Massachusetts Secretary of State William Galvin is coming down on Merrill Lynch, one of the largest securities firms in the U.S., for not disclosing to its investors the volatility of the auction-rate market.

Galvin claims that Merrill sold auction-rate securities to investors, even though it was aware that the market was collapsing. Galvin asserts that Merrill profited by $90 million over the past two years because of its program to sell auction-rate securities.  

Merrill’s research analysts were censored from disclosing the high risk of the market, which failed in mid-February this year and left many investors with illiquid holdings.  Galvin’s complaint also claims that Merrill pressured and often evaluated its analysts based on how they projected positive messages about auction-rate securities.

Galvin filed a complaint against UBS AG in late June for similar deceptive actions by the bank to sell auction-rate securities as money-market funds.  

This is not the first time Merrill Lynch has been accused of using questionable research to attract buyers. In 2000, Merrill was found to have published misleading research that encouraged investors to invest in two Internet companies, Interliant Inc. and 24/7 Real Media Inc., both of which held shares that plummeted in value over the course of one to two years. The SEC accused Merrill, along with nine other firms, in 2002 with using biased research to attract investors, which resulted in a $1.4 billion settlement.

The claim against Merrill Lynch urges the firm to compensate its investors for their investment losses and potentially pay a fine.  However, investors generally do not see any recovery from regulator actions.  The best (and often only) way for investors to seek redress is through an individual arbitration action.

Imagine, after the market collapsed you were forced to sell your auction-rate securities at a significant discount, even though you were advised beforehand that these securities were as safe as money-market funds. Then, at your arbitration hearing, one of the three panel members charged with deciding your case is an employee of another firm that also sold auction-rate securities. Do you expect you will receive a fair and unbiased hearing?  

That is the question posed by Jane Bryant Quinn in her commentary on today’s Bloomberg.com.

According to Ms. Quinn, the recent arbitration claims regarding auction-rate securities illustrate how the odds are stacked against investors in the securities-industry arbitration.

All claims exceeding $50,000 require that the panel of decision makers includes two public members and one industry representative. The industry rep often acts as the “talking head” for Wall Street. Their job is to explain the industry’s point of view to the others, but of course will likely be favoring the exact practices you are there to protest. To make matters worse, as a “specialist”, their opinion is considered superior and their input may be given greater weight.  

The industry and FINRA have always rejected investor lawyers’ wishes to rid the system of the industry position. However, last year when the Arbitration Fairness Act emerged in congress (containing a clause requiring all public members on panels) FINRA hedged their position, slightly. Just last week, FINRA announced a two-year pilot project that allows as many as 420 cases to be heard by the proposed all-public panel.

Many lawyers embraced the plan as a trivial, small step to fairness. But this path to fairness was interrupted by FINRA after the Public Investors Arbitration Bar Association (PIABA) asked that potential panelists who had worked for firms that originated or sold auction-rate securities be excluded from hearings on auction-rate cases. FINRA shot down the idea and decided arbitrators are merely required to disclose if they worked for firms that sold auction-rate securities, sold them themselves or supervised anyone who did after January 1, 2005. The decision to select those arbitrators will then be left in the lawyers’ hands.  

Though it sounds like a fair proposal, the decision has lawyers irritated. “The steam is coming out of my ears,” said Phillip Aidikoff of Aidikoff, Uhl & Bakhtiari. “Where are the people who speak for individual investors?” 

Panels are chosen by both sides of the case, and then ultimately named by FINRA. Each party gets three lists of eight names, randomly picked by a computer from the arbitrator pool (one list for the industry panel and two lists for the public members). Each side is permitted to strike up to four names for whatever reason they want, and rank the remaining four. Then FINRA chooses the arbitrators most acceptable for both parties.  Since the arbitrators involved with auction-rate securities are still in the panelists pool, it forces the lawyers to use up their challenges to get rid of them. These challenges may have been used for reasons such as ridding of someone whose awards consistently disfavor of the industry, or challenged for cause – meaning direct and definite bias or interest.

