For the municipalities, student loan originators and other ARS issuers behind the suits, the freeze has triggered the imposition of maximum interest rates of up to 20% to compensate investors for their inability to trade their ARS contracts.
As the first flurry of legal actions are launched, Morgan Stanley has been served papers in a class-action suit by investor Gary Miller for "deceptively marketing" ARS bonds as cash alternatives. He is seeking court approval to "compel Morgan Stanley to rescind millions of dollars in ARS transactions" while also pursuing damages.
ARS paper was widely marketed as a cash alternative because the purchase commitments of the backstop broker-dealers provided the market with liquidity comparable to money market funds. Accordingly, between 1984 and 2006 just 13 auctions failed to attract bids or were purchased by auction agent broker-dealers. By February, as many as 700 auctions were failing every day following the broker-dealer exodus.
The Morgan Stanley suit follows three additional claims filed earlier this month against Merrill Lynch, Deutsche Bank and UBS, again over complaints that auction securities were deceptively marketed to investors who were unaware liquidity could quickly evaporate.
So far, the security issuers have refrained from legal action, but municipalities such as the Port Authority of New York and New Jersey, which told Risk it chose the ARS market as a means of financing on the recommendation of its broker-dealer partners, might feel they have grounds to sue.
Dealers have reported that ARS issuers are seeking to rapidly restructure their debt into either long-term fixed-rate bonds or floating variable rate demand notes, which provide similar short-term financing to ARS through notes linked to the performance of underlying indexes such as Libor. So far, as much as $20 billion of the $330 billion ARS market is being restructured, analysts say.
The Securities and Exchange Commission has sought to assist issuers by permitting them to bid at auctions to buy back their own debt, thereby avoiding exorbitant penalty interest rates. However, the move is regarded to have little impact on the orderly dissolution of the ARS market now under way.