This article was published in the Fall 2008 issue of the CADS Report, a publication of the American Bar Association Section of Litigation.

Transcription

1 CLASS ACTION ISSUES ARISING FROM AUCTION RATE SECURITIES LITIGATION This article was published in the Fall 2008 issue of the CADS Report, a publication of the American Bar Association Section of Litigation. BY LARRY POLK This article addresses some of the particular issues arising from the recent wave of class actions filed by purchasers of Auction Rate Securities ( ARS ). The mechanics and structure of the ARS market will be addressed first. Next, the specific issues involved in the certification of class actions filed by investors will be explored. The article reaches the conclusion that due to the particular nature of these securities, class certification will be extremely difficult. Auction Rate Securities Generally ARS consist of municipal bonds, corporate bonds, and preferred stocks that pay interest or dividends to investors. 1 The interest rates or dividend yields paid by these securities are periodically re-set through auctions. 2 The price of the security remains the same from auction to auction; only the rate that will be paid to the investor between one auction and the next (i.e., the investor s return and the corresponding cost of financing borne by the issuer) changes, and the bidding that takes place during the auction focuses on the security s rate of return rather than its price. These auctions typically take place every 7, 14, 28, or 35 days, and the rate of return established at an auction remains in place until the next auction, when it is re-set. Prior to the auction, prospective investors including current holders of the security who wish to buy more shares can submit buy bids. A buy bid does not offer to purchase a security for a particular price because the price remains constant at par value. Instead, a buy bid specifies (a) the number of shares that the bidder is willing to purchase at par and (b) the rate at which the bidder is willing to buy those shares. While prospective investors are submitting buy bids, current holders of the security may submit one of three orders in an auction: (1) hold, meaning that the holder will continue to hold the security after the auction regardless of the rate that is established at the auction; (2) hold-at-rate, meaning that the holder will hold the security after the auction if the rate established at the auction is equal to or greater than a specific rate, but the holder will sell the security if the rate established at the auction falls below that specified rate; or (3) sell, meaning that the holder will sell the security at the auction, regardless of the rate established. These bids and orders are processed in a Dutch auction in which bids with successively higher rates are accepted until all of the securities made available for sale have been sold. In other words, the buy bid with the lowest rate is accepted first, followed by buy bids with progressively higher rates, until the number of buy bids matches the number of shares up for sale. When the number of buy bids matches the number of shares for sale, the rate of the final buy bid is the clearing rate. That clearing rate 1 Debt instruments like municipal or corporate bonds pay interest; equity instruments like preferred stock pay dividends. 2 For a debt instrument like a municipal or corporate bond, the interest rate is set at auction. For a preferred stock, the dividend yield is set at auction. For ease of reference, the term rate encompasses both interest rates and dividend yields.

2 becomes the interest rate or dividend yield that will be paid to all holders of the security until the next auction. 3 The issuer of the security selects one or more broker-dealers to underwrite the offering and one or more broker-dealers to manage the Dutch auction process. The auction manager receives an annualized fee from the issuer, typically 25 basis points (.25% of 1%) of the par value of the securities it manages. The issuer also selects an auction agent. The auction agent collects orders from broker-dealers prior to a pre-set submission deadline. After receiving orders from broker-dealers, the auction agent then determines the clearing rate for the auction, fills the orders according to established procedures, and allocates the securities to the broker-dealers. For more than two decades, the ARS market enjoyed stable market conditions, experiencing relatively few auction failures. 4 Throughout this time, investors in ARS were usually able to liquidate these instruments at face value. As a result, many investors viewed ARS as cash-like instruments. 5 The Collapse of the ARS Market In February 2008, the ARS market essentially collapsed, as broker-dealers and underwriters, already stung by their holdings in the subprime mortgages and structured finance products, decided to no longer support the auction markets by submitting bids for their own accounts. 6 Failed auctions sporadically occurred in mid to late 2007 and early 2008, as there was no longer enough investor demand to support the securities being sold. 7 During the week of February 10, 2008, all the major broker-dealers purportedly stopped supporting ARS auctions. 8 With the collapse of the ARS market, investors were not able to liquidate (sell) their securities, sometimes receiving below market interest resulting from failed auctions. 9 3 If all current holders of a security elect to hold, the clearing rate that applies until the next auction is the all-hold rate, a below-market rate calculated using a pre-determined formula set forth in the security s offering documents. If there are not enough buy bids to cover all of the securities for sale, then the auction is said to fail and the issuer pays an above-market rate set by a pre-determined formula in the offering documents. 4 Stephanie Lee, Auction-Rate Securities: Bidders Remorse? A Primer, NERA Economic Consulting, May 6, 2008, 2. 5 Id. 6 See Liz Rappaport & Craig Karmin, Train Pulls Out On New Corner Of Debt Market - Auction-Rate Securities Failing to Draw Bidders; A Toll on Port Authority, The Wall Street Journal, February 14, 2008, C1. See also Ivy Schmerken, Opportunity From the Ashes In the Wake of the Crisis, A Platform Designed to Trade Restricted Stocks is Rescuing Investors Trapped in Auction Rate Securities, Wall Street and Technology, June 1, Liz Rappaport, Randall Smith & Tom McGinty, Auction-Rate Headaches - Issuers Search for Ways Around Soaring Costs; Prior Trouble in Market, The Wall Street Journal, February 21, 2008, C1. 8 See Ivy Schmerken, Opportunity From the Ashes In the Wake of the Crisis, A Platform Designed to Trade Restricted Stocks is Rescuing Investors Trapped in Auction Rate Securities, Wall Street and Technology, June 1, See Liz Rappaport & Craig Karmin, Train Pulls Out On New Corner Of Debt Market - Auction-Rate Securities Failing to Draw Bidders; A Toll on Port Authority, The Wall Street Journal, February 14, 2008, C1.

