In the News: Recent Developments

Citicorp, American Airlines, Chase Manhattan and the Risks of Dutch Auction Rate Securities

By Joseph S. Fichera

First released in 1991
Modified 2004

There is trouble with one of Wall Street’s hottest products of the 1980’s. Citicorp, Chase Manhattan, Sara Lee, American Airlines, Wells Fargo and GTE are among the corporations that have had problems with their securities priced through a Dutch auction. Each firm has had to pay rates from the mere exorbitant to the astronomical because of Dutch auction securities. Citicorp, the nation’s largest bank and largest issuer of Dutch auction rate preferred stock, has unexpectedly been forced to redeem over one-third of its outstanding issues. In fact, $10 billion of the $30 billion of Dutch auction rate new issues in the last five years have been redeemed.

These problems underscore an inherent flaw in the now $20 billion floating rate preferred stock market. Whenever an issuer has gotten into trouble in its industry, Dutch auction rate securities have made matters worse. Even corporations that lacked troubles have been caught up in the volatile and fickle Dutch auction rate security process.

When investment bankers introduced the Dutch auction security, they told corporate issuers it would be low-cost permanent equity; for many it has proven to be both expensive and temporary. The problem, however, clearly is not the market or investors, but rather the Dutch auction rate product. Preferred stock can be safe for issuer and investor. The market is deep and investors plentiful. Solutions to Dutch auction rate securities already exist. Only now are they being more closely considered.

How We Got Here: A 16th Century Solution to a 20th Century Problem

In 1984, investment bankers invented Dutch auction preferred to solve a problem in Wall Street’s previous preferred stock innovation–Adjustable Rate Preferred Stock (ARPS) introduced in 1981. This security adjusted its interest rate according to a pre-set formula off a broad market index of U.S. Treasuries. It too had a simple built-in flaw. Once issued, the formula never adjusted to changes in credit quality or other market factors specific to the issuer. The market collapsed in 1983 after $11 billion in new issues. “Variable Rate Preferreds: The Tale of a Good Idea Crippled by Wall Street Fervor” read the headline in the Sunday New York Times in March 1983.

Dutch auction rate preferred solved this problem. It allowed investors to adjust the interest rate for any reason every 49 days. The rate would be determined by a mathematical formula based on bids submitted in a Dutch auction the same way tulips were sold in the 16th century in Holland. The lowest rate needed to sell all the shares would “clear” the market. The risk previously borne completely by the investor now shifted completely to the issuer. The market grew rapidly, just as it had done for ARPS only two years before.

Wall Street’s major firms quickly copied the product. Each firm created its own “proprietary” version. “Except for the share price, they are all the same – they just copied our prospectus” boasted Shearson Lehman’s Ronald Gallatin who in 1985 invented the auction product. And, oddly enough, the savings and loan industry led the market’s development. Between 1984 and 1988, the height of the market growth, S&Ls accounted for 40% of the issues. Some of the most controversial S&Ls which were issuers, now are in receivership.

For investors, Dutch auction rate securities have brought good returns and somewhat low risks. The problems with Citicorp and Chase and others should not overly concern investors. As proponents point out, most auctions succeed. No investors (except investors in MCorp, a Texas bank and perhaps those in Tucson Electric) have lost their investment. Investors have been paid well, so, there is little evidence for investors to be very concerned.

Yet, for issuers it is another story. In solving the ARPS disaster, Dutch auction rate preferred created many problems of its own. Indeed, the rate adjustment could reflect any investor concern on a single day. Now the issuer became exposed to all market and event risks on the auction day.

The mechanics of the process forced other unanticipated problems. For example, the securities reprice on an inflexible schedule every 49 days and ignore seasonal market factors like the annual year-end upheavals. This forces issuers to auction rate securities in the week between Christmas and New Year’s, one of the worst times of the year to sell securities. An issuer never would willingly do this, yet issuers must because of the Dutch auction.

A Problem of Its Own Making

Dutch auction rate securities’ greatest problem, the one that creates its greatest risk, are their fundamental inflexibility. The issuer cannot adapt to market conditions except by increasing the rate. Once a Dutch auction rate security issue is sold into the market, the entire issue must be resold every 49 days on a single day, at a single time, regardless of market conditions. There is only one investment term and therefore a fixed repricing schedule. The issuer’s cost increases until the last share is sold despite the rate needed to sell the other shares. Everyone gets the clearing rate. If the last share is not sold, though all other shares are sold, the auction is said to have failed and severe penalties ensue.

A Dutch auction is designed to be a “blind auction” open to many firms bidding and having their customers own shares. In a “blind” marketing process participating firms do not know the bids of current owners or other bidders until the auction is over. This uncertainty, according to Wall Street theorists, ensures broad market participation and a competitive rate. The theory says the entire broker-dealer community is working for the issuer at each auction and, because of the uncertainty in the bidding process, their investors will bid a low rate to win the stock.

