Mirror, Mirror On the Wall… Who’s the Culprit For My Financial Fall?

As an investor advocate, I’m always on the lookout for easy-to-understand materials that can readily explain why investors should be wary of stockbrokers, insurance salesmen, and other peddlers of financial products that are supposedly a “sure thing” or “totally risk free.”  One of the best legal documents on this subject is the fraud complaint Massachusetts’ securities head William Galvin filed against Merrill Lynch in connection with the sale of auction rate securities.  The document is rich in detail about how Merrill Lynch always put its interests ahead of its customers.

Neil Weinberg, a senior editor at Forbes and one of the most knowledgeable personal finance journalists in the business, earlier this month published a feature that decidedly is one of the most insightful articles I’ve read about Wall Street in recent memory. Weinberg candidly warns his readers that the markets are a “rigged game” and provides a litany of evidence showing how investors are constantly being duped and deceived.  Among his examples: Nearly three quarters of the tax-deferred annuities sold in the first quarter were placed in IRA and other retirement accounts.  Annuities are great products for insurance brokers because they carry whopping commissions; but for investors, they are pricey and “dim-witted” (Weinberg’s words) for a retirement account.

Weinberg also quite possibly is the only mainstream financial journalist to appreciate the significance as to why Wall Street and the insurance industry fought so aggressively — and ultimately successfully — to eliminate a passage in the recent financial reform bill that would have held brokers and insurance salesmen as fiduciaries. Under this standard, brokers and insurance salesmen could be held liable for selling products that were not in the best financial interests of their clients. The upshot: bye, bye, 8 percent commissions for dubious annuities products. But Congress once again opted to put Wall Street’s interests ahead of investors.

Fortunately, there are signs that individual investors are getting wise to Wall Street’s shenanigans.  Merrill, Morgan Stanley, and Smith Barney last year controlled 25 percent of the industry assets under management in 2009, down from 32 percent in 2007, according to Cerulli Associates statistics cited in Bloomberg Businessweek.  Independent advisers and regional broker-dealers have increased their percentage of assets to 32 percent from 28 percent in 2007. That’s a comforting trend.

Merrill, now part of Bank of America, and Wells Fargo, the third-largest full-service U.S. brokerage, apparently are racking up some nice profits cross-selling banking services.  It might behoove investors to be wary of this cross-selling as big banks can no longer claim they adhere to a higher moral standard than brokerage firms.  A District Judge recently accused Wells Fargo of “gouging and profiteering” for changing its policies to process checks, debit card transactions and bill payments from the highest dollar amount to the lowest, rather than in the order the transactions took place. This, in turn, caused customer accounts to be overdrawn, thereby allowing Wells Fargo to pocket additional overdraft fees.  California also charged Wells Fargo with fraud for its aggressive sale of auction rate securities.

The warnings signs are as clear as day. As Weinberg pointedly tells readers: “Wall Street gets rich while you eke by. If you are looking for a culprit, look in the mirror.”

UBS Gets Hit Again

An arbitration panel ordered UBS to pay a small business in Maryland ten times the amount it lost as a result of its auction rate securities (ARS) holdings. The assets were frozen when Wall Street stopped supporting the ARS market and overnight investors who were told ARS’s were “cash equivalent,” found themselves without liquidity, or “oxygen” as the owner of the Maryland business described it.

As I stated in today’s Wall Street Journal, “This case sends a shot across the bow for Wall Street firms that if they violate securities laws, they can be held liable for consequential damages.”

The Maryland business asserted that because of UBS’ dubious sales practices, their business suffered significant damages. The business went from having 60 employees to 15 because of a lack of cash. Attempting to add insult to injury, UBS tried to argue that the business failed because of its management and not a lack of cash, but an arbitration panel didn’t buy it.

You may remember that David Aufhauser, UBS’s general counsel, was banned from the industry last year and ordered to pay a penalty to settle insider trading charges after he dumped his ARS holdings. He was the recipient of an internal company email warning of risk in the ARS market. Obviously, the Maryland business in this case and hundreds of other UBS customers weren’t afforded that same alert.

This is yet another example of UBS putting its own interest ahead of its customers. Fortunately, an arbitration panel made UBS pay dearly.

