Brokerage practices draw criticism

Clients say they were misled about risks of auction-rate debt

Wall Street firms may have led their own brokers to believe auction-rate securities were safer than they really were, by labeling them as cash investments and failing to warn brokers of their risks, according to customer records and interviews.

UBS Financial Services Inc., for instance, called these investments "Cash alternatives/Municipal Securities" on customer account statements until May - three months after the auction-rate market had collapsed.

Then last month, UBS, under fire for selling these investments to individuals and small-town treasurers who didn't understand them, started listing the securities under a new heading: "Fixed income," a broad term for bonds.

That more precise disclosure came too late for clients of UBS and other firms, who now have $250 billion trapped in bonds of nonprofits and municipalities that they cannot sell. It appears that firms' internal practices - what they called the securities and how they allowed brokers to sell them - contributed to how widely and casually these investments were sold.

UBS spokeswoman Karina Byrne confirmed that UBS "reclassified" auction-rate securities on customers' statements in May.

"For 20 years, the market provided a reliable source of liquidity and return for investors," Byrne said. "Once the market collapsed, [auction-rate securities] could no longer be sold reliably in the auction markets, so the securities industry no longer considered them as 'cash alternatives,' so UBS adjusted the way we classified them on statements."

But it was the apparent promise of safety that kept many customers and brokers from examining these investments more deeply, investors said.

Tom Keyes, a Boston University biochemistry professor, moved $150,000 he had in money markets and certificates of deposit in his Merrill Lynch & Co. account into auction-rate securities when his longtime broker suggested he do so. The broker knew the money had to be safe and available, Keyes said, because he and his wife were about to renovate their Beacon Hill home.

"We were talking about cash equivalents, and all you're getting is a little bit of extra interest," Keyes said. "My alarms didn't go off."

And his Merrill Lynch account statement, which Keyes checked online, offered no reason for concern: It listed the investments under "Other Cash," according to printouts of those statements reviewed by the Globe. Merrill continued to list the auction-rate securities as such into March, even after all trading in the investments had stopped in February, leaving investors unable to sell them and retrieve their cash.

In April, Merrill changed the category listing for the securities in online statements to "Fixed Income-Other." That heading can include all sorts of debt instruments, many of which carry risk and are known to fluctuate in value.

Merrill Lynch acknowledged the change, but said its paper statements were always clear.

"When a client bought auction-rate securities, he or she got a confirmation from us that expressly described this as a security purchase, and not cash," Merrill spokesman Mark Herr said. "Their written monthly statements reflected these as securities. It is hard to see how a client could not have known what he or she had purchased was a security."

Merrill and the other firms interviewed for this story declined to say whether their brokers adequately warned investors about the risks looming in the auction-rate market by late 2007.

Auction-rate securities enabled nonprofits, municipalities, and closed-end investment funds to borrow money at low interest rates. But last year's subprime mortgage crisis spurred panic in other debt markets, and by February, the auction-rate market had no buyers, only sellers.

The people stuck in these investments include retirees in their 80s and 90s, families who were counting on the funds to pay for college, and people like Keyes, for whom the ordeal has been mainly an inconvenience. All share a similar outrage: As ultracautious investors, why were they suddenly being offered a product that could lock up their cash indefinitely?

Lance Pan, director of investment research at Capital Advisors Group, a Newton firm that's advising large clients on auction-rate investments, said borrowers and investors enjoyed the benefits of this market while they lasted.

But, "In the end, it was a mirage, really," Pan said. "You only get liquidity when there's someone else willing to take your spot." And when there were no buyers, he said, "The dealers didn't have to support the market."

But brokers typically did not disclose this inherent risk - and often didn't seem to understand it themselves, investors said.

Stephen Benda, a lawyer and Morgan Stanley customer in Menlo Park, Calif., believes his broker was as much in the dark as he was when the market froze.

In an e-mail urging Benda to sell his $500,000 investment if the opportunity arose, the broker wrote, "We bought them as a cash surrogate, and they have proven not to be this."

Benda took that e-mail, a copy of which he sent to the Globe, to lawyers at Morgan Stanley, and, after a barrage of complaints, persuaded the firm to return his money in May.

Morgan Stanley declined to comment. The firm has asked Benda to take the rest of his business elsewhere, a letter from a Morgan Stanley lawyer shows.

Money is shaking loose mainly for investors in closed-end funds, some of which are refinancing their debt so people can cash out. Keyes, the professor, said he has received $25,000 from a Calamos Investments fund and stands to get money out of a Blackrock fund soon.

Michael J. Martella of Deland, Fla., has $250,000 in auction-rate securities of student lenders in Texas and Kentucky. A former broker himself, he says he was suspicious when his broker at Banc of America Investment Services Inc. called last November, trying to persuade him to move out of money markets and into this different type of investment. The broker assured him the bonds were "seven-day money," Martella said, meaning they traded weekly and were almost like cash.

Only later would Martella learn this was student-loan debt. Banc of America Securities was also investment banker to the Texas and Kentucky lenders, assisting them with their debt offerings.

"How come they were calling investors in money markets to sell them these things?" Martella asked.

The brokerage group's parent, Bank of America Corp., declined to discuss Martella's case. A company spokesman, Matthew Card, said, "The market for auction-rate securities has changed dramatically. We fully appreciate the impact this is having on some of our clients and are committed to working with those clients during this difficult period."

Martella last week learned that he may soon get $50,000 back from the Kentucky student loan group.

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