Cos. Face Auction Rate Insecurities

As the epitaphs are written on the market for auction rate securities, corporate investors are left to struggle with how to clean up the mess they’ve created for their balance sheets and income statements.

Trading in auction rate securities lurched to a halt in February as credit worries deepened, making even the most common transactions seem toxic to buyers of any kind of credit-based instrument. Now corporate holders of an estimated one-third of the market’s $300 billion to $330 billion in illiquid auction rate securities must rethink how to classify and describe them in the financial statements.

Auction rate securities are highly rated, long-term debt instruments such as bonds or preferred stock that are traded as short-term liquid instruments through a “Dutch auction” process. Since the early 1980s, auctions have been held consistently where the securities are traded when the number of bidders equals the number of sellers, which establishes the interest rate.

Coopersmith

That all sounds great … until would-be buyers disappear and no auction can happen. The system first sputtered last summer when a few auctions failed; it konked out completely in February when auctions failed in far larger numbers. Buyers avoided any instrument supported by debt, so they quit bidding on ARS. The result: “Failure of auctions means the holders of investments are not able to cash in on their investments when they want,” says Jeff Coopersmith, a securities litigation lawyer with the firm DLA Piper.

Still, it doesn’t mean the holder is sitting on a worthless investment; the underlying debt instruments may still be sound. “It means the underlying securities are long-term securities,” Coopersmith says. “You may not be able to liquidate it for 30 or 40 years, but it’s still a long-term investment.”

Legal Cases Abound

Regulators and plaintiff lawyers are already swinging into motion. The Massachusetts attorney general’s office reached an agreement with UBS Securities last week in which UBS will repay $35 million to various Massachusetts municipalities and government agencies caught in the freeze. Attorney General Martha Coakley said her office is reviewing whether additional penalties might be warranted under the False Claims Act.

Meanwhile, the plaintiff lawyers are laying siege to UBS, with Merrill Lynch, Morgan Stanley, and Deutche Bank all in their sights as well. Merrill Lynch said in its most recent quarterly report that it plans to “vigorously defend itself in these actions.” The firm said it also has received requests for information “from various governmental agencies” regarding auction rate securities and failed auctions.

Campos

Former SEC Commissioner Roel Campos, now heading the Washington office of law firm Cooley Godward Kronish, says he doesn’t expect to see significant plaintiff victory in any legal actions. The SEC issued a cease-and-desist order in 2006 against a number of broker-dealers to clear up claims of bid rigging and flush out new disclosures, so “investors will have a hard time saying they didn’t understand the mechanics,” he contends.

Campos also notes that investors may have no liquidity, but that doesn’t mean they’re losing money. In fact, when auctions fail, the interest rate typically resets at a higher rate, meaning investors earn a higher return. (Conversely, those parties issuing auction rate securities get whacked with rates far higher than what they expected to pay.)

ARS ABUSES

Below is an excerpt from the complaint filed against Merrill Lynch for alleged improprieties in promoting auction rate securities.

During the Class Period, Merrill Materially Misrepresented the Liquidity of and Risks Associated With Auction Rate Securities and Omitted Material Facts About Its Role and the Auction Market

Auction rate securities were extremely profitable for Merrill and for the Merrill financial advisors who sold the securities. As a large underwriter of auction rate securities, Merrill received significant underwriting fees from the issuers of these securities. As one of the largest broker-dealers, Merrill also entered into broker-dealer agreements with the issuers and was paid an annualized broker-dealer fee for operating the auction process for more than auction rate securities. Merrill also acted as a principal for its own account, using its access to inside information about the auction process to buy and sell auction rate securities for its own account. Individual Merrill financial advisors had a significant financial incentive to sell auction rate securities, as they were compensated by Merrill for each auction rate security sold.

To perpetuate the auction market and sell as many auction rate securities as possible, Merrill represented to investors in its written materials and uniform sales presentations by financial advisors that auction rate securities were the same as cash and were highly liquid, safe investments for short-term investing. Pursuant to uniform sales materials and top-down management directives, Merrill financial advisors throughout the United States represented to current and potential Merrill clients that the auction rate securities sold by Merrill were equivalent to cash or money market funds and were safe, highly liquid short-term investment vehicles suitable for any investor with at least $25,000 of available cash and as little as one week in which to invest.

Merrill failed to disclose to purchasers of auction rate securities material facts about these securities. Merrill failed to disclose that these securities were not cash alternatives, like money market funds, and were instead, complex, long-term financial instruments with 30-year maturity dates, or longer. Merrill failed to disclose that the auction rate securities it was selling were only liquid at the time of sale because Merrill and other broker-dealers in the auction market were artificially supporting and manipulating the market to maintain the appearance of liquidity and stability. In fact, at all relevant times during the Class Period, the ability of holders of auction rate securities to liquidate their positions depended on the maintenance of an artificial auction market maintained by Merrill and the other broker-dealers. When Merrill and the other broker-dealers stopped artificially supporting and manipulating the auction market, the market immediately collapsed and the auction rate securities sold by Merrill became illiquid. Merrill also failed to disclose that the auction rate securities it was selling were not short-term investments, but rather long-term bonds or preferred stocks with maturities sometimes exceeding 30 years. Finally, Merrill failed to disclose that the short-term nature of the securities and the ability of investors to quickly convert their auction rate securities into cash depended entirely on the perpetuation of the artificial auction market being maintained by Merrill and the other broker-dealers.