The “Sophisticated” Regulators at the Sec and FINRA

The Wall Street Journal ran an impressive page one story over the weekend about how the auction rate securities debacle is hurting the economic recovery.  Some 400 companies are holding more than $20 billion in securities that can’t be unloaded or are worth dramatically less in value. These companies claim they would use this money to bolster their businesses if it were liquid.

Unlike individual investors who regulators forced Wall Street to make whole, companies who bought auction rate securities pretty much have to fend for themselves. Under the terms of regulatory settlements last year, securities firms who sold auction rate securities to corporations only have to make “best efforts” to make these companies whole because corporate treasurers are supposedly “sophisticated” and understood risks relating to auction rate securities.  “Best efforts” is a nebulous term that in practicality means “as little as possible.”

At the end of the day, the auction rate securities market was rigged and its beyond me how or why corporate treasurers should have been wise to the wrongdoing.  Moreover,  if corporate treasurers should have known about the wrongdoing, why is it that the SEC and FINRA weren’t on to the scheme, particularly as the SEC launched an action against some 15 Wall Street firms in 2006 for rigging the auction rate securities market (link to settlement announcement).

Regulators were wrong to exempt institutional investors from the auction rate securities settlements.  Admittedly, redeeming $20 billion in securities would be a prohibitive undertaking. But Wall Street made the auction securities mess.  They should be forced to clean it up - all of it.

Suit Says Schwab Misled Investors

The Perils Of Peddling Faulty Microwave Ovens

Retail investors historically have had very short memories. I’d crash your computer if I recounted all the scams and cons I’ve seen in the three decades I’ve represented individual investors, yet somehow Wall Street’s systemic fraud and dishonesty never seems to lead to a shortage of customers. Even the dot.com fraudulent research scam didn’t lead to a massive client exodus.

But Wall Street might have exploited its customers one time too many. According to a survey by Prince & Associates, a whopping 81% of investors with $1 million or more of investible assets plan to change investment advisers. An even larger number, 86%, plan to tell other investors to avoid their adviser. A mere 2% of investors plan to recommend their broker to other investors. So much for those client referrals…

Admittedly, not all “investment advisers” are brokers at the big Wall Street firms, but “wealth management” has been one of their major focus areas these past few years. And $1 million in investible assets wouldn’t even get you a meeting with the receptionist at the top-tier multifamily offices.

I suspect one of the tipping points might have been the marketing of auction rate securities, which Wall Street sold as cash equivalents but were in fact quite risky. Amazingly, these securities were aggressively sold to Wall Street’s most wealthy - and profitable — customers. Brokers were under considerable pressure to move those microwave ovens.

One of the few growth businesses in the months ahead will be conflict free multifamily offices with established and unblemished track records serving the interests of their clients. Indeed, marketing tools multifamily offices might want to consider are the state attorney general ARS complaints against the big brokerage firms, such as Massachusetts’ARS lawsuit against Merrill Lynch. These easy-to-understand complaints unquestionably offer some of the most impressive insight into the conflicted workings of Wall Street ever written.

Auction Rate Securities Hearing in Washington: Wall Street’s Comeuppance?

Today, House Financial Services Committee Chairman Barney Frank, Chairman Spencer Bachus and Ranking Member Paul Kanjorski will hold a hearing to examine the continuing crisis in the markets for auction rate securities and auction rate bonds. The witness list will be comprised of regulators, investment-service providers, dealers and issuers of auction rate securities. Specifically, the hearing cover potential solutions to the auction rate securities market, which continue to be frozen. 

Originally only large institutional investors bought auction rate securities.  But following a 2005 SEC advisory clarifying the way corporations could account for auction rate securities forcing them to stop including them as cash on the balance sheet, Wall Street targeted retail investors. The pitch, as we all know, is that they were an alternative to money market funds.

According to most reports, over 160 arbitration claims related to auction rate securities have been filed since March 2008 including many by Zamansky & Associates.  Four enforcement actions arising from auction rate securities investigations have been lined up for hearing. Credit Suisse is the latest financial institution to settle an auction rate probe, agreeing to buy back the securities from individuals, charities and small businesses with accounts valued up to $10 million.

But despite the fact that several major banks have agreed to repurchase auction rate securities from the retail investors, investors still hold billions of dollars worth of auction rate securities.  Moreover, investors that are included in auction rate securities buybacks will not be compensated for their significant consequential damages unless they file securities arbitration claims to recover these damages.

