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A recent spate of litigation suggests that various investors are combing the financial statements of numerous companies to scrutinize how some funds, broker-dealers, and public companies have characterized and marketed auction rate securities.

Auction rate securities are municipal bonds and other highly-rated financial instruments with interest rates set at periodic auctions. Through these auctions, holders of the securities have the ability to sell their investments. Although these securities usually have long-term maturity dates, for years auction rate securities have been classified (and at times marketed) as cash equivalents, akin to money market funds, because they could be liquidated at regularly scheduled auctions. On February 13, 2008, however, the ability to liquidate these securities deteriorated virtually overnight just as many broker dealers began withdrawing their support for the auctions.

In the wake of the failures of the auction rate securities markets, some now question whether it is – or ever was – proper to characterize these securities as liquid instruments. Several large broker-dealers have been targeted for allegedly pitching these securities to their clients as cash equivalents and for allegedly manipulating auction markets to mask the risk of failure. Despite the higher interest rates that auction failures trigger, investors have claimed that they relied on the cash equivalent status of these securities and would not have invested in these securities had they known the securities were not liquid instruments.

Effects of These Auction Market Failures

If some recent lawsuits are successful, then the companies that hold these securities on their books, and/or the financial institutions that sold these securities to investors, may have to compensate investors who were not properly notified of the risks inherent in these securities.

Already, some public companies have adjusted their financial statements, re-classifying the securities as “non-current assets.” At least one firm apparently felt compelled in recent weeks to disclose that:

(1) auctions for some of these securities were not successful, resulting in the firm continuing to hold the securities and the issuers continuing to pay interest at the maximum contractual rate;

(2) based on current market conditions, it is likely that additional auctions related to these securities will be unsuccessful in the near term;

(3) unable to auction these securities, the firm will hold the securities beyond their next scheduled auction reset dates, limiting the short-term liquidity of these investments;

(4) the failures in the auction process have affected the firm’s ability to access these funds in the near term; and

(5) further deterioration may result in an impairment charge.

Additional disclosures are possible following a recent SEC Staff Letter that was sent to some public companies whose SEC filings reported significant amounts of asset-backed securities, loans carried at fair value or derivative assets. The SEC letter identified some disclosure issues that companies may wish to consider in their quarterly reporting.

What Does It All Mean?

Hedge funds, broker-dealers, and other financial institutions may need to reassess their exposure to auction rate market failures. No doubt, these developments may lead to further class and derivative litigation against affected institutions. Likewise, concomitant SEC investigations may not be too far behind.