New York sues UBS for alleged auction rate securities fraud

UBS executives sold off $21 million in personal auction rate securities (ARS) holdings just days before the market ground to a halt, while continuing to market the securities to unwitting consumers, a New York State lawsuit has alleged.

Attorney-general Andrew Cuomo has filed suit against the Swiss bank at the Supreme Court of New York, seeking $25 billion in restitution for UBS customers caught holding the illiquid paper once the investment bank stopped supporting the ARS market in its role as an auction agent.

Cuomo’s suit contends UBS “falsely sold and marketed auction rate securities as safe, highly liquid, and cash-equivalent securities. However, the representations were deceptive as the auction rate securities market came under tremendous strain, leaving the securities with mounting liquidity risks that eventually blocked thousands of customers from accessing their holdings.”

The ARS market effectively shut down during the week of February 11 after investors fled the sector. The exodus was triggered by concerns over monoline insurers - which had wrapped a large chunk of ARS debt – suffering a series of ratings downgrades. Dealers were left to act as bidders of last resort on increasing volumes of ARS paper, tying up large sums of cash in the midst of a liquidity drought. Eventually investment banks elected to stop supporting auctions, simply allowing the auctions to fail when no bidder emerged.

This meant investors holding ARS paper before the auctions were unable to extract their cash from the instruments and were essentially stuck holding them. Note-holders were compensated by penalty coupons of up to 20% for the auction failure, but this provided negligible comfort for investors who entered the market on the understanding ARS notes were a cash equivalent. According to the suit, as of February 2008, UBS had more than 50,000 customer accounts containing auction rate securities.

The New York Attorney-General’s Office claims UBS customers are holding more than $25 billion in illiquid, long-term paper as a result of UBS’s fraudulent misrepresentations and illegal conduct. Although the paralysis of the market was unexpected – with only 13 auctions failing between 1984 and 2006 – if UBS managers are proven to have liquidated their own positions shortly before the bank withdrew from its backstop role at auctions, while simultaneously continuing to market the product to consumers, the state could have a very strong case.

Cuomo’s investigation has subpoenaed internal UBS emails that allegedly detail executives’ efforts to sell off personal holdings of auction rate securities. The seven managers in question were all part of an ARS working group UBS allegedly established in late 2007 to address the unsustainable growth in size of the bank's holdings of the securities and its need to support auctions to avoid auction failures.

According to the complaint, among the solutions UBS hit upon was “to have its financial advisers sell auction rate securities and lessen the mounting pressure of UBS’s growing inventory. While many options were discussed, the only one that was repeatedly implemented was to re-double sales efforts to UBS clients.”

“Not only is UBS guilty of committing a flagrant breach of trust between the bank and its customers, its top executives jumped ship as soon the securities market started to collapse, leaving thousands of customers holding the bag,” said Cuomo in announcing the suit. “Today we bring the first nationwide lawsuit against UBS, seeking to recover billions of dollars for customers and sending a resounding message to the rest of the industry that this type of deceptive behaviour will not be tolerated.”

UBS has by no means escaped the ARS market clean, however. In March the bank announced it was writing down 85% of its $5.9 billion ARS inventory.

Elsewhere a number of other lawsuits are apparently in the works across the US as municipal authorities that issued debt into the ARS markets – and ended up paying penalty coupons when the sector broke down – look to sue dealers who similarly assured them that the market was essentially a cash equivalent with virtually no chance of widespread auction failures.

See also: UBS to write down $5.9bn auction rate securities book
Banks sued over ARS lockdown
Auction rates securities investigations gathering steam
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