Our work in numerous ARS matters includes cases brought by issuers and investors against investment banks that served as underwriters and broker-dealers for ARS.
Starting in late 2007, the number of auction failures increased dramatically, peaking in February–May 2008. Following the auction failures, both issuers and investors filed claims against the investment banks that served as underwriters or broker-dealers of the ARS.
Issuers and investors alleged that the investment banks had previously “propped up” the ARS market by bidding at auctions, thereby obscuring the illiquidity in the ARS market. They alleged the underwriting banks knew, but failed to disclose, that the ARS market would collapse without underwriter support.
Issuers that had to pay relatively high fixed maximum rates as a result of the failed auctions typically claimed that they would have opted to issue different types of debt—such as fixed-rate bonds—had the banks made appropriate disclosures. Investors that could not sell their ARS because of the auction failures claimed that they would have purchased more liquid securities or securities offering higher rates.
Cornerstone Research staff analyzed auction and inventory data of the broker-dealers, demonstrating that their previous auction participation was not to “prop up” the market but rather to provide liquidity between auctions. Our analyses also found there was investor demand for ARS as the inventory purchased by broker-dealers was typically sold to investors before the next auction. In addition, we assessed damages estimates proffered by issuers’ experts, and showed interest savings for issuers relative to other types of debt issuances.
In the investor cases, Cornerstone Research staff analyzed alternative investments and their returns, and demonstrated that investors were fairly compensated for the higher liquidity risk of the ARS.
About Auction Rate Securities
ARS usually have long-term maturities (twenty years or longer) with interest rates that are reset at short-term intervals via Dutch auctions. Importantly, ARS interest rates are typically subject to an interest rate cap in the form of a maximum rate. This maximum rate can be fixed or can vary formulaically over time.
Because of this cap, interest rates cannot always adjust so that demand for ARS equals supply. If there are not enough bids to purchase all the ARS to be sold at an auction, the auction “fails.” When an auction fails, the interest rate for the next interval is set at a “maximum rate” specified in the ARS offering documents. Investors wanting to sell their ARS in the auction may not be able to do so in these circumstances.