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Banks Settle With Regulators Over Auction Rate Security Misrepresentations

Expert Witness: Fulcrum Inquiry
Last February, enormous numbers of investors were caught with illiquid investments that were sold as cash equivalents. Over the last week, five major banks agreed to repurchase these investments and pay substantial civil fines. The remaining non-settling banks now face increased pressure to also settle. However, litigation will continue over substantial consequential damages that customers incurred.

Auction-rate securities (ARSs) are long-term debt instruments sold at weekly and monthly auctions (at which point new rates of return and related values are set). The instruments were marketed as alternatives to money-market funds and touted as being safe and liquid. However, in February 2008, the $330 billion auction-rate market collapsed in the wake of the global credit crunch, causing the auctions to fail and banks to turn away customers who sought to sell for their investments.

Emails that surfaced from Merrill Lynch and UBS showed that ARSs were sold to unsuspecting investors at a time when, internally,
it was clear the market was poised to collapse.

During this last week and a half, regulators and five major investment banks entered into settlements over their misleading sales practices. All of the settlements pertain to the investment banks misrepresenting the value of the ARSs. Here are the major settlements at the time of this writing:

1. UBS will repurchase approximately $20 billion of securities, plus a $150 million civil penalty.
2. Wachovia will repurchase approximately $9 billion of securities, plus a $50 million civil penalty.
3. Citigroup will repurchase approximately $7.3 billion of securities, plus a $100 million civil penalty.
4. Morgan Stanley will repurchase approximately $4.5 billion of securities, plus a $35 million civil penalty.
5. JPMorgan will repurchase approximately $3 billion of securities (including those sold by Bear Stearns), plus a $25 million civil penalty.

Merrill Lynch is the largest investment banker who has not yet reached settlement terms. Merrill Lynch indicated it would be willing to repurchase about $10 billion of the securities, but this has not been adequate to reach a settlement with the regulators. The other main banks in the market who have not yet settled include (in expected order of importance) are Goldman Sachs, Bank of America, Royal Bank of Canada, and Lehman Brothers.

Although certainly substantial, this is not the largest group of settlements in the last few years involving investment banks. In 2003, mutual-fund abuses resulted in more than $5 billion of penalties and agreements to reduce fees, and tainted research tied to investment-banking deals cost ten firms $1.4 billion.

The settlements with regulators may get investors their money back (generally over periods of up to a year), but some investors also suffered consequential damages arising because the ARSs were not as liquid as anticipated. Consequently, there should be a large number of continuing litigation with individual customers. Although the settlement agreements no doubt will assert that the investment banks have not admitted wrong, the continuing suits should get a boost from the appearance that regulators required billions of dollars of securities to be repurchased. Examples of consequential impacts of the illiquidity include:

1. Individuals not being able to complete transactions, such as home purchases and tuition payments.
2. Companies with seasonal cash flows not being able to meet business objectives because cash requirements could not be met when required.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials, CPA, MBA, CMA and ASA.

Copyright Fulcrum Inquiry

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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