Thursday, August 20, 2009

Auction Rate Securities (what are they?): Charles Schwab and David Markowitz

Busy week. David Markowtiz, attorney under NYAG Cuomo’s Investor Protection Bureau, filed a complaint against brokerage firm Charles Schwab on Monday. The complaint contained four causes of action as regards auction rate securities (“ARS”): alleging fraud, misrepresentation, and deception under various state laws, including the Martin Act. Among the relief sought is a Schwab buy-back at par value of all the auction rate securities it sold. The complaint was not a surprise for a number of reasons. We are all familiar with the auction failures in 2008, and the subsequent series of bank buy-backs at par value. Specifically as regards Schwab, Cuomo signaled last month his intent to file the allegations. Schwab's counsel Faith Gay at Quinn Emanuel responded then with a letter accusing the NYAG of abusing its prosecutorial discretion. It was only natural then, that this Monday’s complaint would be filed in tandem to Quinn’s public disclosure of its July letter. Too, just yesterday Mr. Charles Schwab himself wrote an op-ed for the WSJ arguing the NYAG Office’s litigation effectively spells the end of the open market.

So what are auction rate securities, who are the parties involved, and what are the various arguments for and against the NYAG’s most recent foray into market conquest.

In broad-broad strokes, what are ARS?
ARS are either debt bonds or perpetual equity instruments. Both pay variable interest rates to the holders. The interest rates are determined as the securities are bought and sold at a “Dutch auction.” Buyers at a Dutch auction place bids for ARS, specifying both the number of securities they want and the minimum interest rate they are willing to accept for that security. The lowest interest rate proposed among the bidders becomes a “clearing rate,” establishing the variable interest rate the ARS pays to holders until the next Dutch auction. Auctions are held at variable time periods, ranging anywhere between seven to thirty-five days apart.

If however, there are not enough buyers participating in a Dutch auction, the auction “fails” and no securities are bought or sold. The rate paid on the securities then is called a “fail rate” (different from the variable interest rate, and established among the terms in the origination paperwork). This failure creates the liquidity concern that is the focus of the NYAG Office's complaint. Effectively, buyers are incapacitated from selling their securities; they’re forced to hold the security for the term of the debt bond, or in perpetuity in the case of the equity instrument.

NYAG’s Markowitz’s arguments in the complaint
The complaint is like a pitbull on the matter of liquidity; every allegation and factual assertion is premised on it. Markowtiz argues, inter alia, that Schwab and its management held themselves out as a trusted financial advisor, and therefore negligently and recklessly: failed to understand the ARS market, failed to properly train and inform its sales force of the same, and failed to properly communicate the liquidity risks and product consequences to its clients. Markowitz alleges Schwab distributed ARS underwritten and managed by banks, and was then compensated for those successful sales. Further, these transactions passed through New York trading desks and via New York auctions.

Faith Gay’s arguments in Schwab’s retort letter
Gay’s arguments are many-fold. First, Schwab maintains that it did not underwrite any ARS, and therefore did not make or break any commitment to support the ARS market. Schwab maintains it did not actively market ARS to its customers, but rather, made ARS available to its customers upon request. Schwab employees who completed consumer requested ARS transactions were not in fact compensated specifically for doing so. Further, Schwab did not buy any ARS for its own account or inventory. Schwab also maintains it did not enter any support bids in the ARS market (bids which have largely been credited as the artificial liquidity of the market, and its eventual collapse last February).

Gay also criticizes the NYAG’s office for a number of the state law grounds they use, and the façade of litigation for a goal that has long been predetermined (force Schwab to buy-back the securities at par value).

A large portion of Gay’s arguments, however, relies on an unclear distinction between "upstream" (underwriter banks such as Citigroup) and "downstream" (brokers such as Schwab) actors. The gist: the upstream actors “created, sustained, and [then] abandoned” the ARS market; Schwab is as much a victim of this as are the individual consumers who now hold securities indefinitely. Problematic in this regard is the recent buy-back at par by downstream actors such as TD Ameritrade and Fidelity Investments.

This post has grown long – please excuse! – I will write more numerous, but shorter posts as the matter develops in the coming weeks. Thanks – Sls.

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