If you have an auction-rate case against a large brokerage firm and get an industry panelist from a different large firm, how can they award the investor damages when his company is up against the same charges? That question has yet to be answered by FINRA.

UBS AG is facing charges for promoting auction-rate securities as conservative, money-market funds at a time when the auction-rate market was plummeting.

New York Attorney General Andrew Cuomo alleges that UBS is responsible for repurchasing $25 billion in auction-rate securities from its investors rather than the mere $3.5 billion it is currently offering to buy back, according to a July 24, Bloomberg.com article.  Although UBS claims it has not committed any illegal activity and does not have a deceptive, nationwide campaign to reduce their $11 billion auction-rate debt, it acknowledges that some of its individual employees are being evaluated for disciplinary action.

This case highlights the ongoing problems brokers and investors are encountering with auction-rate securities. Many investors had bought auction-rate securities with the understanding that they were holding safe, liquid investments, only to see the market collapse in February and leave them with substantial losses.

Other state regulators are also investigating the offers and sales of auction-rate securities. Massachusetts Secretary of State William Galvin is investigating UBS, Bank of America, and Merrill Lynch. In addition, the SEC and FINRA are cracking down on banks that are being suspected of advertising auction-rate securities as liquid funds to investors.

A team of investigators inspected Wachovia Corp.’s securities division Thursday as part of an ongoing investigation into the company’s sales of auction-rate securities. Regulators from more than five states searched the St. Louis headquarters to uncover information about sales practices, internal evaluations of the auction-rate securities market and marketing strategies. Wachovia executives and agents were issued over a dozen subpoenas. 

Wachovia was warned Wednesday about the raid because the company had not “fully complied with the Missouri probe,” Missouri Secretary of State Robin Carnahan said.  This search is another strike for Wachovia, which ousted CEO Kennedy Thompson in June after a $708 million first-quarter loss.  

It looks like the bank will encounter even more setbacks.  According to a June 17, Bloomberg.com article, Wachovia is expected to record a loss of at least $2.6 billion for the second quarter. 

In May, Wachovia reported it had received inquiries and subpoenas from the SEC and state regulators concerning underwriting and sales of auction rate securities, and that it expected “further review and inquiry.” 

Wachovia clients have filed more than 70 formal complaints to the state since February, totaling over $40 million in frozen assets. Hundreds of Missouri investors have called the Secretary of State’s office because of inability to access money needed to run their business make medical payments or pay tuition.  

Over $218 billion of auction-rate bonds sold by student-loan providers, municipalities and closed-end mutual funds remain frozen since firms quit roles of last minute buyers in February.

Investors continue to have a difficult time retrieving money they have invested in student loan auction-rate bonds. These securities, originally perceived by millions of investors as safe, money-market funds, have turned out to be highly illiquid and have forced investors to sell them at a loss.

UBS AG and Citigroup are among the firms who have been accused of seriously underwriting these securities. 

A July 10th Bloomberg article noted that Pluris Valuation Advisors LLC discovered that that about two-thirds of companies responsible for valuing student-loan auction rate securities have written down the debt, some as much as 35%.

The consequences of the failing auction-rate securities market have fallen most heavily upon bonds backed by federally guaranteed loans, where many lenders have been forced to lay off employees or reduce the amount of loans they issue to clients. Student Financial Aid organizations are scrambling to find solutions to raise more money and refinance the debt.  

Although some student loan issuers such as Sallie Mae are attempting to slowly regain some of its losses, retirees who heavily invested in student loan auction-rate bonds see almost no signs of hope of the market recovering and unable to access their money.

After a 10-month investigation, the Securities and Exchange Commission (SEC) found that some of the most prominent credit-rating firms such as Moody’s Corp., McGraw-Hill Cos.’ Standard & Poor’s unit, and Fimalac SA’s Fitch Ratings have been giving low-quality ratings and following poor procedures when analyzing subprime mortgage debt. With such inflated ratings, the credit-rating firms were able to collect higher fees from clients.  

