Securites Hot Spots

Auction Rate Securities

Auction Rate Securities (ARS) are bonds (corporate or government-issues) and preferred stocks whose interest rates or dividend yields are set periodically through auctions that take place at various intervals. Such intervals may be daily or every 7, 28, or 35 days.

ARS were sold by the broker-dealers as “cash equivalents” and an alternative to traditional money market funds for investors seeking a combination of high credit quality, principal protection, the potential for a higher return over similar cash alternatives, and, in some cases, tax exempt income.

The inherent risk of the ARS, which made them materially different from money market funds, was evident to auditors as far back as early 2005, when the largest accounting firms in the U.S. changed the accounting treatment of ARS from cash equivalents to short-term securities. This change in accounting treatment significantly reduced the cash positions in corporate balance sheets, which prompted institutional investors to cut back on, and eventually stop, investing in the ARS.

In February 2008, auctions for the ARS began to fail when investors declined to
bid on the securities. The four largest investment banks that made a market in ARS (Citigroup, UBS AG, Morgan Stanley and Merrill Lynch) declined to act as bidders of last resort, as they had done in the past. The decision of these firms to remove themselves from the ARS market was the result of the credit market crisis, combined with their need to protect their own capital, putting their own financial interests ahead of the interests of their clients. Despite the decline in the demand for ARS, Respondents continued to market the securities as cash alternatives. The illiquidity of the ARS has prevented many investors from investing their “cash equivalents “ thereby created loss of opportunity and loss of income.

What are investors doing? Some investors have decided to wait out the storm and some have decided to sell or borrow against their ARS. Obviously, the biggest advantage of waiting would occur if the ASR’s are redeemed or refinanced, in whole, in the near future. This would give the investor liquidity and would remove the uncertainties related to the current frozen market at no loss to the investor. Waiting would allow the investor to avoid realizing an immediate loss on his or her ARS holdings. However, there may be little incentive for the ARS issuers to redeem their bonds or for anyone else to buy them in a secondary market, which may cause ARS purchasers to have to wait for a long time to get their principal back. This can cause significant damage to those investors who need the liquidity to make their house payments, pay for educational expenses of children, etc.

Some investors are choosing to sell their ARS positions. Investors must face the reality that they will most likely not receive face value if they decide to sell their ARS, if they can find a buyer. However, if the investor is contemplating legal action, selling fixes the investor's damages and weakens arguments by the firms that the investor did not attempt to mitigate his damages. Additionally, if the investor is hiring an attorney on a contingent fee basis, the investor will likely end up paying a smaller contingent fee (based upon actual losses) if the claim is successful.

However, most people do not want to sell and fix the loss. Some investors may consider a claim for recission— the cancellation of the contract and the return of the parties to the positions they would have had if the contract had not been made. Legal fees for recission claims could be handled on a contingent fee, hourly rate or a combination therof.

Please contact us if you feel you have suffered losses as a result of a frozen ARS.

Variable Annuities

A variable annuity is an insurance product that is subject to regulation under state insurance laws and the securities laws. They are generally a hybrid type of mutual fund with the following additional features (1) tax deferred treatment of earnings; (2) a death benefit and (3) annuity payout options that can provide guaranteed income for life. Sale of variable annuities has exploded over the past few years, primarily because it pays the broker a very high commission. However, the recommendation of variable annuities is subject to suitability guidelines. The investment representative must review the customer’s investment objectives, risk tolerance and other information to determine that the variable annuity as a whole and the underlying sub-accounts recommended are suitable. In addition, the representative should discuss with the customer market risk, liquidity issues, such as the surrender charges and IRS penalties, and fees, including mortality and expense charges. Many times, the broker is so anxious to get his commission that he neglects to adequately inform the customer as to the financial realities of a variable annuity.

If you have been damaged as a result of purchasing a variable annuity without your best interests being considered by the broker, please contact us.