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In Re Merrill Lynch Auction v. Merrill Lynch & Co.

February 9, 2011


The opinion of the court was delivered by: Loretta A. Preska, Chief United States District Judge:


This Document Relates To:

Rate 09 MD 2030

Plaintiff, the Anschutz Corporation, brings this action alleging various state and federal causes of action against Defendants Merrill Lynch & Co., Inc.; Merrill Lynch, Pierce, Fenner & Smith Inc. ("MLPFS"); Moody's Investors Service, Inc.; and The McGraw-Hill Companies, Inc. (the parent of Standard & Poors or "S&P"). The action alleges that Defendants' activities related to certain auction rate securities ("ARS") purchased by Plaintiff ran afoul of the law. Defendants are divided neatly into two sets. Of those just listed, Merrill Lynch & Co., Inc., and MLPFS (together, "Merrill") include the underwriter and broker-dealer for the ARS at issue (MLPFS) and its parent company. The others (the "Rating Agencies") are credit rating agencies that issued ratings on the ARS here. Each set of Defendants moves to dismiss under Federal Rule of Civil Procedure 12(b)(6) separately. Defendants' motions are GRANTED.


The Court takes as true the following factual allegations in the complaint and draws all reasonable inferences in favor of Plaintiff. Goldstein v. Pataki, 516 F.3d 50, 56 (2d Cir. 2008).

A. Auction Rate Securities

In short, ARS are variable-rate debt instruments or preferred stock with interest rates set by way of periodic auctions in which potential buyers submit bids at various interest rates. (First Amended Complaint ("Compl.") ¶¶ 25-29.) The highest bid accepted sets the interest rate for the ARS issuance as a whole -- the "clearing rate." (Id.) Holders may sell ARS at these auctions, but auctions with insufficient buy bids result in auction failure; then, prospective sellers are unable to sell ARS. (Id.)

The details and operation of the ARS here are not materially different from the ARS described in other opinions in this Multidistrict Litigation. The Court thus presumes familiarity with the ARS structure as previously described. In re Merrill Lynch ARS Litig. (Merrill II), No. 09 MD 2030, 2010 WL 5094296, at *1 (S.D.N.Y. Dec. 7, 2010) (describing ARS). Plaintiff draws attention to one difference, however: the ARS here had a "put" feature, which allowed the ARS to be converted to preferred shares in Ambac Assurance Corp., the issuer, at its option. (Compl. ¶ 149.)

B. Merrill's Conduct

MLPFS underwrote the "Dutch Harbor" and "Anchorage Finance" issuances of ARS of Ambac Assurance Corp. (Id. ¶ 47.) Plaintiff made the following purchases through its broker, Credit Suisse: (1) on July 21, 2006, $7.95 million worth of Dutch Harbor Finance Sub-Trust #II ARS and (2) on January 25, 2007, $5 million worth of Dutch Harbor Finance Sub-Trust #III ARS and $6 million worth of Anchorage Finance Sub-Trust #2 ARS. (Id. ¶ 189.) MLPFS was the sole broker-dealer for those issuances. (Id. ¶ 51.) As broker-dealer, MLPFS selected the agent to conduct the auction; received and transmitted all buy, hold, or sell orders; participated in the preparation of ARS offering statements; and entered into remarketing agreements with downstream brokers who would buy, then sell, MLPFS ARS to their customers, like Plaintiff here. (Id. ¶¶ 45, 50-51.) MLPFS received fees both for its underwriting and its broker-dealer services. (Id. ¶ 46.)

MLPFS also participated as a buyer and seller in the auctions for its own account in an effort to ensure that the auctions would not fail. (Id. ¶¶ 4-6, 53.) It placed bids -- called "support bids" -- for one-hundred percent of the notional value of the Dutch Harbor and Anchorage Finance ARS up for auction through July 2007 in one-hundred percent of those auctions. (Id. ¶ 59, Ex. B.) The extent of this practice was not fully disclosed to investors, and MLPFS knew that demand for ARS absent its bidding was insufficient to feed the auctions. (See id. ¶¶ 56, 58, 60, 64, 68, 71, 73, 190.)

The support bids established the clearing rate in "a significant percentage" of the auctions. (Id. ¶ 59.) That clearing rate (or the failed auction rate) was lower than rates "otherwise would have been," meaning that Plaintiff earned less interest on its ARS that it otherwise would have earned. (Id. ¶¶ 29, 72.) Additionally, the support bids were undisclosed and therefore "injected false information into the marketplace" about the liquidity of these ARS. (Id. ¶¶ 60, 73.) The nefarious consequences related to these allegations constitute the primary injuries MLPFS allegedly caused here. (See id. ¶¶ 60, 65, 72, 73, 192-193.)

In August 2007, MLPFS discontinued its practice of submitting support bids, and the auctions for the two ARS here failed. (Id. ¶¶ 63-64.) The market for these ARS "completely evaporated" and has not recovered. (Id. ¶¶ 64, 193-194.) Plaintiff was and has been unable to sell its ARS, which have been converted to preferred shares of Ambac Assurance Corp. earning no interest with no liquidity. (Id. ¶ 194.) Plaintiff claims it relied on the appearance of a liquid market (allegedly manufactured by MLPFS) and its prior success buying and selling similar ARS when deciding to make its purchases. (Id. ¶¶ 188, 190-191.) It says it never would have bought ARS had it known the truth and that it now holds nearly $19 million worth of "severely impaired securities." (Id. ¶ 190, 193.)

