Auction Rate Securities Fraud
Auction rate securities (ARS) are long-term variable rate bonds tied to short-term interest rates that are reset through a “dutch auction” process which occurs every 7 to 35 days. The holder can participate in the auction and liquidate the auction rate securities to prospective buyers through their broker/dealer. The holder does not have the right to put the security back to the issuer.
Auction rate securities are considered highly liquid by market participants because of the auction process. However, because the auction rate securities have long-term maturity dates and there is no guarantee the holder will be able to liquidate its holdings, these securities do not meet the definition of cash equivalents per paragraphs 8 and 9 of FASB Statement No. 95, Statement of Cash Flows
To clear up some misconceptions: First, it wasn’t the reclassification of ARS from cash equivalent to marketable securities that caused the recent run on the ARS markets. That change took place three years ago and apart from a temporary divesting, demand for ARS actually increased thereafter as a result of the attention (so much so that for a time, taxable ARS actually yielded less than commercial paper.) The cause of the recent trouble was two-fold: failed auctions in August and September, 2007 for CDO-backed ARS (the least safe variety) and the revelation that municipal bond insurers had sub-prime exposure.
Secondly, it was not the SEC that mandated the reclassification of ARS. Price Waterhouse, in 2005, unilaterally, allegedly decided that ARS would no longer be treated as cash equivalents. FASB and the SEC simply accepted the auditor’s decision. This somewhat capricious decision, while now seeming to have been prescient, raised strong objections from the issuer community at the time as it did not allow for a period of comment from practitioners, as is the standard FASB practice. Clearly, this flies in the face of many Wall Street Firms who told their customers that these were “highly liquid” “cash equivalents” or “cash alternatives,” sometimes actually written on customer statements or in their online statement.
“It now appears that many customers were not told that the dutch auctions could fail or that their securities could become illiquid,” said Jeff Sonn, Esq., who is representing some investors in their claims to recoup lost investments in ARS. “When Wall Street sells these securities as “cash like” or “cash equivalent,” we will hold them to their word and sue to enforce that promise” said Sonn.
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