I’m quite sure the committee understands the scope of this issue. But just in case, they should read a recent Legal Times article: “The auction rate securities debacle is the largest bond market failure in U.S. history. Although the buyback agreements represent real progress, any suggestion that auction rate securities holders no longer have enough at stake to merit their continued representation by counsel would be misguided.”

Chairman Frank has shown himself to be a results driven regulator.  He urged that issuers of auction rate securities be permitted to bid in auctions for their own securities, and demanded fast action on pending requests from mutual funds seeking clearance to issue new auction rate securities.  

Still, here are some questions I hope he will address at the hearing:

• Why did the SEC allow the auction rate securities market to continue business as usual after investigators found impropriety in 2006?

• What training did retail brokers have before they were told to sell auction rate securities to investors?

• Given that many Wall Street managers bought auction rate securities themselves, did any of them sell their auction rate securities knowing that the market was soon to collapse?  If so, how will they be punished?

• Wall Street sold many auction rate securities as hybrids in the private market under names such as auction pass through trusts, auction market preferred stock, among other now dubious names.  Purchases of these securities were not included in the buy back settlements.  How will Wall Street be held accountable for fraudulently marketing these?

• Will the brokerage house executives who oversaw the sale of auction rate securities be fined or punished?

• Exactly how much revenue did Wall Street generate through the auction rate securities market and did the fines that were levied along with the settlements equate to those revenues?

No doubt, today’s hearing on auction rate securities is necessary and warranted; let’s just hope it’s productive.

Structured Auction Rate Securities: The Next Shameful Chapter for Wall Street

As I posted about before, notably left out of the regulator’s Wall Street settlements are holders of structured auction rate securities, which go by any number of names such as “auction pass through trusts” and “Rule 144 private placement auction rate securities.”  These securities are unlike traditional ARS’s in that they are not issued by municipalities or closed end mutual funds, but are derived from individual securities, commonly preferred stock.  Make no mistake, these are separate products from auction rate securities; they are similar in name only and firms such as Merrill Lynch, Credit Suisse and Lehman Bros. were aggressive sellers.

The vehicle for structured auction rate securities are “pass-through trusts,” which means they are issued as private placements outside the regulatory framework.  Generally only institutional investors and high net worth individuals qualified to purchase structured auction rate securities.  Our investigation has found many were duped into buying them after they were pitched as…you guessed it…cash equivalents.  A common target were conservative investors like endowment funds and foundations.

The most shocking feature of structured auction rate securities is that often the underlying asset that determines valuations are tied to the subprime mortgage market.  For example, at least one brokerage firm aggressively sold structured auction rate securities tied to Fannie Mae and Freddie Mac’s preferred stock, which is well on its way to being worthless.  Many of these so-called “auction pass through trusts” received AA and AAA ratings from the major rating agencies which made them attractive to institutional investors.  Indeed, these were far from being anywhere near “cash equivalents,” which is how they were marketed.

I have a few theories as to why the holders of structured auction rate securities were left out of the auction rate securities settlements with the regulators.  In particular, structured auction rate securities are likely to lead to substantial “real” losses.  By comparison, the auction rate securities Wall Street bought back from its customers at the behest of regulators were purchased at par.  There was no decline in their value so firms like Merrill Lynch and UBS will not suffer losses.  If Wall Street was forced to buy the billions of dollars worth of structured auction rate securities, the write downs would be immediate and severe; in some cases the underlying assets are only worth cents on the dollar.

Arguably, institutional investors that purchased structured auction rate securities were misled on a larger scale than the retail investors covered in the ARS settlements because of the toxic underlying subprime and CDO-related assets.  These investors wanted an instrument similar to a money market fund and were not told they were buying a derivative whose reference security was a preferred stock of a financial institution.  To be sure, preferred stocks still carry inherent risk as the preferred holders in Fannie Mae and Freddie Mac are learning.  And if investors had an appetite for this kind of risk, they could have simply bought preferred stock rather than a derivative such as structured auction rate securities, which are now near worthless and illiquid.

We’ve been contacted by several institutional investors holding structured auction rate securities and its likely many others will be filing arbitration claims against their brokers.  Based on our investigation, billions of dollars worth of structured auction rate securities were underwritten and issued by Wall Street. This represents a huge liability for brokerages, a gaping hole in the regulator’s settlements and a total disregard for investor suitability standards.