Suits claim firms deceived clients on bonds

Investors say top companies misled on risk

NEW YORK - Morgan Stanley, the second-largest US securities firm, and Merrill Lynch & Co., the third-largest, were sued by customers who claim investors were misled about the risks of bonds known as auction-rate securities.

The investors accuse Morgan Stanley and Merrill Lynch of inappropriately marketing the bonds as money-market alternatives that could be readily sold, according to separate complaints filed yesterday in federal court in New York.

"Morgan Stanley uniformly failed to disclose that ARS are not cash alternatives to money-market funds but are instead complicated financial products based on bonds having maturities of 30 years and longer," investor Gary Miller wrote in his complaint against Morgan Stanley.

Auction-rate borrowers and taxpayers are suffering as fallout from the collapse of the subprime mortgage market threatens the credit ratings of the world's largest bond insurers, tainting even the safest insured debt. What was supposed to be the cheap alternative to traditional long-term debt is now more expensive. Thousands of auctions have failed from lack of bids, triggering penalty terms that sometimes raise annualized interest rates fourfold in one week.

"Morgan Stanley denies the allegations in the complaint," company spokeswoman Christine Pollak said. "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 recent market conditions."

Merrill spokesman Mark Herr declined to comment on a suit brought by investor Frederick Burton.

Both suits seek unspecified damages and class-action, or group, status to represent people who bought the bonds from the firms. On March 17, an investor filed a similar lawsuit in New York against Deutsche Bank AG, Germany's biggest bank.

Interest rates on the securities are reset through auctions at intervals ranging from seven to 35 days, allowing buyers and sellers to treat them like short-term investments. When an auction fails because of lack of demand, current investors must hold onto the securities, whose yield is reset at a penalty rate according to a preset formula.

The firm "failed to disclose that ARS were only 'liquid' because Morgan Stanley and other broker-dealers created an artificial market for ARS which would dry up as soon as these broker-dealers decided to remove themselves from the auction process," Miller said in his complaint.

"Morgan Stanley is working to address its clients' liquidity needs, on a case-by-case basis, through various alternatives including lending," Pollak said.

Goldman Sachs Group Inc. is the largest US securities firm.