For over 25 years, Auction Rate Securities (ARS) products were considered safe and sound investments. Then, everything changed in 2008 when investment banks stopped purchasing ARS products at the beginning of the Great Recession. The pause in ARS purchases caused an overall market freeze that snowballed into a massive influx of investor complaints against brokers who were making investment recommendations based on information given to them by broker-dealers who had misrepresented the liquidity of ARS products. The major communication breakdown between broker-dealers and investors as well as the public’s limited knowledge of ARS investments caused brokers to take a major financial hit that still haunts them to this day.
As late as December of 2007, One research analyst even referred to ARS investments as “the conservative’s conservative auction security."
The Birth of Auction Rate Securities
Auction Rate Securities (ARS), were invented by Ronald Gallatin at Lehman Brothers in 1984. This kind of investment issued long-term securities that could pay their buyers interest rates only a little above short-term rates. That was achieved by having periodic auctions to reset the rate. As long as there were willing bidders for the securities, any holder could sell the security at face value whenever there was an auction.
Over time, the Auction Rate Securities market would steadily grow to over $200 billion without any hiccoughs. Investment banks would often act as “bidders of last resort” on ARS products, meaning that, if investors were not bidding on ARS investments, the investment banks would step in and repurchase the ARSs to ensure liquidity in the market. This led to ARS products generally being viewed as safe investments until the US economy crashed in 2008.
Auction Rate Securities Had a Long-Standing Reputation for Being a Safe Investment
With no widespread liquidity issues in the ARS market since the 1980s, and the knowledge that banks were acting as a safety valve for the liquidity of ARS investments, several broker-dealers eventually began representing Auction Rate Securities as cash or money market alternatives. Some broker-dealers classified ARS products as cash and cash equivalents on investor account statements to both brokers and investors. As late as December of 2007, one research analyst even referred to ARS investments as “the conservative’s conservative auction security.”
A Frozen ARS Market Leads to a Rise in Investor Complaints
Everything changed in February 2008 when the market went into a freefall and investment banks stopped purchasing ARSs. The liquidity of the ARS market froze as a result, and the investors who were relying on the liquidity of Auction Rate Securities, began to file complaints against the brokers who were selling them ARS investments. According to those clients, the brokers had deceived them by misrepresented the nature of the liquidity of the securities. The truth of the matter is that the brokers had not done anything wrong; they were just carrying a message. Instead, the broker-dealers were actually responsible for misrepresenting the liquidity of Auction Rate Securities to the brokers.
Had the general investing public been aware of what an ARS is or what happened to the market for ARSs in February 2008 and beyond, this may not be a big deal.
Broker-Dealers Repurchased ARS Investments to Absorb the Blow for Investors
Before they reached a global settlement, many broker-dealers attempted to hand investors more liquidity by giving them the option to take out loans with interest rates that matched the rates of the ARS investments they owned. However, many investors were not satisfied with the offer.
After FINRA Regulatory Notice 09-12 was issued in February 2009, some broker-dealers were required to repurchase ARS investments at par value from individual investors and from some institutional investors. The broker-dealers were also required to make whole certain investors who had sold their ARS products below par value.
Brokers Are Still Feeling the Impact of the ARS Freeze and the Broker-Dealer Communication Breakdown
Ultimately, the ARS liquidity debacle put brokers with otherwise clean BrokerCheck and CRD records into a position where they now have customer complaint disclosures on their U4. Had the general investing public been aware of what an ARS is or what happened to the market for ARS investments in February 2008 and beyond, this would not be a big deal.
Unfortunately, the general public is largely unaware, so when investors see these ARS-based investor complaints on a broker’s BrokerCheck record and read that the brokers are associated with six- or seven-figure settlements, they turn away and look for help from someone else.
The pool of brokers who received these types of customer dispute disclosures include some of the most honest, caring, and professional advisors in the industry, and many were in the industry for decades without a single customer dispute on their Form U4. In many instances, these brokers accurately represented the illiquidity of ARSs at the time they recommended the investment.
In most situations, brokers rightfully relied on the due diligence of broker-dealers, the history of the liquidity of the ARS market going back over 20 years, and the industry’s view on ARSs at the time they made the recommendation. Yet today, brokers suffer from the effects of these blemishes as negative marks on their BrokerCheck and CRD records.
As industry professionals are all too aware, brokers are presumed guilty until proven innocent when it comes to customer dispute disclosures. We at AdvisorLaw have the experience in protecting your livelihood and can help you navigate through the waters of seeking an expungement through FINRA’s arbitration forum.
