The Financial Industry Regulatory Authority (FINRA), the Securities and Exchange Commission and New York Attorney General Andrew Cuomo are looking into possible irregularities in auction rate securities (ARS).

There were reports at deadline, that the A.G.'s office last Monday and Tuesday subpoenaed 18 investment giants, including Merrill Lynch, Goldman Sachs and UBS. FINRA, which recently sent securities firms a survey on ARS, has reportedly begun a sweep investigation, with help from the SEC.

John Heine, a spokesman for the Commission, said that "while we cannot discuss specific matters, we are looking into representations made to investors when they purchased auction rate securities."

More than $300 billion of ARS are held by individual and institutional investors, including corporations and mutual funds. They are long-term bonds with interest rates set in auctions held every seven to 35 days by large banks such as Citigroup, Goldman Sachs, Merrill and UBS.

Since the inception of the market more than two decades ago, the bonds have been viewed as virtually the equivalent of cash, and brokers have sold the securities as liquid, safe alternatives to money market funds, with slightly higher interest rates. In at least one state, Massachusetts, many of the buyers were retail investors.

Last month, Citibank, Merrill Lynch, Morgan Stanley and UBS were all sued by ARS clients in separate actions.

The problem, experts say, is that the market has become illiquid due to the failure of hundreds of auctions, leaving investors with assets they are unable to sell. Their tumbling value has given rise to complaints that firms misrepresented to investors the safety of the securities.

Late last month, UBS said it was reducing the value of ARS in customers' accounts, a sign that the problems are spilling over into investors' principal holdings. UBS, which is using an internal valuation model, said markdowns will range from a few percentage points to more than 20%. While the Swiss bank has not disclosed the total value of auction rate securities held by clients, Martin Hoekstra, head of wealth management at UBS, has called it "a reasonable amount."

Website BloggingStocks reported on April 8 that handheld device maker Palm had to add $25 million to its first-quarter losses because of a write-down in the value of ARS.

As fears grow that more companies will soon report losses, FINRA appears to be moving to get out ahead of the game with its questionnaire. The ARS survey, a copy of which was obtained by Securities Industry News, asks about sales practices and types of customers that have purchased the securities. Questions include the total value of auction rate securities held by clients, whether margin loans are offered to customers using ARS as collateral, how they are marketed, whether they are used as a cash sweep product alternative, and the number of complaints about the securities since October 2007.

FINRA spokesperson Herb Perone would not name any recipients of the survey. He called it "a fact-finding, informational request. We do these routinely for CDOs [collateralized debt obligations], structured products, for retail hedge fund products, for variable annuities, and more."

FINRA Supervision?

Others say FINRA's concern is anything but routine. "A number of states [state securities regulators] have subpoenaed firms," seeking documents related to the securities, said Brian Rubin, partner at law firm Sutherland Asbill & Brennan in Washington and former deputy chief of enforcement at FINRA predecessor NASD. "FINRA is interested in seeing whether there were misrepresentations or omissions. Ultimately FINRA may be looking at supervision of these types of sales. FINRA might also bring enforcement actions or issue a statement of best practices. It is significant."

On March 28, Massachusetts Secretary of State William Galvin issued subpoenas to UBS Securities, Merrill Lynch and Bank of America requesting documents relating to ARS sales practices, following accusations from investors that they were misled.

"The recent freezing of the auction markets appears to be yet another aftereffect of the subprime lending excesses and the subprime market meltdown," Galvin said.

"Within the last couple of weeks, my office has received many calls from people who thought they were investing in safe, liquid investments only to find that they had, in fact, purchased auction market securities that are now frozen, and they cannot get their money," he added.

According to a source, the problems in Massachusetts stem in large part from the fact that many municipal obligations trade on the auction rate market. When some of their bond insurers were downgraded, it called into question their ability to make good on the insurance.

"This was a factor across the board," the source said, adding that the state's investigation began as a probe of ARS sold as preferred shares in closed-end mutual funds. "Investors who bought them were told [they were] as good as cash, and now they cannot get their money," he said. After what he described as a "flood of calls from investors," the state issued the subpoenas.

At the heart of the matter, said the source, is that large investment banks have decided not to "stand in the shoes of investors and make the market liquid." Asked to comment on the case, Bryan Lantagne, director of the Massachusetts securities division, said that "it is really a point-of-sale issue: What were investors sold, and what were they told?"

A key question, according to Rubin, is to what degree the securities were sold to small investors. In Massachusetts, Lantagne said, complaints have largely come from "average, unsophisticated people-mom and pop investors and retirees."

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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