State: Firm knew of market woes

Galvin says bank pressed its brokers to unload securities

Executives at the highest level of UBS Financial Services Inc. knew as early as last fall that the auction-rate securities market was failing, and urged brokers to move the investments from the firm's books into the hands of individual clients, state regulators alleged in a lawsuit filed yesterday against the brokerage.

In a scathing rebuke of the Swiss banking firm, the Massachusetts Securities Division complaint charged UBS with fraud and dishonest conduct in the sales of the investments. The state alleged that UBS brokers were encouraged to sell the securities - especially debt issued by student lenders - as if they were as safe as cash, even as top management knew the market could disappear.

UBS engaged in "profoundly deceptive sales practices," the state alleged, even misleading their brokers into believing the market was safe. UBS and other firms allowed the auction-rate market to fail on Feb. 13, no longer willing to buy the investments from clients who wanted to get out. The securities have not traded since then, leaving billions of dollars trapped.

"Our goal is to make people whole, the individuals we believe have been unfairly treated," said Secretary of State William F. Galvin, who oversees the securities division. The state is looking to compel UBS to repay the Massachusetts investors who bought the securities. It is also seeking a fine.

Karina Byrne, a spokeswoman for UBS, said in a statement, "We are disappointed that the Massachusetts Securities Division has filed this complaint against us, as we, our peers, and the industry work toward solutions." She said UBS would defend itself against the allegations and added, "UBS is committed to serving the best interests of our clients."

Internal UBS e-mails and records obtained by the state in its investigation paint a different picture, however.

By last August, David Shulman, UBS's chief of municipal bonds and fixed income, was under pressure to reduce the amount of auction-rate securities on the firm's books, the state said in its complaint. He kicked off a marketing campaign that month, including conference calls with brokers to tout the investments. He held such calls 13 times from Aug. 22 through the market's collapse in February.

But while Shulman was encouraging investors to buy the securities, he was selling: On Aug. 22, he sold a large portion of his own holdings in auction-rate securities, the state alleged.

UBS declined to comment on Shulman's behalf. He could not be reached at home late yesterday. He works in New York.

By early September, Shulman, in an internal e-mail, was discussing the turmoil building in the auction-rate market and suggested that the firm consider leaving the business. He acknowledged the "many legal and reputational issues on this decision."

On Feb. 12, the day before the auctions failed entirely, a UBS risk management executive urged Shulman by e-mail: "we need to beat the bushes harder than ever to unload this paper." In the 30 days before the market froze, 237 Massachusetts investors were sold $190 million worth of the securities, according to the state.

Wall Street invented auction-rate securities more than 20 years ago, but they grew in prominence in the past few years. They allowed nonprofits, like student lenders and city and state entities, to borrow money inexpensively. The debt was long-term, with interest rates that re-set at weekly or monthly auctions run by brokerage firms. The bonds offered investors returns slightly better than money markets.

But starting last fall, with the credit crisis and a new federal law that stood to dent the earnings of student lenders, buyers began to shun the auction markets. Corporations dropped out first, when auditors warned the investments were not truly cash-like. Brokers like UBS had to use their own money to buy the securities from clients who wanted to sell, leaving them with a huge inventory of investments they did not want.

By February, UBS and the rest of Wall Street decided to stop propping up the auctions, leaving thousands of investors stranded in the investments. The state alleges that UBS should have warned investors it was the sole keeper of the market for the securities it sold, and that it could step away at any time.

Brokers were not trained about the risks of auction-rate securities, the state found, and those interviewed as part of the investigation said they had no idea the investments carried this inherent risk.

At the end of 2008's first quarter, UBS says it had $10 billion of auction-rate securities on its books. Across the country, investors with all firms have an estimated $220 billion in auction-rates.

In an e-mail to a colleague last Halloween, Shulman called the auction-rate market "a huge albatross." The hand-wringing within UBS accelerated in the following weeks and months, with one of Shulman's deputies declaring in a Dec. 11 e-mail, "The auctions aren't going to come back." Shulman sold the rest of his personal holdings the next day.

Still, the firm encouraged its brokers to sell the securities, the state alleged. Ominously, on a Feb. 8 conference call, brokers were assured that the auctions continued "to be very effective." On that advice, UBS brokers in Massachusetts alone sold $50 million worth of the securities in five days.

On Feb. 14, individual clients were stunned and trapped. But Shulman, in an e-mail to a colleague, looked at the bright side for UBS. Restructuring this $330 billion failure, he said, "is a banker's dream market."

Beth Healy can be reached at bhealy@globe.com.