Auction-Rate Securities: Legal Headache for Wall Street, and How

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When we last told you about the now-frozen auction-rate securities market, Law Blog readers engaged in a spirited debate about legal theories plaintiffs could use against Wall Street.

We asked some knowledgeable defense lawyers to see what they thought.

The conclusion: Some lawyers say Wall Street banks may have a tougher time defending auction-rate suits than claims related to mortgage-backed securities in part because the banks played such an extensive role in facilitating the market. And legal claims by individuals have a more public and sympathetic face than some of the litigation arising out the woes in the mortgage-backed market, which largely concern institutional players. Here’s today’s WSJ story by Amir Efrati (that’s me) and Liz Rappaport, and here’s a breakdown of the legal angles.

Gov’t probes: The SEC and AGs like New York’s Andrew Cuomo are investigating. Cuomo’s probe is focused on what investors were told at the point of sale; whether some investors were put into those securities without their approval; how Wall Street banks and brokers made their money; and whether banks tipped off favored institutional investors before the banks withdrew their support for the market, so that those investors could escape the market’s implosion, according to people familiar with the matter.

Wall Street Defenses: In civil litigation, lawyers say, Wall Street’s best defense is the economy. “If the banks had good faith belief that the securities would be liquid and only because of the credit crunch that changed, that would be a major defense,” says Irving Pollack, a former SEC commissioner now at Fulbright.

For lawsuits seeking class-action status, the bar is high for establishing a “pattern and practice” of misrepresentation. “You’d have to see email [from an executive] that said, ‘Make sure our brokers say it’s like a money-market fund,’” says Trace Schmeltz of Dewey.

A basic issue in private claims will be what investors were told, both in legal documents and by salespeople, about the market’s risks. Offering documents, which need to be shown only to a the security’s original buyer, generally include caveats, so a legal claim over disclosure may be tough. And from the get-go, Wall Street has been adamant that it is not required to make a market or to support auctions.

Plaintiff Allegations: Some plaintiffs allege they were never shown offering documents and were guaranteed liquidity. In one arbitration claim, filed by ASTAR Air Cargo Inc., the private cargo airline alleged Merrill Lynch promised it would buy the debt between auctions. (Merrill denies having made such a promise. Click here for documents.)

There is no shortage of potentially sympathetic plaintiffs. Richard Walden, who runs a charity called Operation USA, says he had to lay off two employees and close an office in Cambodia after the charity’s nearly $1.5 million in auction-rate securities became frozen and left him unable to get needed cash. The charity is considering joining a recently-filed potential class-action lawsuit as a named plaintiff against UBS AG, his organization’s broker. (A UBS spokeswoman said the firm doesn’t comment on individual clients and said the firm has offered customers loans against their securities if they need cash immediately.)

Municipalities as Plaintiffs: William Doyle, a municipal finance lawyer at Orrick, says he expects some municipal and state-government issuers, who have been hurt by failed auctions, will sue Wall Street regardless of their chances of success because of political pressure.

If any auction rate investors have stories to share, or any lawyers can give us insight into this legal mess, email me at amir.efrati@wsj.com.