Financial Services: Prompting an SEC complaint

By: James J. Eccleston
Shaheen, Novoselsky, Staat, Filipowski & Eccleston

Recently the Securities and Exchange Commission filed a federal lawsuit against Morgan Keegan & Company Inc. alleging widespread sales-practices violations in connection with its underwriting, marketing and sale of auction rate securities (ARS).

The SEC’s complaint contains a treasure trove of alleged facts against Morgan Keegan, which investors, and their lawyers, should find to be fascinating reading. As background, auction rate securities are bonds (issued primarily by municipalities and student loan entities) or preferred stock (issued by closed-end funds) that provide for interest rates or dividend yields that are periodically reset through auctions. Auctions fail when there are not enough bids at the auction to cover the securities for sale. If an auction fails, then the issuer (the municipality, student loan entity or closed-end fund) must pay a pre-determined maximum rate or yield, but, importantly, the ARS is illiquid at that point in time and until the next successful auction.

Let’s highlight the key allegations of the SEC’s complaint. First, Morgan Keegan underwrote 60 ARS issues with a total par value of about $1.1 billion. Additionally, Morgan Keegan resold to its customers another $1.1 billion of auction rate securities that other broker dealers had underwritten. For its efforts between June 2007 and February 2008, Morgan Keegan was paid about $4.3 million in fees and commissions.

Second, the SEC concludes that, between 2002 and Feb. 27, 2008, a majority of the ARS auctions for which Morgan Keegan served as the lead broker dealer would have failed without Morgan Keegan’s participating in the auctions by placing bids for its own account. Morgan Keegan’s participation thus gave the impression, and provided false reassurance, that an ARS was liquid.

In fact, when Morgan Keegan stopped supporting ARS auctions beginning Feb. 27, 2008, the auctions started failing on a widespread basis. By March 20, 2008, Morgan Keegan customers were left holding about $1.2 billion of illiquid securities.

That figure remained at $272 million as of July 15, 2009.

Third, the SEC alleges that Morgan Keegan violated securities laws by selling auction rate securities through misrepresentations and omissions of fact — both to the firm’s customers and to its brokers as well! For example, the SEC charges that Morgan Keegan never disclosed to its customers or to its brokers the level of the firm’s participation that had been required to prevent failed auctions. Furthermore, Morgan Keegan routinely sold ARS issues as an “attractive alternative” to money market funds, “liquid and safe” and “guaranteed.” Not until March 20, 2008 — five weeks after ARS auctions had begun failing on a widespread basis — did Morgan Keegan institute an “enhanced disclosure” policy requiring customers to sign a detailed warning before purchasing. The SEC appears particularly disturbed that no action was taken earlier to properly train brokers and/or warn customers. The Morgan Keegan credit committee notes, dated Aug. 30, 2007, reflect that Morgan Keegan’s general counsel “expressed concern” during the meeting about how auction rate securities were being sold and “asked how we can make sure people know [auction rate securities are] not a money market.”

Fourth, Morgan Keegan knew of “significant and increasing risks associated with ARS” in late 2007 and 2008. For example, on Jan. 18, 2008, Morgan Keegan’s head of retail ARS warned of a “sell off” for Morgan Keegan’s auction rate securities, which “could potentially cause a failed auction.”

Between Jan. 22, 2007, and Feb. 13, 2008, Morgan Keegan witnessed its normal-sized ARS inventory of about $20 million mushroom to $75 million. By Feb. 21, 2008, the inventory ballooned to $180 million. At that point, Morgan Keegan’s credit committee “definitively capped the firm’s ARS inventory at $185 million,” which, according to the SEC’s complaint, meant “effectively withdrawing the firm’s support for future auctions.” The SEC concludes, “Morgan Keegan-managed auctions then began to fail on a widespread basis.”

Fifth, rather than alert its customers or notify its brokers of auction failures and its decision to stop supporting auctions, Morgan Keegan actually accelerated sales of auction rate securities in late 2007 and 2008.

The SEC finds particular fault with the Morgan Keegan’s credit committee’s looking to “broaden the demand” for auction rate securities when it met on Feb. 19, 2008, several days after other firms’ ARS auctions had started failing on a widespread basis.

Worse still, the SEC alleges that Morgan Keegan downplayed the liquidity risks, for example, in December 2007 (”Check out Santa’s ARS Specials”), and in January (”yields from ARS are so attractive” due to “seasonality”). Perhaps most alarming is the series of e-mails uncovered by the SEC in which Morgan Keegan discouraged its brokers from selling their customers’ ARS holdings.

In its lawsuit the SEC requests, among other things, an order or rescission for all auction rate securities that Morgan Keegan sold prior to March 20, 2008.

That relief certainly is justified.