But, an anomaly of the Dutch auction rate security product is that, no matter what the theory says, everyone thinks the issue’s original underwriter is responsible for the process and ensures a successful and orderly auction. While this is what everyone thinks, the fact is that this firm has only a moral, not a legal, responsibility to do anything. It is not even required to use its “best efforts” to market the security.

To deal with this anomaly, just before an auction, the original underwriter usually engages in “price talk” with other broker-dealers to get a sense of how much is for sale, how much will be bought, by whom, at what rate and through which broker-dealer. In essence, the banker tries to eliminate the “blind” nature of the auction that is the product’s essential feature.

With this information (which, unlike a sale, can be changed as soon as the phone is hung-up), the banker decides whether there is a gap and whether to submit a bid for its own account (a “house bid”, i.e., without an independent investor behind it). This bid will ensure liquidity for investors by clearing the market at what the banker thinks is a “reasonable” cost to the issuer, which in turn sets the rate for all investors.

To determine how much to bid for and at what rate to clear the market, the original underwriter can only estimate supply and demand from owners and potential investors. Poor estimates may lead to auction failures or very high clearing rates. If one really wanted to ensure an orderly market, the firm would know precisely what is for sale and then be given time to sell it. Unfortunately, the auction product’s design precludes that firm from having any more information about investor bids than any other firm. Also, because it is an auction, the banker cannot sell the shares to any investors until the auction.

Here is the contradiction and the problem. If there is a deep market and the auction means broad participation and competition, then a single firm (like the original underwriter) should not have a significant effect on the issue’s liquidity, stability in the market, or rate. But the outcome of an auction is so uncertain that both issuer and investor rely upon a single bank to “support” the auction by submitting clearing bids. This practice runs counter to the product’s design. So one must ask, “why does one go through the motions of an investor auction?” The auction imposes severe restrictions on the timing and marketing of the shares. If the banks control the auctions through the house bid, what purpose do these severe restrictions on the corporate treasurer’s flexibility or the auction itself serve?

More Risk than Necessary

The auction’s contradictions magnify the issuer’s risks in the market. The issuer expects the original underwriter to minimize the auction’s built-in risk regarding both an outright failure and achieving a reasonable cost. Yet the bank has incomplete information to manage that risk. The “blind” nature of the auction also means the underwriter does not know for certain how much is for sale, what bids exist, at what rate, or how much supply needs to be covered with a house bid. The issuer gets little certainty. It becomes exposed, not only to the vagaries of the market, but also to the guesstimates of the investment bank. And, because the Dutch auction rate preferred market is concentrated among not more than six banks, the original underwriter probably is making the same guesstimates and house bids on numerous other auctions on the same day.

For the issuer that pays the bills, recent events have shown the high price paid for issuing an inflexible Dutch auction rate security. If there is trouble with a particular auction, it is difficult to detect. And, once detected, it is probably too late to do anything about it. “Broad participation,” if ever it were present, quickly dissipates as brokers go running. Sara Lee’s recent auctions swung 100 basis points up and down in three weeks with no change in the market. American Airlines’ auctions failed unexpectedly on takeover rumors. In a blaze of publicity and panic, all its subsequent auctions failed although the rumors subsided. Chase Manhattan’s auction created near panic when a two-year debt security Dutch auction rate bond cleared at 492 basis points above the Treasury, eight basis points short of the maximum rate and therefore failing. Whatever the problem, the Dutch auction made it worse. Commercial banks, once 35% of the market, are redeeming their issues in droves. Industrials are also making a quick exit.

Never mind that everyone has issued these securities and is likely to continue to do so. Like the demand for junk bonds, Citicorp, Sara Lee and Chase and others were riding the Dutch auction rate securities boom of the 1980’s. “This is perpetual preferred,” exulted Denis O’Leary of Manufacturer’s Hanover in a 1985 trade publication, one of the first issuers of the Dutch auction rate securities. “It’s hopefully like getting married: The savings last forever,” he went on. About two years later, Manny Hanny was the first issuer forced to redeem its securities.

Underwriters, committed to their “proprietary” product and to increasing their share of the rapidly growing market, resisted continued innovation to address these risks. For example, when an alternative structure was developed in 1986, a top-ranked Dutch auction rate security underwriter issued a report deriding the innovation. The firm listed the other top ranked firms that had not endorsed the new idea and proclaimed the new structure too risky for issuers to do anything different from their standard Dutch auction security. “The prospective issuer should weigh this (our) collective judgment seriously” the report proclaimed. Ironically, the report was issued about the same time the first Dutch auction failed. Yet, interest rates were low; fees were high; Dutch auction rate security issuers were plentiful. One should worry about what happens tomorrow … well, tomorrow.

Flexibility: The First Rule for the Corporate Treasurer

The first rule for a corporate treasurer is “Don’t put all your eggs in one basket.” No one is smart enough to know investor demand 49 days from now, in six months or next year. No one knows what market conditions will be like. Diversification is the first rule. And to diversify, one needs flexibility.

