Cash Management

It’s Mass. v. the Bull on Auction Rates

The commonwealth charges that Merrill Lynch fraudlently pushed ARS while it knew the market was unstable.
Stephen TaubJuly 31, 2008

The state of Massachusetts charged Merrill Lynch with fraud in the sale of auction rate securities, saying that it pushed them to investors while the company was misstating the stability of the auction market.

The administrative complaint, filed by the secretary of the commonwealth, William F. Galvin, also alleged that Merrill Lynch co-opted its supposedly independent research department to help sell auction rate securities.

The complaint seeks to order Merrill Lynch to make good on the sales of ARS that are now frozen, and to make restitution to those who had to sell at less than par. The order would also censure the firm and impose an administrative fine.

“This company was aggressively selling ARS to investors and its auction desk was censoring the research analysts to make sure they downplayed ARS market risks in research reports up to the day Merrill pulled the plug on its auctions,” Galvin said. “They knew the auction markets were in trouble, but the investors were the last to know.”

The complaint is the second action brought by the state’s securities division in the wake of the collapse of the auctions earlier this year. In June, a similar complaint was brought against UBS. A related investigation of Bank of America Corp. is continuing, according to Bloomberg News.

The complaint in the Merrill Lynch case charges that Merrill permitted sales and trading managers, including auction desk personnel, to communicate to members of the research department (in violation of company policies and procedures) sensitive confidential information concerning inventory levels, marketing initiatives, and enhanced sales incentives offered to financial advisers. Year-end employment reviews of certain research analysts also took into account the level of support that analyst provided to his “business partners” at the auction desk, the complaint added.

Despite these efforts, Merrill Lynch “had known for a period of several months that auction markets were not functioning properly and were, in fact, in significant danger of collapsing,” according to the complaint.

Galvin noted, for example, that on Nov. 19, 2007, one executive in a personal E-mail had written, “Market is collapsing. No more $2k dinners at CRU,” referring to a Manhattan restaurant.

On Feb. 7, 2008, Merrill analyst Kevin Conery told financial advisers, “But is it (the auction business) an area we think represents a good, conservative, reasonable investment? Yes, it is,” according to Galvin.

Five days later, Merrill Lynch decided to stop supporting the auction rate securities program and most of their auctions failed the next day, the complaint noted.

It also charged the very process of the auctions was “fundamentally flawed,” with Merrill submitting support bids to prop up the market. “Broker-dealer support created a false impression that there were deep pools of liquidity in the auction market,” the complaint said.

Galvin said Merrill made about $90 million in profit from this program in 2006 and 2007, but their dual role in representing bond issuers and investors buying ARS “created significant and inherent conflicts of interest which could not be reconciled.”

In a statement sent to, Merrill Lynch said, “We are disappointed that Massachusetts filed this action because it ignores the only reason our advisors sold auction rate securities: they believed they were good investments for clients willing to trade some liquidity for higher return.” It is an “inarguable fact” the company added, that only a small number of auction had failed over nearly two decades, and last year “there were no failed auctions of securities sold to retail clients and, in fact, none to these clients until late January 2008.” The Merrill statement said that its research “reflected the honest belief that ARS offered higher returns in exchange for less liquidity and noted that market changes had begun to occur.”

In May the company said it had been asked for auction-rate-related information by several jurisdictions, although it did not identify them. On March 25, a class action lawsuit was in a New York federal court against the firm on behalf of persons who purchased ARS between March 25, 2003, and last Feb. 13. A second, similar action was filed the next day in the same court.