According to the SEC, analysts from these firms have downplayed the amount of risk of certain deals, ignored conflicts of interest, or knowingly gave low-quality ratings to collateralized-debt obligations. One rating firm even gave lower loss expectations than it should have on subprime second-lien mortgages, which are particularly risky mortgages that have incurred large losses.  

The SEC also noted that it could file lawsuits against any rating firm if it has violated antifraud laws. So far, Standard & Poor and Moody’s Corp. have made efforts to improve their rating models, and Fitch denies that the SEC has found any problems with their firm’s analytical processes.

The SEC plans to continue examining several other rating firms in the near future. Unless rating firms make better quality ratings a higher priority than profits, the market could lose confidence about their securities, which are based on these ratings. 

America’s baby boomers are increasingly becoming targets for investment brokers who put their hard-earned “nesteggs” at risk.  

Many examples are emerging where retirees are losing significant funds from their pensions and 401(k) accounts because they are seduced into turning them over into high-fee investments that promise high returns. Studies show that as much as 69% of pre-retirees miscalculate how much money they can annually withdraw from their retirement accounts, which gives rogue brokers the opportunity to take advantage of these investors in order to generate more commissions. 

Brokers and brokerage firms gain access to groups of workers who are close to retirement through free seminars and advisory services offered through the workers’ employers. These presentations have the potential to be misleading for workers who have limited knowledge or experience investing money. Studies show that 10% of these so-called seminars have explicitly offered fraudulent advice and given unrealistic guarantees on high rates of return. 

In January, a group of Kodak and Xerox retirees from Rochester, NY, filed a class-action lawsuit against two of Morgan Stanley’s top brokers, Michael Kazacos and David Isabella, and branch manager Ira Miller. These Kodak and Xerox employees were advised to withdraw 10% from their portfolios annually with the promise that they would still have plenty of money leftover, perhaps millions, in their accounts.

Many other investment brokers in Rochester lost clients to Kazacos because they were capping the amount in which the employees could withdraw from their funds at 4%.  However, at 10%, many of these workers almost depleted their long-saved retirement funds. Some of these retirees are being forced to return to work again. Kazacos, Isabella, and Miller could face disciplinary actions for breach of fiduciary duties and using deceptive sales tactics.  

Morgan Stanley’s policy is to cooperate with the investigation and claims that many of the clients’ losses were caused by the market downturn of 2000-02 and other excessive withdraws from the clients. Investor attorneys have filed a number of arbitration claims on behalf of Kodak and Xerox employees.  

InterSecurities, a financial firm in St. Petersburg, FL, gave similar explanations to why some of its investors lost money from their retirement funds. Two of InterSecurities’ brokers were accused of promising a 13% return on investments made by a group of Kansas City Southern employees. These brokers earned a high commission of 7.25% for each investment sale.

Likewise, in 2006, 32 former ExxonMobil employees won $13.8 million in an arbitration case against Securities America because one of its top brokers told the employees that they would receive 18% return and still withdraw sums of money equal to their salaries. Since then, Securities America has greatly improved its oversight and policies.  

Investors should be on the lookout for brokers who recommend they withdraw money from their retirement plans in order to make other investments.  Oftentimes the only one who wins under these circumstances are the brokers themselves.

In a lawsuit filed yesterday by Massachusetts Secretary of State William Galvin, the head of UBS AG’s municipal securities group David Shulman is alleged to have exchanged emails with UBS executives that discussed how the bank should promote its failing auction-rate bonds as money market securities.  UBS attempted to shift its burden of $11 billion in auction-rate bonds by selling them to investors.

