In this space approximately six weeks ago (click here), we reported on the failure of over $100 million in auctions concerning auction rate securities and cautioned that, “[r]egardless of the cause, the continued blossoming of the credit crisis should be of significant interest to insurers and reinsurers because failures in other areas of the debt markets could potentially lead to D&O and E&O claims similar to those seen in connection with the subprime mortgage crisis.”  Over the last several weeks, the auction rate securities crisis has reached the next stages: devaluation of auction rate securities by a major brokerage house, regulatory investigations and investor class-action suits.

On Friday March 28, UBS AG began downwardly adjusting the values of the auction rate securities held in its clients’ accounts by amounts ranging from a few points to over 20%, according to the Wall Street Journal Online.  This came after Merrill Lynch announced last month that it would begin reporting auction rate securities at an “estimated market price,” although to date Merrill Lynch has reportedly not marked down any such securities.

These changes in valuation methodology resulted in the filing last week of lawsuits against both Merrill Lynch and Morgan Stanley by certain of their respective clients who allege that they were sold the investments as risk-free “cash equivalents.”  For example, the complaint against Merrill Lynch alleges that “defendants knew, but failed to disclose that these auction rate securities were not cash alternatives, but were instead, complex, long-term financial instruments with 30 year maturity dates, or longer.”  A Morgan Stanley spokeswoman reportedly stated that Morgan Stanley denies the allegations and further noted that “The challenges of the auction-rate markets are industrywide, and result from broader credit-market conditions.  The auction-rate securities market has existed for over 20 years without significant disruption until market conditions.”  To view a copy of the complaint filed against Merrill Lynch, please click here.

Massachusetts Secretary of State William Galvin has also issued subpoenas to Merrill Lynch, Bank of America and UBS seeking documents related to the firms’ sale of auction rate securities to individual investors.  Mr. Galvin also issued a statement, noting that “Within the last couple of weeks, my office has received many calls from people who thought they were investing in safe, liquid investments only to find that they had, in fact, purchased auction market securities that are now frozen and they cannot get their money.”

As explained in our prior post, an auction rate security is a debt instrument (such as corporate or municipal bonds) whose interest rate is reset through  an auction in which the auctioneer begins with a high bid price and lowers that price until a bidder is willing to accept that price or the price falls below a pre-determined reserve price set by the seller (a “dutch auction”).  Auctions for auction rate securities are typically held every 7, 28, or 35 days and interest on the securities is paid at the end of each auction period.  If not enough buyers are found to buy the securities at prices above the seller’s reserve price, the auction fails and the securities revert back to the holders.

Given estimates that investors hold approximately $300 billion in auction-rate securities, the fallout from failures in the market for these products could be significant — continuing to impact both E&O and D&O coverage.

We will continue to monitor developments related to the subprime mortgage/credit crisis and provide updates at InsureReinsure.com.