it faltered last year. It worked with the Municipal Securities Rulemaking Board on a plan to improve disclosure by reporting interest rates and prices. "There were lots of discussions,'' said Lynnette Hotchkiss, executive director of the MSRB, a self-regulatory organization based in Alexandria, Virginia that was created by Congress to oversee the municipal market. The SEC didn't improve sales practices fast enough to protect investors, said James Cox, a professor at Duke University who specializes in securities law. "In some areas the SEC remains in the clutches of the brokerage industry.''