The emails also indicate that UBS almost pulled out completely from the auction rate market nine months ago, but instead bought out bonds in order to prevent the auctions it managed from failing. These emails came after the fact that UBS executives recognized the high risk of auction-rate securities in August. Despite these warning signs, the emails indicated that UBS faced pressure to free up capital because it had an overload ($10 billion) of auction-rate holdings. 

Galvin holds UBS responsible for committing fraud for not informing investors that the auction-rate market was collapsing. Galvin also plans to have UBS liquidate its auction-rate bonds, which adds up to $190 million, so investors can get their money back.   

Last year, the popularity of auction-rate bonds decreased significantly for securities firms (who are typically the buyers) in the auction-rate market because the bonds were reclassified as long-term investments rather than money-market instruments. Many investors are now left with bonds that will not sell and are having to pay high penalty rates. 

Investors harmed by the current auction-rate market meltdown accuse Wall Street of hiding the recognized risks of the securities from them. According to a June 26, Bloomberg article, some investors are even comparing this crisis to the dot-com scandal involving former Merrill Lynch analyst Henry Blodget.

Many wonder why brokers did not see the impending catastrophe for the market. But, according to recent reports they actually were aware.   

To date, at least 24 proposed class action lawsuits have been filed against brokerages. A nine-state task force is also investigating how these firms went about marketing the securities to clients. Among the task force is Massachusetts, which charged UBS Thursday with fraud for its sale of auction-rate securities to investors in the state. They claim UBS told clients their investments were “safe, liquid cash equivalents”, when they had knowledge this was completely not the case.  

One investor claims her broker at UBS recommended investing in auction-rate securities last December. At the same time UBS is reported to having told an issuer of these securities that the $330 billion market was in danger of collapsing. Shortly thereafter, dealers who underwrote and managed the market for over 20 years were forced to stop buying as last resorts due to the escalating mortgage losses in February.  

Over the past two decades, auction-rate bonds have allowed local governments, hospitals and universities to borrow money for the long term at cheap, short-term rates because they would resell the debt at upcoming auctions every seven, 28 or 35 days.  Once banks were no longer the “last minute buyers”, rates skyrocketed as high as 20 percent because failed auctions brought a penalty rate for issuers. In many cases, this penalty rate was set recently due to banks recognizing a decrease in demand. 

As light continues to shine on the problems associated with the auction-rate collapse, it becomes clearer every day that some on Wall Street were well aware of the potential issues with these products before the auctions themselves started to fail.    

Securities and Exchange Commission (SEC) Chief Christopher Cox is facing criticism for his lack of involvement in handling Bear Stearns’ financial crisis. The failure of Bear Stearns and alleged neglect from Cox has stimulated debate over who should be in charge of Wall Street, the SEC or the Fed.

Treasury secretary Henry Paulson suggested broadening the Fed’s responsibilities to include overseeing investment banks. 

Bear Stearns began having problems last July when two large hedge funds collapsed due to securities tied to subprime mortgages. The firm incurred $1 billion in write-downs by December. Some critics argue that Cox and the SEC should have pressured Bear Stearns to raise capital and increase the confidence in their investors.  

Cox was said to have been absent during crucial conferences with the Fed and the Treasury, who negotiated a bailout plan for Bear Stearns. One such call discussed J.P. Morgan Chase & Co. granting a loan to Bear Stearns, and the other meeting discussed J.P. Morgan potentially buying out Bear Stearns and the Fed’s role in lending money to investment banks.  

Many of Cox’s predecessors, such as Richard Breeden and Harvey Pitt, were seen as more proactive in taking charge over the securities market during times of financial turmoil.

According to reports, Mr. Cox claimed that the SEC acted appropriately during the Treasury and Fed bailout negotiations because the SEC’s responsibility was to regulate the industry—not arrange its deals.

Cox has encouraged constructive debate over the issue of shifting authority to the Fed, but his stance is primarily passive, saying that the outcome is up to lawmakers in Congress and not the SEC. He also says that if the Fed continues to loan money to investment banks, it will inevitably play a larger role in Wall Street.