Executive Vice President
5 Ways to Protect Your Reputation
You’re there for your clients through life’s most landmark moments—births, bris ceremonies, baptisms, graduations, marriages, home purchases, retirements, and even deaths. You become an extension of your clients’ families in some ways, because you share a mutually vulnerable relationship with them. For your clients, it’s all about their lives and their futures. For you, it’s your career and your good name. So what can you do to avoid accusations of wrongdoing from a client or a client’s family, were they to have a negative experience with their investments? How can you stay ahead of the curve enough to preserve your good name?
1. Keep Records on Money Management Consultations
It goes without saying that good, clear meeting notes and copies of your transactions are both key to your career success as well as your ability to defend your good name. Unfortunately, some advisors choose to let this best practice go by the wayside. This is a recipe for disaster, as those advisors will find it difficult to build lasting relationships with clients and defend themselves in difficult times.
Advisors who do keep good records, on the other hand, have a greater chance of self-preservation. Late last year, one AdvisorLaw client was accused of taking out a life insurance policy without his client’s consent. During the arbitration hearing, the advisor was able to present a copy of the life insurance policy application signed by the client. As a result, the advisor was able to have the false accusation expunged from his BrokerCheck profile.
2. Maintain as much client information as you can when you transition
If you plan to transition out of your current firm, take as much of your past client information with you as is permissible by your employment agreement. It may seem unnecessary, but holding on to your client notes can be the thing that saves you, if a sneaky or disgruntled client comes back to wreak havoc on your career.
For example, an advisor client of ours was recently accused of wrongfully selling a tenancy-in-common (TIC) investment to two seasoned investors, just before the 2008 market crash. The claim, raised until six years after the customers sold the investment and the advisor changed firms, alleged that the investment was unsuitable—even though both customers met the suitability requirements for the TIC investment, and the TIC was suitable for the customers, based on their overall portfolios.
During his hearing for expungement of the dispute, the advisor was able to turn the conversation around by providing a copy of the PPM that had been given to the customers. The PPM showed that both investors met the suitability requirements of the TIC and that the customers were made aware of the risks associated with the investments. He was also able to share copies of the customers’ investment applications, a record of the extensive conversations that he’d had with the customers about the investment, and additional evidence to corroborate his claim of no wrongdoing. As a result of the advisor’s ability to provide proof, he was able to remove the wrongful claim of unsuitability from his BrokerCheck record.
3. Set realistic expectations around investment performance and strategy
Trust and vulnerability are key pillars in the advisor-investor relationship. Your investor clients are constantly vulnerable to your recommendations and judgment, and they’re trusting you to do right by them. To protect your good name, your best bet is to always act in the best interest of the client and to set realistic expectations for an investment. Be explicit and candid about the risks, and avoid inflating the investment’s potential outcomes.
4. Avoid Selling Unnecessary or Unsuitable Products
Sometimes, you may find yourself towing the line between generating profits for your firm and acting in the best interests of your investor clients. While your clients’ needs always take precedence, there might have been times when you found yourself pressured into a situation where you felt the need to facilitate a transaction for a proprietary product that the client did not need or select an investment that wasn’t a good match for a client’s risk profile.
Being objective in a sales- and performance-driven role is exceptionally difficult, yet, more often than not, it is the best path to take. When you avoid selling unnecessary products and unsuitable investments, you’re protecting the client, as conflicts of interest such as these can impose a risk upon meeting client objectives. Likewise, you’re also avoiding potential FINRA investigations and ultimately protecting your career. Avoiding conflicts of interests helps to ensure that everyone wins in the end.
5. Give All Clients Equal Respect and Priority
It’s normal to give priority to the people who share a stronger bond with us. Though, in the investment business, it’s best to avoid falling prey to this tendency, even if we want to attach the label of “favorite” or “most important” to our top investors or the folks to whom we feel closest.
Giving one client priority over another or, perhaps, giving your most profitable investors exclusive access to certain investments, can lead to a downgrade in client satisfaction and blame. Giving all clients the same time and opportunities is the pathway to greater success for all involved. When clients are happy and have equal access to suitable investment opportunities, you open the door to improving your clients’ lives, strengthening the meaning of your good name, and elevating your career.
President and Founder
This blog is our ongoing effort to inform and educate FINRA licensed professionals about the evolving regulatory ecosystem in which we operate.