WASHINGTON - Merrill Lynch & Co. sales and trading managers altered their research department's reports on the auction-rate securities market to minimize the risks of the securities and to forestall a collapse of the $330 billion ARS market, Massachusetts Secretary of the Commonwealth William Galvin argued in a lawsuit filed against the firm yesterday.
The complaint was filed by the securities division within Galvin's office on the same day that leaders of the House Financial Services Committee announced they would hold hearings to examine problems in the auction-rate market as well as changes that could be made to improve municipal disclosure and accounting standards.
Committee chairman Barney Frank, D-Mass., and Rep. Paul Kanjorski, D-Pa., announced that they would send letters to the Treasury and Education departments, urging them to do more to help nonprofit student loan lenders that still have billions of dollars stuck in illiquid ARS.
Galvin's complaint against Merrill, which comes about a month after he filed a lawsuit against UBS Securities LLC and UBS Financial Services over their ARS sales practices, asks that Merrill be ordered to "make good" on the sales of ARS that are now frozen and make restitution to those who had to sell their holdings at below the par value. Galvin also asks that the firm be censured and ordered to pay an administrative fine. Merrill has three weeks to respond to Galvin's complaint.
"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 in a statement. "They knew the auction markets were in trouble, but the investors were the last to know."
The auction-rate market collapsed in mid-February when firms that historically supported the market, but were under no contractual obligation to do so, stopped propping them up.
In April, the North American Securities Administrators Association formed an ARS task force to coordinate a series of state investigations of whether state securities laws were violated in connection with the offer and sale of securities.
Since then, Massachusetts and New York - which has opted out of the task force - have filed charges against UBS. Texas has announced a September hearing to consider revoking UBS' securities license in that state. A related investigation of Bank of America NA is still ongoing by Massachusetts, according to Brian McNiff, Galvin's spokesman.
In a statement, Merrill said yesterday that it is disappointed by the suit, "because it ignores the only reason our advisers sold auction rate securities: they believed they were good investments for clients willing to trade some liquidity for higher return.
"The inarguable fact is the number of auctions that had failed in nearly two decades of ARS sales was small. In 2007 there were no failed auctions of securities sold to retail clients and, in fact, none to these clients until last January," the firm added.
Merrill also stressed 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."
As with the UBS lawsuit, the complaint against Merrill shows that broker-dealers became aware of problems in the ARS market as early as last summer yet continued to sell them as safe, liquid investments.
Unlike UBS, however, the Merrill suit suggests that the firm's research department was subservient to the needs of Merrill's auction desk, which was part of its sales and trading department. For instance, when auction desk personnel did not agree with the tone or context of a published research piece, Merrill managers permitted sales and trading to insist the published report be retracted and replaced with a more sales friendly piece.
After a small number of auction failures in August 2007, a research piece that was published in the firm's Fixed Income Digest primarily to highlight the differences in liquidity features between auction rate preferred stock and variable rate demand obligations noted that the VRDOs have a hard put feature - guaranteeing that a bank will purchase the security if it cannot be remarketed. The auction preferred share product did not.
Frances Constable, a Merrill managing director who was in charge of the auction desk, sent an all-caps e-mail to other bank employees that said: "I had not seen this piece until just now and it may single-handedly undermine the auction market. If you are getting any calls, please let me know. I have asked for an immediate clarification to be published an a retraction of this."
The research department agreed to retract and rewrite the piece in a manner that was markedly different in both focus and scope from the original conclusion and concluded that ARS presented "a buying opportunity for investors who are looking for short-term instruments," according to Galvin.
Pressure and objections from the auction desk had lasting effects on the research department's published options, Galvin said, citing a January e-mail from a researcher requesting that someone else review his work before it was published to ensure that it did not upset the auction desk.
"I want to make sure that research cannot be accused of causing a run on the auction desk, like was the case in August," the e-mail said. "I think we have sufficiently covered that risk, but would like his thoughts."
The suit shows that the firm also heavily relied on the triple-A ratings of its auction products as a selling point, even though they let fail some triple-A CDO-backed securities and other auction-rate products that were rated triple-A last August. For example, a Sept. 25 marketing presentation, prepared by Constable, referred to closed-end auction market preferred shares as "generally rated AAA with very few exceptions," adding that student loan and municipal-issued ARS were also rated triple-A.
Still, Galvin noted that the firm was aware - yet did not disclose to investors - that the triple-A rating did not provide protection against Merrill's dropping support of its ARS program, as it did on Feb. 12.
The suit further alleges that Merrill may have blindsided at least some municipal issuers by not warning them away from the auction-rate market before it collapsed.
The suit cites a series of e-mails from late January in which auction desk senior trader Jim Brewer told an investment banking colleague that it was time to warn the East Bay Municipal Utility District in Oakland, Calif., that the market was no longer working.
"Lehman [Brothers] failed five auctions yesterday - this is unprecedented," Brewer wrote. "We have to let EBMUD know that we feel the auction rate market is going to get worse, not better, and they would be best served exiting the market."
He was reacting to questions about an increase in rates on $74 million of the public utility's water system revenue bonds. Later, he realized the debt was sold as variable rate demand obligations, negating the need for his earlier advice. But in citing Brewer's e-mail, the suit appears to allege that the firm was considering telling its issuer clients to switch out of the ARS market, and noted that "similar concerns were not shared with FAs [financial advisers] or retail customers."
Meanwhile, leaders in the House Financial Services committee announced that the committee will hold a Sept. 18 hearing to discuss possible solutions to illiquidity in the auction-rate market.
The committee also plans to hold a hearing Sept. 11 to discuss municipal market disclosure, at which Securities and Exchange Commission chairman Christopher Cox is scheduled to testify and discuss a 2007 white paper that urges Congress to consider boosting municipal disclosure and accounting standards.
Committee leaders said they would support better disclosure for revenue and other tax-exempt debt that is not backed by the general obligation of issuers. They said GOs are as safe as Treasury bonds and additional disclosures for them are not needed.
Andrew Ward contributed to this story.