Merrill also failed to disclose to purchasers of auction rate securities material facts about its role in the auctions and the auction market in which these securities were traded. Merrill failed to disclose that in connection with the sale of auction rate securities, Merrill simultaneously was acting on behalf of the issuer, who had an interest in paying the lowest possible interest rate, on behalf of the investor, who was seeking the highest possible return, and on its own behalf, to maximize the return to Merrill on its holdings of the auction rate securities. Merrill failed to disclose that it and other broker-dealers routinely intervened in auctions for their own benefit, to set rates and prevent all-hold auctions and failed auctions. Merrill failed to disclose that without this manipulation of the auction market, many auctions likely would have failed, as a result of which investors would have had the ability to determine the true risk and liquidity features of auction rate securities. Merrill continued to aggressively market auction rate securities after it had determined that it and other broker dealers were likely to withdraw their support for the periodic auctions and that a “freeze” of the market for auction rate securities would result.

During the Class Period, Merrill failed to disclose that the auctions it was conducting were not governed by arms-length transactions by instead suffered from systemic flaws and manipulative practices, including allowing customers to place open or market orders in auctions, intervening in auctions by bidding for Merrill’s proprietary account or asking customers to make or change orders, preventing failed auctions and all-hold auctions to set the market rate, submitting or changing orders after auction deadlines, not requiring customers to purchase partially filled irrevocable orders, providing certain customers with higher returns than the auction clearing rate, and providing inside information about the process to certain customers in connection with the auction bidding.

Source

Frederick Burton v. Merrill Lynch & Co., Inc. (March 25, 2008)

“Many of the instruments have not defaulted,” Campos says. “They’re just not liquid at the moment. Most of the commitments are being complied with, so you could argue investors are making more money. It becomes difficult to show damages with the way the situation has gone forward.”

On the Balance Sheet

While the lawyers and regulators proceed with the post-mortem, financial reporting executives must still determine how to account for auction rate securities. Accounting executives typically intended for the securities to hold a short-term, available-for-sale position in financial statements with incremental gains flowing through to earnings. Now that the instruments are largely illiquid, does that mean they’re impaired, requiring writedowns and losses against earnings?

Ueltschy

As with virtually anything accounting these days, there’s no straightforward answer. It requires careful analysis of the underlying securities, says Rick Ueltschy of accounting firm Crowe Chizek.

Many fingers have been pointed at Financial Accounting Standard No. 157, Fair Value Measurement, as a prime culprit, since it spells out how companies should determine the fair market value of an asset or liability. In reality, Ueltschy says, the standard has little to do with how illiquid ARS should be measured. FAS 157 defines how to measure fair value where it is required, but ARS have long been regarded as securities that should be booked at fair value.

Instead, the valuation conundrum with illiquid ARS is deciding when to describe a particular security as “impaired,” and whether to describe the impairment as temporary or longer-term. Those determinations affect whether a decline in value will nick the earnings numbers, Ueltschy says.

Coopersmith points out that FAS 115, Accounting for Certain Investments in Debt and Equity Securities, requires an investor to determine the probability of collection on a given security. If the impairment, or the likelihood of default, is “other than temporary,” the writedown flows through to earnings.

Nielsen

With any given auction rate securities encompassing any number of underlying securitized debts, an investor holding an illiquid ARS must first sort through the underlying debts and determine what’s likely to remain in good standing. “The challenge for people doing the financial reporting is understanding what seems to be driving that unrealized loss,” Ueltschy says. “Is it a leading indicator that the company may not get paid? It’s a matter of understanding the very precise cash flows in securitization structures that move toward the particular security you own. We have clients involved in those analyses every quarter.”

Jeff Nielsen, managing director at Navigant Consulting, says clients ask his firm to help make those determinations. “As a general statement, we haven’t seen a substantial degradation in the actual credit quality of the underlying collateral,” he says. “There’s no question the markets have seized up, but when you drill down to the underlying credit quality in many cases, the emperor really is wearing a suit.”

Robak

Espen Robak, president of Pluris Valuation Advisers, says the jitters over credit markets aren’t entirely to blame for the ARS freeze. Guidance from the Securities and Exchange Commission and from Big 4 audit firms told investors they couldn’t view ARS as equivalent to cash, so they became less popular as a cash management vehicle for corporate treasuries, he says. That contributed to the sell-off and dwindling number of buyers.

Robak says companies went on a selling spree in the latter half of 2007, shedding some $70 billion in ARS: “That’s an awful lot of paper to change hands in such a short period of time.”

Barry Silbert, CEO of Restricted Stock Partners, has thrown together a secondary market for holders of seized ARS to help unplug the dam on liquidity. Activity is slow so far, he says, as sellers come to a determination of how much of a discount they will accept for the liquidity trade-off. Different types of securities are getting different levels of discounts, depending on the nature of the underlying securities, he says.

Municipal ARS, for example, backed largely by municipal bonds, are seeing discounts of only 2 to 7 percent, Silbert says. Auction rate preferred (that is, those sold by closed-end funds) are showing discounts of 10 to 20 percent. Student-loan ARS are seeing discounts in the range of 25 percent, he adds.

Hardest hit are auction rates backed by collateralized debt obligations, which many times contain mortgages and even the dreaded sub-prime mortgages. Transactions are still nil, and the best offers are generally half the original value because the underlying debt is so difficult to analyze, Silbert says. “Those are the most toxic,” he says. “A lot of companies own some of this stuff.”

Bristol Myers Squibb demonstrated just how toxic ARS can be in its first-quarter report. The company showed it paid $807 million for the ARS it holds, but booked a fair value of $351 million. It took a $25 million charge to earnings in the first quarter and has identified another $39 million in securities that are temporarily impaired but may yet get charged to earnings in a future period. In the first quarter, the company shed only $4 million of its ARS holdings at par value.

Broker-dealers like UBS and Citibank, which helped prop up meager auctions by buying some of the securities themselves, are reporting predictably larger numbers. UBS said its first-quarter loss was $974 million. Citibank said it lost $1.5 billion by writing down its inventory of auction rates.