Flexibility will make preferred stock safer for issuer and investor. It will increase the likelihood that the investor can sell its securities at par, reduce an issuer’s exposure to market and event risks and lower the cost to the issuer.

The most efficient capital markets are negotiated and competitive. Buyers, sellers and issuers have different objectives, needs, views on interest rates and views on the value of the credit. Merging them all into a blind auction serves no one very well. Investment bankers are paid to make markets among disparate views. It makes sense to employ the time-tested principles that allow diversification of risk. There should be multiple investment terms and certainty of bids and sell orders, negotiation and accountability. These are the missing tools needed to apply the first rule to the preferred market.

Exxon Corporation, recently selected by an investor publication as having one of the best corporate treasury departments, knew this and issued a highly-flexible preferred stock as part of a $750 million shelf program in 1988. It was known as a “per-share remarketed” stock. We added to the market a very simple innovation from which all other innovations followed: the interest rate and duration could be varied, not just on the entire issue, but on each individual share. By making the pricing of the shares independent of one another, the repricings could be spread out instead of done all at once. This also allowed Exxon to appeal to the multitude of investor demands, respond to seasonal factors (like year-end upheavals) and other needs. The innovation applied the first rule: it diversified repricing risk. By doing so, it also increased liquidity for the investor.

To carry out this flexibility, a single firm (or group of firms) is selected as “remarketing agent” to be responsible, and accountable, for the ongoing marketing. The agents set the flexible rate and duration, not by themselves, behind a closed door, but in a remarketing. A remarketing is negotiated directly with market makers and investors similar to the way a new issue is priced and sold. Each side gets only what they agree to under the market conditions when they make the trade, just like every other capital markets instrument. With flexibility, the agent however can make intelligent business decisions concerning market conditions, the repricing schedule and average maturity of the terms. The agent is accountable, not just morally, but legally to use its best efforts in marketing the shares and establishing the rates and durations.

The Exxon per-share remarketed process removes much of the Dutch auction’s mystery and risk. Here, investors must submit sell orders in advance, the agents can confirm buy orders immediately during a 24 hour marketing period, and the offering of rates and the investment terms can change with the market during this period. When the agent buys for its account (like a house bid) in making a market for the selling shareholder, the transaction does not affect the rate of any other investors as the Dutch auction rate security process requires. Here, each share is independent.

Critics claim a remarketing agent isn’t impartial (it’s a negotiated market between willing buyer and willing seller) and no one should rely on a single firm (then why the need for house bids), that it is too confusing to give investors choices (choices allow issuer and investor to meet different needs), that it is too much work (that is what we are paid to do) and, when all the arguments are dealt with, if it is so good why haven’t more of them been done (quality does not depend on volume).

Exxon’s program will serve as a model for more issuers concerned about risks and wanting lower costs. Over the past 2 1/2 years, Exxon has used its flexible program to weather the highly-volatile seasonal flows of capital in the short-term market, particularly at year-end. The program also has appealed to a very wide investor base. In fact, it brought new investors into the market.

Learning from the 1980’s: A Return to Common Sense

This approach is neither radical, nor complicated. In fact, it is conservative and based upon straightforward principles established for other floating rate products, such as commercial paper or medium-term notes. It displays common sense. Flexibility increases an investor’s liquidity and reduces an issuer’s risk. It is more work for the investment banker, which perhaps explains why it has been resisted in the “high-margin, low-effort” decade of the 1980’s.

With Dutch auction rate securities, low-cost equity became very expensive; permanent capital became temporary. Worse, the issuer assumed substantially increased risk. In a perfect world, if interest rates were stable, if there were no seasonal flows of capital in and out of the market and if an issuer’s credit never changed nor faced difficult times in its industry, then the Dutch auction would be fine. But this is not a perfect world. No matter how many auctions succeed, no matter how low Dutch auction rates get, the risks will always be there. For the issuer, the hidden cost in every Dutch auction rate security is risk. And when risk becomes reality and the market turns (as events have proven), Dutch auction rate securities will always make matters worse. But we should take heart. These are problems not with preferred stock, but with the Dutch auction rate product.

In many ways the Dutch auction rate product represents the best and the worst about Wall Street. It represents the best in that truly it was innovative. It brought together a variety of corporate financing objectives. Issuers received a lower cost form of equity. New corporate investors were brought into financing other corporations and were compensated better than other forms of investment. It represents the worst in that in the rush to earn high-margin fees, bankers inadequately scrutinized who issued the security or, more important, how it would perform over time. Nor did the bankers adequately consider what their cost or commitment was. Book it today; worry about it tomorrow.

Solutions to the problem exist. Nevertheless, the Dutch auction rate security market remains much like Winston Churchill’s colleague in parliament whom he described many years ago. “He’s the sort of fellow who occasionally stumbles over the truth, but quickly picks himself up and hurries on as if nothing has happened.” Rumor has it though, that the last time this fellow stumbled, he decided to pause and think about it for a while.

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