In the News: Recent Developments

September 19 2008, 1:00am EDT

Barney Frank Calls For New Rules to Curb ARS Market Abuses

By Patrick Temple-West

House Financial Services Committee chairman Barney Frank, D-Mass., called for new rules to curb abuses in the auction-rate securities market at a hearing yesterday, as federal and state regulators indicated the ARS market is virtually dead and would require major structural changes to regain liquidity.

Meanwhile, an industry official warned committee members that the billion-dollar ARS buyback programs that 16 banks and broker-dealers have agreed to under settlements with federal and regulators may be at risk amid the current liquidity problems and major turmoil facing the financial markets.

The committee heard testimony from market participants, issuers, and regulators from the Securities and Exchange Commission, the Financial Industry Regulatory Authority, and Massachusetts who described the causes of the ARS market collapse.

Frank was not specific about the rules that should be put into place, but William Galvin, Secretary of the Commonwealth of Massachusetts, made several recommendations. He called for conflicts of interest to be more aggressively monitored and disclosed to investors. The training of financial advisers needs to be enhanced so they understand the products they are selling to investors, he said. Galvin also said that broker-dealer research reports need to be more tightly regulated to ensure that they are objective.

Asked about the continued viability of the ARS market, Linda Chatman Thomsen, the SEC’s enforcement director, told the lawmakers “right now is a difficult time for anyone to raise capital through the auction-rate securities process … in part because of the [auction] failures” that led to the collapse of the market in February.

“The product itself is going to have to change .. if it’s going to be marketed as a liquid product.”

Galvin went further telling committee members, “The whole concept of the auction has been discredited.” Galvin said it was a “fantasy” to call the ARS process an auction because the firms routinely bid in the auctions, a practice that he said created huge conflicts of interest.

Frank applauded the regulators’ efforts to work together to reach settlement agreements with firms to return ARS money to clients.

But Leslie Norwood, managing director and associate general counsel for the Securities Industry and Financial Markets Association, told the lawmakers, “Many firms are facing capital limitations as a result of the continuing credit crunch. They have limited funding available to buy back outstanding ARS.”

The buy-back programs, touted as successful by the regulators, may be put in jeopardy by recent events including the bankruptcy filing by Lehman Brothers Financial Holdings Inc. and the federal bailout of American International Group Inc. Since the hearing was scheduled in July, 16 broker-dealer firms and one retail brokerage have reached settlement agreements with state and federal regulators to redeem ARS for retail clients. The liquidity crisis on Wall Street may impede the firms’ ability to raise the capital needed to fund their buyback programs, Norwood said.

But Mike Decker, co-CEO of the Regional Bond Dealers Association, which submitted a written statement to the committee, has said that these firms should be able to conduct their buyback programs even as credit is tight because of their access to the primary dealer window.

Goldman Sachs & Co. and Deutsche Bank Securities Inc. have started their buyback programs. A spokesperson with Goldman Sachs said this week that the firm has sent letters to ARS clients notifying them of the buyback program. A Deutsche spokesman declined to comment.

Trying to determine how brokers marketed ARS as cash-like investments when they were not, Rep. Carolyn Maloney, D-NY, asked Thomsen why said the SEC did not uncover these sales practice abuses when it investigated the ARS market two years ago.

Thomsen said that the earlier investigation focused on auction practices, such as dealers presenting their own bids for ARS in an auction to prevent it from failing, and the failure of banks and broker-dealers to disclose those practices to investors. She said the SEC was not aware of the sales practices abuses until it began receiving complaints from investors -more than 1,000 complaints in mid-February.

Galvin called for the regulatory structure to be rewritten with the emphasis on individual investors and Frank said the ARS debacle showed that,”investor protection was falling between the cracks.”

The SEC’s goal “has been to return as much liquidity to investors as quickly as possible,” Thomsen said, adding that the settlement agreements “represent … substantial progress toward the attainment of that goal, while at the same time avoiding further disruption in the financial markets.”

Rep. Spencer Bachus, R-Aia., the ranking minority member of the committee, asked why there is no mention of ARS at all in broker licensing examinations. Susan Merrill, FINRA’s chief of enforcement, said that until earlier this year, “We saw these are relatively low risk” and that exams cannot cover every securities product.

Galvin told the regulators, “There has to be some duty of the seller to be aware of the circumstances of the buyer,”

Merrill responded that FINRA has suitability rules that require brokers to take into account whether the products they are selling investors are suitable for them. But she said the regulators need to be more sensitive to potential abuses and need to engage in “anticipatory enforcement rather than just “enforcement after the fact.”

But Joseph S. Fichera, CEO of Saber Partners LLC in New York, who has expertise in ARS and attended the hearing, said, “Today’s hearing shows that the recent settlements with brokers on auction securities do not fully resolve the problems for either issuers or all investors. The ARS market remains opaque and the solutions proposed seem to rely on government intervention which should only be a last resort.”

Meanwhile, FINRA announced before the hearing that it has reached agreements in principle with five firms, under which they will buy back at par more than $1.8 billion of auction rate securities that individual investors and some institutions purchased from them between May 31, 2006 and Feb. 28.

The firms also have agreed to make whole individual investors who sold it below par after Feb. 28, when the ARS market collapsed.

The five firms will pay a total of $3.25 million in fines, ranging from $1.65 million for SunTrust Robinson Humphrey Inc. of Atlanta to $250,000 for WaMu Investments Inc. of Irvine, Calif.
Besides Sun Trust Robinson Humphrey and WaMu, the firms are: Sun Trust Investment Services, Inc. of Atlanta, which was fined $300,000; Comerica Securities, Inc. of Detroit, fined $75,000; and First Southwest Co. of Dallas, which was fined $300,000.

FINRA said its investigations of almost 50 additional firms are continuing.

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