Auction Rate Securities:"Liquid Assets" That You Can't Sell
In her March 30 “Fair Game” column in the New York Times Business Section, veteran reporter and columnist Gretchen Morgenson reviewed the latest developments in the plight of thousands of individual investors stuck with auction-rate securities that their brokers had told them were “as good as cash.”
As we now know, auction-rate securities are debt obligations of an issuer – usually a municipality, non-profit or closed end mutual fund – whose interest rates are set at regular auctions, typically held every seven to thirty five days. With the gridlock in $330 billion auction-rate securities market, investors cannot get out of these investments while the auctions continue to fail. They have limited choices: They can hope that the issuers of the auction-rate securities offer to buy them back, they can hope to sell them in the secondary market, they can hope the market unfreezes or they can sue the brokers who sold them the securities, often with a promise that they could be cashed in weekly.
Investors in auction rate securities issued by municipalities or non-profits are probably best positioned. Most such auction rate securities provide for much higher default rates when auctions fail. Accordingly, the issuers have strong incentives to seek refinancing to redeem their auction rate securities. Already various such issuers have announced their intent to refinance.
Closed-end mutual funds have issued $65 billion worth of auction rate preferred shares. In many ways, investors in these instruments are in worse shape than those who invested in municipal auction-rate securities. A conflict of interest exists in closed end funds between the interests of the preferred shareholders and those of the common stockholders. Because of the leverage involved, the issuance of auction rate preferred shares increases the yield to the common stockholders. Thus, while the preferred shareholders want the issuer to buy back their shares, doing so would deprive the common shareholders of the extra “juice” in the yield. To date, only a few closed-end fund sponsors, including Nuveen Investments and Eaton Vance, have announced plans to help investors in preferred shares to cash out. Additionally, while interest rates do rise to the penalty rates when an auction fails, these rates are far lower than those on many municipal auction-rate securities.
The preferred investors mostly wanted a place to stash their short-term cash and not an investment for life. Many of this group are relatively small investors who got into the preferred shares when the minimums fell from $100,000 to $25,000.
Investors in auction rate securities almost certainly relied on their brokers’ assurances that these securities were safe, sound, and liquid. The brokerage firms, however, earned more commission by selling these securities than if the investors had put their cash into money market funds. If the auctions keep failing and the issuers refuse to buy out the investors, the brokerage firms who sold these cash equivalents are in for a “blitz of litigation.”
If you own any of these auction-rate securities, you must monitor the situation and be prepared to protect your interests.
Page Perry, LLC is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in counseling institutional and individual investors regarding their auction-rate investment problems. For further information, please contact us.