C. SEC Order and Website Disclosure

In May 2006, following an investigation, the Securities and Exchange Commission ("SEC") reached a settlement with several investment banks that participated in the ARS market, including MLPFS. (Id. ¶ 36.) The SEC issued a cease-and-desist order (the "SEC Order") on May 31, 2006.*fn1 (Id.) The SEC Order concluded that the banks violated the securities laws by intervening in ARS auctions without adequate disclosure. (Id.)

The SEC determined that disclosures indicating that a broker-dealer "may submit orders in Auctions for its own accounts" and that it "might have an advantage over other bidders" were inadequate. (Id.) The SEC Order enumerated several violative practices, including bidding to prevent auction failures or to affect the auctions' clearing rates, but did not specify which banks engaged in which practice. (Id.; Mandel Decl. Ex. C, at 6.) Nevertheless, MLPFS was ordered to pay a larger penalty than other banks because it was among the banks that "engaged in more types of violative practices than" others. (Compl. ¶ 37.) The SEC Order required the banks to post their ARS practices on their websites and provide all first-time purchasers and broker-dealer purchasers with a written description of the bank's ARS practices at or before the completion of each transaction. (Id.)

In August 2006, Merrill Lynch posted a document disclosing its ARS practices on its website (the "Website Disclosure"). See Merrill II, 2010 WL 5094296, at *4 (discussing the same disclosure). The Website Disclosure states that "Merrill Lynch may routinely place one or more bids in an auction for its own account to acquire [ARS] for its inventory, to prevent an auction failure . . . or an auction from clearing at a rate that Merrill Lynch believes does not reflect the market for the securities." (Mandel Decl. Ex. A, at 16.; see also id. at 15 ("Merrill Lynch is permitted, but not obligated, to submit orders in auctions for its own account either as a bidder or a seller, or both, and routinely does so in its sole discretion.") (emphasis added).) It states that MLPFS's bids "are likely to affect the clearing rate." (Id. at 16.) The Website Disclosure also discusses the risk of auction failures and the consequent liquidity risk in the ARS market:

Because of [MLPFS's ARS practices], the fact that an auction clears successfully does not mean that an investment in the securities involves no significant liquidity or credit risk. Merrill Lynch is not obligated to continue to place such bids. . . . Investors should not assume that Merrill Lynch will do so or that auction failures will not occur. (Id.; see also id. at 18 ("There may not always be enough bidders to prevent an auction from failing in the absence of Merrill Lynch bidding in the auction for its own account or encouraging others to bid. Therefore, auction failures are possible, especially if the issuer's credit were to deteriorate, if a market disruption were to occur or if, for any reason, Merrill Lynch were unable or unwilling to bid.").) Finally, the Website Disclosure states that MLPFS had conflicts of interest; "it would likely have an advantage over other bidders because Merrill Lynch would have knowledge of some or all of the other orders placed through Merrill Lynch in that auction . . . . Merrill Lynch's interests in conducting an auction may differ from [investors] who participate in auctions." (Id. at 15-18.)

D. Rating Agencies' Conduct

MLPFS engaged the Rating Agencies to evaluate and assign a credit rating to the ARS Plaintiff purchased. (Compl. ¶¶ 146, 157.) Moody's assigned a "Aa2" rating, and S&P assigned a "AA" rating to these ARS; both ratings indicated a low credit risk and were required for the ARS to have issued. (Id. ¶¶ 146-147.) Plaintiff also alleges that the Rating Agencies consulted with MLPFS to structure these ARS to ensure they would receive the desired AA or Aa2 ratings. (Id. ¶ 158.) For these services, the Rating Agencies received fees. (Id. ¶¶ 157-158.)

Plaintiff alleges that these ratings were false and misleading. (Id. ¶ 148.) First, Plaintiff asserts that the Rating Agencies should not have issued a credit rating, which is an indication of the probability of issuer default, for these ARS because the put option feature made it impossible to predict possible default. (Id. ¶ 149.) Second, Plaintiff says that the Rating Agencies should have downgraded the ratings on these ARS by mid-2006 or early 2007. (Id. ¶ 151.) Plaintiff alleges that the issuer guaranteed increasing amounts of structured finance products from 2001 to 2007, directly impairing its financial stability and ability to pay on its obligations, and that the Rating Agencies should have known the ratings were not deserved. (Id. ¶¶ 152-153.) Third, Plaintiff avers that the ARS here were, by way of the put option feature, contingent capital pools available in times of crisis -- meaning that the credit ratings should have been lower. (Id. ¶ 154.) Fourth, Plaintiff asserts that the ratings were false representations about the liquidity of these ARS. (Id. ¶ 156.) In effect, Plaintiff claims that the Rating Agencies knew about the alleged malfeasance of MLPFS yet failed to disclose these facts. (Id.)

Plaintiff claims that it relied on the Rating Agencies' credit ratings in making its purchase decision. (Id. ¶ 163.) It says that the details of the asset pools supporting these ARS were not disclosed to the investing public, so the credit ratings were the "only basis by which prospective investors could evaluate the credit quality of these securities." (Id. ¶ 162.) It says that the Rating Agencies generally relaxed their credit rating criteria to obtain and retain business from underwriters (id. ¶¶ 134-135) and that the Rating Agencies were understaffed and provided employees with inadequate resources to do their work (id. ¶ 136). It also says that the Rating ...

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