SEC, FINRA Probing ARS Sales

WASHINGTON - Spurred by hundreds of complaints from investors stuck holding illiquid auction-rate securities, the Securities and Exchange Commission and the Financial Industry Regulatory Authority are probing whether broker-dealers misrepresented the liquidity risks of the securities when they sold them.

The regulators also are looking at a number of other things, including whether broker-dealers favored certain customers by ensuring they would be able to sell their auction-rate securities, when others could not.

SEC officials would not provide details. "While we cannot disclose specific matters, as a general matter, we are looking at representations made to investors when they purchased auction-rate securities, in coordination with FINRA," a spokesman said.

A spokesman at FINRA denied his agency's sweep is an enforcement action. "This is not an enforcement sweep. It is a fact-finding sweep," he said. "As in any fact-finding sweep, if information comes to light that suggests the possibility of misconduct, that information would be referred to enforcement for further investigation."

Market sources said the probes began over the past two weeks when SEC enforcement staff and FINRA officials separately sent more than 15 banks and broker-dealers questionnaires and document requests pertaining to auction-rate securities transactions going as far back, in some cases, as 2006.

Most of the questions focused on auctions that failed during the past few months. Auctions fail when there is a lack of sufficient investor interest in buying the securities. When an auction fails, existing investors continue to own the bonds.

While the holders typically receive above-market rates when auctions fail, they nevertheless are stuck holding the securities. And the lack of liquidity can be a major problem because most investors who purchased ARS typically were seeking cash-like investments. In many cases the auction-rate bonds were offered as being liquid and had higher yields than money market mutual funds or certificates of deposit.

Most of FINRA's questions centered on firms' auction-rate securities sales, sales practices, and marketing, the sources said.

The SEC probe is its second in the auction-rate securities market. The commission in June 2006 reached a global settlement with 15 banks and broker-dealers, under which they paid $13 million to settle charges that they violated the securities laws by engaging in undisclosed practices, such as bidding in auctions to prevent them from failing.

Market sources said yesterday that while the first SEC probe focused on how auctions work and the omissions firms made by not disclosing certain practices, this one focuses on sales practices and whether firms made misrepresentations about the securities, such as the risks they posed.

The probes stem in part from the fact that during the past weeks, the SEC and FINRA have received hundreds of complaints from auction-rate securities investors who reported they had no idea that they could become stuck holding the securities.

The SEC's enforcement division set up a specific mailbox for complaints about auction-rate securities: enf-ARScomplaints@sec.gov. The commission did not announce the address, but bloggers picked up on it and wrote about it, the sources said. Meanwhile, FINRA notified firms earlier this month that they should report ARS complaints for the first quarter of this year under three new separate product categories and codes that cover municipal debt, corporate debt, and closed-end funds.

The agency probes also come as several groups of investors have filed class action suits against major Wall Street firms over auction-rate securities and after Massachusetts Secretary of State William Francis Galvin recently subpoenaed Merrill Lynch & Co., UBS Securities LLC, and Bank of America Investment Services LLC for information on auction-rate securities to try to find out whether they warned investors about liquidity risks.

Earlier this week, Goldman, Sachs & Co. reported in its quarterly 10-Q financial filing with the SEC that it had "received requests for information from various governmental agencies and self-regulatory organizations relating to certain auction products, the interest rate or dividend rate of which is reset at a periodic auction, and the related recent failure of such auctions in whole or part." The firm said it is cooperating with the requests.

Yesterday, sources confirmed that five other large firms received similar requests: Bear, Stearns & Co., JPMorgan Chase & Co., Citi, Merrill, and UBS. But spokesmen for those firms declined to comment.

Meanwhile, representatives for other firms that were part of the 2006 global settlement that either declined to comment or could not be reached for comment include: Morgan Stanley, RBC Capital Markets,Lehman Brothers, Banc of America Securities, LLC, Morgan Keegan & Co., Piper Jaffray & Co., SunTrust Capital Markets Inc., and Wachovia Capital Markets LLC.


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