3 Litigation Following the ARS Collapse The collapse of the ARS market left investors holding approximately $330 billion in suddenly illiquid securities. 10 These holdings may be broken down into three large segments: (1) the municipal securities market, comprising the largest dollar amount; (2) the securities issued by closed-end mutual funds; and (3) the balance of the market, comprised of corporate securities, obligations issued by student loan entities, and collaterized debt obligations. At present time, it appears that the issuers of the instruments in the first two groups eventually will redeem many of the securities at par. The future is not as certain for those holding securities issued by the third group. The collapse of the ARS market led to a proliferation of class action lawsuits (as well as individual securities arbitrations) against issuers, underwriters, auction agents, and selling broker-dealers. Investors are claiming that broker-dealers violated state and federal securities laws, primarily Section 10 of the Securities Exchange Act, and Rule 10b-5 promulgated thereunder, by failing to properly disclose investments risks. Currently, at least 24 of these lawsuits are purported class actions, where investors typically claim that they were told their ARS were almost liquid as cash. 11 Putative class members often are parties to mandatory arbitration clauses in customer agreements with their brokerage firms, and thus have the option of filing an arbitration claim with Financial Industry Regulatory Authority ( FINRA ) Dispute Resolution. According to FINRA, securities claims are resolved within a year after filing, as opposed to the procedural delays associated with class actions. 12 An investor is required to opt out of a pending class action in order to file an arbitration claim for the same security involved in the class action. 13 The claims asserted by investors often allege point of sale misrepresentation. The investors claim that even though ARS are long-term variable rate instruments, broker-dealers sold them as liquid cashmanagement vehicles and as an alternative to money market mutual funds. 14 These investors allege they have not been able to liquidate their ARS holdings following the collapse of the market. 15 Investors also allege broker-dealers failed to disclose material facts about ARS investments, including: (1) ARS were not cash alternatives, like money market funds, but were instead, complex, long-term financial products based on bonds with 30 year maturity dates, or longer; (2) ARS were only liquid because broker-dealers artificially supported or manipulated the ARS market to maintain the appearance of liquidity and stability; (3) broker-dealers routinely intervened in auctions for their own benefit, to set rates and avert all-hold auctions and failed auctions; and (4) broker-dealers continued to market ARS as liquid investments after they determined that they were likely to withdraw their support for the periodic auctions and that the ARS market would collapse as a result Tom Weidlich, Auction Failure Damages Face Burden of Proof Eluding Lawyers, Bloomberg News, May 27, Id. 12 NASD Manual Code of Arbitration Procedure for Customer Disputes, (adopted April, 16, 2007). 13 Id. 14 See Complaint at 2, Zisholtz v. Suntrust Banks, Inc. et al., No. 08-cv-1287 (N.D. Ga. 2008). See also Complaint at 1-2, Swanson v. Citigroup Inc. et al., 08-cv (S.D. N.Y. 2008) 15 Id. 16 Id.

