Sell Side

Merrill Lynch in ARS Deal

WASHINGTON - Merrill Lynch & Co. on Friday agreed to a preliminary settlement-in-principle over auction-rate securities with the Securities and Exchange Commission that would enable investors who purchased ARS from the firm to receive a total of up to $7 billion to restore their losses and liquidity.

The settlement with the SEC came one day after the firm, along with Goldman Sachs Group Inc. and Deutsche Bank AG, reached similar ARS agreements with New York Attorney General Andrew Cuomo and other state regulators, under which they agreed to reimburse municipal issuers for all refinancing fees on ARS issued between Aug. 1, 2007, and when the auctions failed in mid-February.

The settlement with the SEC differs from the ones with the states in that Merrill is prohibited from liquidating any particular ARS in its inventory before it liquidates its investors' holdings in that security. Additionally, the SEC may impose an additional fine against Merrill. The amount of the fine, if any, will be dependent on whether Merrill satisfactorily completes its obligations under the settlement, what costs it incurs in meeting those obligations, and the extent of the firm's misconduct in marketing and selling ARS, the SEC said.

The settlement with the SEC is similar to the ones with the states in that Merrill agrees to offer to buy back at par, no later than Oct. 1, ARS from retail investors who purchased the securities from the firm before the collapse of the ARS market in mid-February. This offer will include investors who held ARS in their Merrill account as of Feb. 13, but who subsequently transferred the account to another firm. The offer will remain open until Jan. 15, 2010. Retail investors are defined as those with accounts of up to $4 million.

Merrill has estimated that the amount of ARS it will buy back from retail investors will be about $3.25 billion, as a result of announced and expected redemptions that are to take place before that date.

The firm agreed, over the same time period, to liquidate at par all ARS from remaining retail investors with accounts of up to $100 million

Merrill said it would use its "best efforts" to provide liquidity to institutional ARS investors by the end of 2009. These would be investors with accounts of more than $100 million. "Merrill Lynch's conduct harmed tens of thousands of investors who will have the opportunity to get their money back," said Linda Chatman Thomsen, director of the SEC's division of enforcement. "We will continue to aggressively investigate wrongdoing in the marketing and sale of auction-rate securities."

The agreements Merrill, Deutsche Bank, and Goldman reached Thursday with state regulators have similar provisions for reimbursing municipal issuers for refinancing fees that regulators reached with the other firms that settled: Citigroup Global Markets Inc. UBS AG, JP Morgan Chase & Co., Morgan Stanley, and Wachovia Corp. These agreements in principle were all reached with Cuomo and the North American Securities Administrators Association coalition of states investigating ARS. Massachusetts Secretary of the Commonwealth William Galvin entered into a separate agreement Thursday with Merrill Lynch that did not include a fine.

None of the firms admit or deny wrongdoing in any of the agreements.

The ARS market started to show signs of trouble in August 2007, which continued through the beginning of February when broker-dealers and banks stopped supporting the auctions and they all began failing.

Issuers that sold ARS debt during this period generally were unaware of the problems in the market, and they will be able to recoup their refinancing costs under the settlements.

David A. Bryant, treasurer of the Chicago Public Schools system, said Friday that his legal team will begin reviewing the ARS settlements. The CPS system sold one issue of ARS during the period for which it will qualify for reimbursement of refinancing fees, Bryant said.

"Whatever [the settlements] would entitle us to, we would certainly take advantage of it," he said.

The settlement agreements do not obligate firms to refund ARS restructuring fees some municipalities have paid to escape high interest rates as the ARS market failed. Issuers were obligated to pay high default interest rates, some as high as 20%, when auctions failed. Bryant said municipalities could save "substantially more" if the cost of restructuring ARS was included in the settlements.

With eight firms now agreeing to buy back ARS, Cuomo's office estimates the firms will provide $50 billion of liquidity for more than 183,000 investors. But regulators are still conducting investigations.

Cuomo is investigating the ARS sales practices of regional brokers Fidelity Investments, Charles Schwab & Co., TD Ameritrade Inc., E*Trade Financial Corp., and Oppenheimer & Co. Cuomo's office said in a letter sent to the Regional Bond Dealers Association last Wednesday that it has uncovered "some disturbing facts" that "belie the innocent picture of downstream brokerages."

The RBDA has tried to protect regional brokers from investigations by saying these firms were unaware that ARS auctions were being propped up by the underwriters in the weeks and months before the market froze. In an Aug. 15 letter to Cuomo, SEC chairman Christopher Cox, and Karen Tyler, president of the NASAA, the RBDA said auction managers at banks such as UBS did not disclose to anyone, including regional dealers, that managers were bidding in their own auctions to "give the market a false sense of liquidity."

"Expecting distributing firms to buy back ARS is simply not practical ... Distributing firms were kept just as uninformed as investors," wrote Michael Decker and Mike Nicholas, co-CEOs of the RBDA.

But Cox made it clear last Tuesday that federal regulators were also interested in the regional brokers.

"Nobody gets a free pass," Cox said in a press conference. "Secondary dealers, other primary dealers that aren't part of the settlements, are being investigated."

While the investigations continue, the firms that have settled must find ways to pay investors for their ARS. Most firms have said the buyback programs will have a "de minimis" impact on their balance sheets, possibly because they expect to write off the redemption fees and fines as business expenses on their tax statements.

Sen. Chuck Grassley, R-Iowa, warned in an Aug. 15 statement that the taxpayers could ultimately fund in part of the buy-back programs and fines.

During the 2003 settlement the SEC reached with Wall Street firms over alleged research manipulation, Grassley and two other senators introduced legislation that would have prevented the 10 broker-dealers and banks that took part in the settlement from using tax breaks to help pay their combined $1.4 billion in fines. The legislation failed to come to a vote.

A spokesperson for the Senate Finance Committee said Friday that no hearings have been scheduled to investigate the ARS matter.

For a list of the ARS settlements click here.


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