This entry is the opening statement I gave for one of my classes last year. I acted as the expert witness to testify why auction rate security (ARS) market makers engaged in fraud.
Auction Rate Securities Statement
It is my opinion that auction rate security (ARS) market makers engaged in fraudulent behavior through the use of control fraud to deceive their clients. ARS market makers engaged in control fraud by manipulating the demand for ARS through the use of support bids by placing their own bids on the Dutch auction so they would not fail. The support bids provided an artificial representation of the market, thus manipulating the normal supply and demand for ARS. ARS market makers withheld this information from their clients.
Clients trusted financial firms to make financial investments on their behalf because the financial firms, the so-called experts, have knowledge and information about financial products to which customers are not privy. Financial firms that make investment decisions for their clients have a fiduciary obligation to provide sound and responsible advice. In the case of ARS, the firms violated their fiduciary obligation by breaking that trust and acting in an irresponsible way.
Financial firms presented their financial agents as ARS experts even though many of them admitted they knew nothing about the product they were selling or even how ARS work. Financial agents were not properly trained on how the products work or, as in many cases, told to just push the product. Financial firms took advantage of this information asymmetry knowing full well many of their financial advisers didn’t know anything about ARS, misleading clients into believing they were working with financial experts.
ARS are long-term debt obligations that usually mature at 30 years, with interest rates set through a Dutch auction every 7, 28 or 35 days. Financial firms misrepresented ARS as liquid-safe cash alternatives by marketing them as such. ARS are liquid only if the Dutch auction is successful. ARS market makers failed to disclose to their clients in the event the auction fails, ARS become long-term debt instead of short-term debt. In addition, if the Dutch auction fails, ARS become illiquid. ARS market makers were not forthcoming with this information, leading clients to make decisions based on misleading information.
Financial firms’ misrepresentation of ARS risk created an environment–through adverse selection–that attracted only risk averse clients. By marketing ARS as safe risk-free liquid financial products, financial firms attracted clients looking to make safe investments only, which is what happened based on the numerous testimonies in the attorney general complaints. Financial firms did not warn their clients about ARS becoming illiquid should the Dutch auction fail, further eroding their fiduciary obligations.
Financial firms continued to sell ARS even when ARS market conditions were deteriorating. Executives, fully cognizant of current events, sold their shares of ARS as they observed market failure was imminent. Not only did executives escape unscathed, they profited greatly from selling their ARS before the market collapsed.
As executives were making a mass exodus, as well as massive profits, from the ARS market, emails obtained from financial firms “encouraged” managers to increase their sales efforts of ARS; hence, they were “encouraged” to continue acting in a perfidious manner with their clients. It’s simple, financial firm executives were privy to what was happening with the ARS market–they took advantage of their information asymmetry. They knew the market was going to collapse, so they sold their ARS while they could in order to profit as much as they could, but their financial advisers continued to sell–in fact increase sales–a risky product teetering on the brink of disaster to risk averse clients.
To conclude my remarks, I believe that ARS market makers engaged in a control fraud. They created trust with their clients, then broke that trust by withholding information. Many times, where there was supposed to be transparency, there was nothing but opaqueness. Firms took advantage of the information asymmetry to mislead their clients, while violating their fiduciary obligation.