4 The Problems Inherent with Class Action Treatment These actions are unlikely to be certified as class actions under Fed. R. Civ. P. 23(a), which allows certification only if: (1) the class is so numerous that joinder of all members is impracticable; (2) there are questions of law or fact common to the class; (3) the claims or defenses of the representative parties are typical of the claims or defenses of the class; and (4) the representative parties will fairly and adequately protect the interests of the class. 17 Specifically, ARS investors are not likely to satisfy Rules 23(a)(2) and 23(a)(3), also known as the commonality and typicality requirements. Commonality Rule 23(a)(2) requires a common question of law or fact between the members of the class. It is unlikely that ARS investors will be able to show a common question of fact to all members of the class because each affected investor brings a unique set of facts to the case. 18 These investors generally claim to be damaged because they were not able to sell their securities. 19 The securities continue to pay interest, often at market rates, thus the claim is for a lost opportunity because the security is illiquid. Each specific instance of lost opportunity gives rise to a unique set of facts. In addition, some ARS pay above market interest after a failed auction, while others pay less. Moreover, the issuers of many ARS products are redeeming or refinancing the products, further complicating the commonality analysis. Thus, the uniqueness of each investor s experience may prevent a court from finding commonality. Independent issues of reliance may destroy commonality. The investors claim that they relied on the misrepresentations by their broker-dealers, or individual registered representatives. 20 The extent to which each affected investor relied on such representations are factual issues that must be resolved independently of every other case. 21 Thus, a wide variance of proof would be necessary to show how the defendants actions damaged each affected investor. The complaints themselves allude to a variety of conduct on the part of the broker-dealers that allegedly harmed investors. The investors allegedly relied on statements that ARS were cash-like; were harmed by artificial support of the ARS market; intervention in auctions; and continued manipulations of the ARS market after it was clear that the market would collapse. 22 Separate lawsuits are therefore necessary to ascertain whether the broker-dealers actions damaged each affected investor and the extent of such damage. 23 Additionally, it is a general rule that an action substantially based on oral rather than written communications is inappropriate for treatment as a class action suit. 24 Thus, the communications between investor and broker-dealer that each investor allegedly relied on in buying ARS may not be appropriate subject for class actions. The exception standardized oral communications does not 17 Fed. R. Civ. P. 23(a). 18 See Polich v. Burlington Nothern, Inc., 116 F.R.D. 258, 261 ( D. Mont. 1987). 19 See Complaint at 2, Zisholtz v. Suntrust Banks, Inc. et al., No. 08-cv-1287 (N.D. Ga. 2008). 20 Id. 21 See Polich, 116 F.R.D. at Complaint at 2, Zisholtz v. Suntrust Banks, Inc. et al., No. 08-cv-1287 (N.D. Ga. 2008). 23 See Polich, 116 F.R.D. at Graham v. Security Sav. And Loan, 125 F.R.D. 687,690 (N.D. Ind. 1989).

5 apply in this case. 25 Here, there are alleged to be various oral representations made to different investors. Such varied representations are not standardized and should not be the subject of a class action suit. Typicality To proceed with a class action, the class representative must be typical of the class. 26 The test of typicality is whether other members have the same or similar injury, whether the action is based on conduct which is unique to the named plaintiffs, and whether other class members have been injured by the same course of conduct. 27 Here, it may prove difficult to find a typical class representative when each investor s situation presents a unique set of facts, including individual issues of reliance and unique damage claims. The varying levels of sophistication of the investors, who would have relied on different sources of information before investing, would require different proof of reliance for each type of investor. 28 Additionally, a court would have to ascertain the extent to which each investor relied on each alleged misrepresentation of his broker-dealer. Thus, there is no typical class representative because individual proof of reliance is required for each investor. 29 Furthermore, it may be difficult for a court to find a typical class representative because each ARS product is associated with a unique market. Every ARS has a different issuer or underwriter as well as varying auction managers. 30 The underlying issues that cause the auction of one particular ARS to fail may be completely different from those causing another auction s failure. Therefore, an investor in one ARS is not typical of an investor in a different ARS. Accordingly, there may be no typical class representative when the class includes investors in various ARS. Conclusion Since the collapse of the ARS market, numerous class actions have been filed by investors alleging wrongdoing by their broker-dealer. However, a class action is not likely the most appropriate procedural mechanism to resolve these claims, and attempts to certify these classes under Fed. R. Civ. P. 23(a) will be fraught with complications arising from the particular circumstances surrounding individual investors, not to mention the many ARS markets. Rather, it is more likely that investors will file individual arbitration claims, which will afford a much more efficient forum to resolve these claims. 25 See Glick v. E.F. Hutton & Co., 106 F.R.D. 446, 449 (E.D. Pa. 1985); Seiler v. E.F. Hutton & Co., 102 F.R.D. 880, 888 (D. N.J. 1984). 26 Fed. R. Civ. P. 23(a)(3). 27 Hanon v. Dataproducts Corp., 976 F.2d 497, 508 (9th Cir. 1992). 28 Hoexter v. Simmons, 140 F.R.D. 416, 423 (D. Ariz. 1991). 29 See Id. 30 See Complaint at 7-10, Zisholtz v. Suntrust Banks, Inc. et al., No. 08-cv-1287 (N.D. Ga. 2008).