Investors desperate for cash turn to courts
A crush of new lawsuits accuse brokerage firms of deceiving investors about the risks of an obscure investment known as auction-rate securities.
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NEW YORK (Fortune) -- Angry investors are suing some of Wall Street's biggest brokers because they can't access money they poured into investments, known as auction-rate securities, that have long been billed as short-term and low-risk.
The defendants in a series of class-action lawsuits filed in mid-March include Merrill Lynch, UBS (UBS), Deutsche Bank, TD Ameritrade, and Wachovia (WB, Fortune 500). The plaintiffs are individuals who are increasingly desperate to get their money out of investments that they thought would be as safe and liquid as money-market funds and savings accounts.
For years, auction-rate securities seemed a sure bet. But ever since the credit crunch hit, investors have not been able to get at their savings because of the way these investments were structured. There are more than $300 billion worth of bonds currently frozen in the auction rate market, and retail investors could hold anywhere between $30 billion and $60 billion of those securities, according to several fund managers.
The lawsuits accuse the brokerage firms of deceiving investors with false promises that auction-rate securities were cash-like investments. Jonathan Levine, an attorney representing investors, said clients were assured that their investments were risk-free and completely liquid. "The misrepresentations and omissions occurred at the broker level," says Levine of Girard Gibbs, a San Francisco-based law firm.
Deutsche Bank (DB), Wachovia, and TD Ameritrade (AMTD) declined to comment. Both UBS and Merrill said the lawsuits are unfounded.
"When clients purchased [auction-rate securities] from us, we provided them with information about the auction-rate security and process. We do not believe this lawsuit has merit," says Mark Herr, a Merrill spokesman.
While large funds and corporations have bought these relatively arcane products, they were also targeted at retail investors. The minimum investment has often been reported at $100,000, but many closed-end funds that held auction rates required a minimum of $25,000.
Auction-rate securities, which have been around since the 1980s, were sold as a way for investors to receive higher yields on their money than they would in traditional cash options like saving accounts and money market funds, but with the same ability to access their money whenever they want.
A look at the prospectus shows that these products came with no such guarantee. For example, money-market funds buy short-term paper and guarantee that investors can access their money and not lose their principal investment.
But investors in an auction-rate security put money into a long-term bond, sometimes with a 30-year maturity date. Since these bonds have historically been sold at auctions held every seven to 35 days, investors have been able to sell their investments relatively quickly. Big banks like Goldman Sachs (GS, Fortune 500), UBS and Merrill would step in and buy any unsold bonds - hence their "cash-like" quality.
Here's the catch: These banks are not obligated to buy the bonds, which is one reason they paid a slightly higher yield than a saving account or money-market fund. In February, as the credit crisis got worse, Wall Street's biggest banks didn't have enough cash to buy auction-rate bonds and keep the market humming. Auctions failed and, as a result, investor funds have been frozen.
Nearly all retail investors in auction-rate securities did not buy bond funds from the asset managers that created them, nor did they buy auction-rate bonds directly from the municipalities, schools, and other institutions that issued them. They bought the securities from brokers who, the lawsuit alleges, did not properly disclose the risks.
The investors in auction-rate securities who spoke with Fortune, most of whom are not involved in the lawsuits, say they requested safe, liquid investments that were cash or cash equivalents. Brokers, they say, never used the phrase "auction rate"; instead, these securities were described as seven-day paper, weekly money-market investments, seven-day CDs, and short-term rolls.
"The broker who sold these products to me represented them as a cash equivalent with absolutely no liquidity risk," says Joseph Lanzisera, whose broker at Merrill Lynch helped put his money into closed-end municipal bond funds from Nuveen, AllianceBernstein, Putnam, and BlackRock (BLK). "He knew that I needed about 25% of the money for this tax season and that I had previously rejected several proposals to invest the money in the stocks or fixed-income markets because they were too risky."
Adam Sherman, who has money tied up in Nuveen and PIMCO closed-end funds, points out that there was nothing in the expense ratio or the yield that would indicate that the risk was that much higher than what an investor would find in a money-market fund. For example, at the end of 2007, Nuveen's Multi-Strategy Income and Growth (JPC) fund had an expense ratio of 0.52%, not much more than the 0.3% fee on a Vanguard Prime Money Market fund. Also, a Nuveen taxable auction-rate fund yielded about 4.75% vs. a little more than 3% in the Vanguard Prime Money Market fund.
"It is a fallacy to think that we were high-risk investors reaching for really high yields," says Sherman. "We were told these were AAA-rated products that were highly liquid."
The investors also said that they were never sent prospectuses and that they were listed along with cash on their statements.
Investors who had been saving money for down payments on homes or to pay college bills, taxes and medical bills have become increasingly desperate to access their cash since the auctions began last month. Three funds run by Eaton Vance have already liquidated some auction rate securities and returned money in full to investors. (See correction at end of story) However, most managers have been unwilling to hurt the value of the fund in order to put cash into the hands of shareholders. Instead they remind investors that their principal has not lost value and that they are being paid a higher yield while they wait.
Even so, that is little comfort for investors who need to pay bills now.
"Even with the extra I'm getting paid for the failed auctions, my yield is not much more than a money market fund," says Sherman.
Correction: An earlier version of this story incorrectly said that Eaton Vance had lost money when it liquidated auction rate securities from its funds. 
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