Arbitrations that involve auction rate securities are about to be tested in new hearing procedures established by the Financial Industry Regulatory Authority Inc.
And small dealers — particularly "downstream firms" that didn't underwrite auction rate securities or run auctions — are at a greater risk of losing arbitration cases and being assessed damages, observers say.
Such firms are less likely to be able to afford to settle with regulators and buy back the auction rate securities from burned investors, they say.
Already,
Stifel Financial Inc. of St. Louis has disclosed that it might not have the capital or borrowing power to buy back the $226 million worth of auction rate securities owned by its clients. A buyback of that magnitude would have a "material adverse impact" on the company,
Stifel said in its third-quarter report.
Firms that have been able to buy back auction rate securities are likely to fare far better in arbitration, observers said. Indeed, if investors pursue these firms under normal arbitration procedures, investors' out-of-pocket losses will be minimal and arbitrators will be unlikely to award damages, plaintiff's attorneys said.
CONSEQUENTIAL DAMAGES
New arbitration procedures offered under terms of the ARS settlements rely on a single public arbitrator to hear cases brought by investors who claim "consequential damages" from auction rate securities.
Those are damages caused by not having access to their funds.
Significantly, under the special arbitration program, firms have agreed not to contest their liability. They could, however, argue that investors haven't suffered consequential damages.
Indeed, proving that they are owed money after getting their ARS holdings cashed out will be difficult for investors, said David Robbins, a plaintiff's attorney and partner at Kaufmann Feiner Yamin Gildin & Robbins LLP of New York.
By contrast, brokerage firms that haven't bought back auction rate securities from customers will be hard-pressed to defend themselves in arbitrations, he said.
"They have no defense. The very basis for securities law is full disclosure of material information," Mr. Robbins said.
With ARS, "there was no discussion [by any firms of] the possibility of a failed auction," he said.
At the end of November, the latest period for which data are available, 275 ARS cases had been filed year to date. But some of those may have been withdrawn in the wake of buybacks.
Last July, as the ARS investigations were picking up steam, Finra had received about 110 ARS-related arbitration claims.
Plaintiff's attorneys said that smaller firms facing arbitrations include Stifel, Raymond James Financial Inc. of St. Petersberg, Fla., and New York-based Jefferies & Co. Inc. and Oppenheimer & Co. Inc.
Anthea Penrose, a spokeswoman for Raymond James, and Brian Maddox, a spokesman for Oppenheimer, declined to comment.
Spokesmen for Jefferies and Stifel didn't respond to questions.
In public filings and statements, several of the downstream firms say they didn't know that underwriting firms supported auctions, and had no indication that the market was about to freeze up.
But plaintiff's attorneys counter that a Securities and Exchange Commission enforcement action concluded in 2006 pointed to many of the shortcomings and conflicts with the auction process. In addition, by the summer of 2007, the industry knew that auctions on some types of the securities were already failing, they say.
Last month, New York and Washington-based Finra provided an update on how the consequential-damages program would run.
Under the program, investors with pending claims can switch to the special procedure — provided they limit their claims to proven opportunity costs.
In return, firms can't contest claims of misrepresentations or omissions, or "use [as a] defense an investor's decision not to sell ARS holdings [or] borrow money from the firm," Finra said.
The program is available for claims against the five firms that have finalized settlements with Finra or the SEC: Citigroup Inc. of New York, Comerica Securities Inc. of Detroit, First Southwest Co. of Dallas, UBS Financial Services Inc. of New York, and WaMu Investments Inc. of Irvine, Calif.
In a separate program announced by Finra in August, investors suing brokerage firms under the normal arbitration process can choose to have their cases heard before a specially formulated arbitration panel.
Under this procedure, arbitrators who since Jan. 1, 2005 have sold auction rate securities, or worked for a firm that sold the securities, would be excluded from hearing ARS cases.
Finra's move to restrict industry panelists was welcomed by the plaintiff's bar, which has long sought to remove industry-affiliated members from arbitration panels. But the procedure has caused some delays in formulating panels, lawyers said.
Ruthann Niosi, a plaintiff's lawyer at the Law Offices of Ruthann G. Niosi Esq. PC in New York, said she filed an ARS case last June, but the panel wasn't selected until December.
"Normally, it takes three months," she said. "It wasn't that Finra was making mistakes, it just seemed to be an arduous process."
Ms. Niosi expects the process to im-prove as Finra administers more cases under the new selection routine.
E-mail Dan Jamieson at [email protected].
