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Fulton Bank, N.A., Successor To Fulton Financial Advisors v. Ubs Securities

November 7, 2011


The opinion of the court was delivered by: Stengel, J.


This case arises out of the collapse of the market for auction rate securities ("ARS"). Fulton Bank, N.A., successor to Fulton Financial Advisors, N.A., is suing the defendants alleging securities fraud and related state law claims in connection with its purchase and retention of various ARS in auctions that the defendants managed. The defendants have filed a motion to dismiss the complaint in its entirety pursuant to Rule 12(b)(6) and Rule 9(b) of the Federal Rules of Civil Procedure. For the following reasons, I will grant Defendant's Motion to Dismiss.


ARS are financial instruments with a long-term maturity that pay interest rates, which are set and reset by auctions conducted at pre-determined intervals, usually seven, twenty-eight, or thirty-five days through a "Dutch auction" process. See Compl. ¶¶ 5, 19.

At such an auction, potential investors specify the number of shares they wish to purchase and the lowest interest rate they are willing to accept. Id. at ¶¶ 5, 19. Existing ARS holders specify the number of shares they wish to sell, either on an unqualified basis or at a specific interest rate, and the number of shares they wish to continue to hold. Id. The bids and offers are conveyed to an auction agent, who ranks each bid and offer according to the interest rate. Id. The lowest bid rate at which all shares offered for sale can be sold establishes the interest rate to be paid until the next auction. Id. The sale price is set at the par value of the security, usually $25,000, while the interest rate, earned by the buyer until the next auction, is determined by the outcome of the auction. Id. ¶ 19.

ARS include bond-like investments issued by municipalities and student loan entities, generally known as auction rate certificates ("ARC").*fn2 The municipalities, student loan lenders, and other borrowers who issue ARS are collectively known as "issuers." They receive the proceeds from the original sale of the ARS and assume the obligation to pay principal and interest. Id. at ¶¶ 5, 15. The issuer engages one or more "underwriters" to structure, underwrite, and distribute the issue. The issuer also engages an "auction agent" and an "auction manager." Auction agents administratively conduct the auctions at which the rates on the ARC are reset. Id. at ¶¶ 15-16. The duties of the auction manager, or what the complaint refers to as the "contractual broker-dealer," are specified in a Broker-Dealer Agreement between the auction manager and the issuer, and include soliciting bids for ARS from investors, securities brokers, and financial advisors; submitting offers to purchase or sell ARS; communicating the results of the auction; and facilitating settlement. Id. at ¶¶ 16, 20. The auction manager is paid by the issuer for performing these services. Id. at ¶ 29.

ARS products were first marketed in the 1980's. Approximately twenty years later, securities firms led a dramatic expansion of ARS markets in the United States. These debt instruments were marketed as providing benefits to both issuers and investors. Securities firms earned fees for underwriting ARS, for selling them, and for managing the auctions. Id. at ¶ 8. These fees were so lucrative that securities firms became secret "guarantors" of the success of the auctions. If there was insufficient investor interest in a particular auction, such that there were not enough buyers to match the sellers, then the auction was at risk of failure. Id. This threatened the entire market, which was based on investor confidence in access to short-term liquidity on demand. To protect the broader market from seizing up, and to protect their stream of underwriting fees and auction management fees, securities firms allegedly entered proprietary bids to ensure that the auctions succeeded, thereby creating the illusion of an efficient, completely liquid market. Id. at ¶¶ 8, 9, 12.

This was the practice until the summer of 2007 when the credit crisis struck and demand for ARS collapsed. Securities firms allegedly reacted with enormous increases in their proprietary ARS purchases to conceal the fact that the markets had become illusory and were near failing. Id. at ¶¶ 9, 12, 32-35. They turned to their retail sales force to bail them out of their ever-increasing exposure to ARS inventory risk, directing account executives to push ARS on customers as hard as possible and increasing commissions and other incentives for success in doing so. Id. at ¶¶ 9, 95. These efforts allegedly succeeded in delaying and concealing the downward spiral of the ARS markets and the skyrocketing ARS inventories held by the securities firms, but the firms were not able to market their way out of the collapse in demand for ARS caused by the credit crisis. Id. at ¶ 10. In February and March 2008, the ARS auction markets failed entirely, leaving the securities firms and their customers with over $350 billion in unsaleable ARS. Id. The plaintiff held and continues to hold more than $300 million of ARC, more than $249 million of which was purchased through the defendants. Id. at ¶ 11. All of the illiquid ARC immediately declined in value, typically by more than ten percent, as a result of the lack of marketability and the disclosure of the true level of risk ARC entailed, resulting in hundreds of millions of dollars of damages to customers like the plaintiff. Id. at ¶¶ 11, 115.

The complaint further alleges that when the ARS auctions began to fail, Defendant UBS Securities increased the frequency with which it placed support bids. Id. at ¶¶ 53-55. When most ARS auctions began to fail in February 2008, auctions for the majority of the ARS that the plaintiff held for which Defendant UBS Securities served as auction manager began to fail on a consistent basis, leaving the plaintiff's ARS investments illiquid. Id. at ¶¶ 68-69. Many of the plaintiff's ARS issued by municipalities were repurchased at par by the issuers because their maximum rates were above prevailing market rates. Id. at ¶ 69-70.

Defendant UBS Securities was retained by ARS issuers to manage their auctions, including the auctions for the ARS issues purchased by the plaintiff and at issue here. Id. at ¶ 11. Its duties as an auction manager were spelled out in broker-dealer agreements entered into with ARS issuers. Id. at ¶¶ 16, 20. Like other auction managers, UBS Securities sometimes prevented the auctions it managed from failing by placing support bids. Id. at ¶ 32. UBS Securities disclosed to the market that: (a) it could, but was not required to, "submit bids for its own account . . . to prevent a failed auction;" (b) it in fact did place "bids in a large percentage of auctions and believe[d] that a significant number of auctions would fail if it did not do so;" (c) such support bids "result in a lower reset rate than otherwise might have occurred;" and (d) UBS Securities' interests in placing support bids could "pose a potential conflict of interest" with other bidders. See Def.'s Exh. 3 at 6.

Defendant UBS Financial Services, an affiliate of UBS Securities, is a broker-dealer that effects transactions in securities for the accounts of its clients. Id. at ¶¶ 2, 4. UBS Financial Services sold ARS to its private wealth-management customers, and there is no allegation here that it ever sold ARS to the plaintiff. Id. at ¶¶ 4, 135.

The plaintiff held institutional investment accounts with two broker-dealers, PNC and NatCity, which served as Fulton's securities brokers. Id. at ¶¶ 24, 160. NatCity and PNC recommended to Fulton that it invest in ARS in order to achieve Fulton's investment goals of a high degree of safety and liquidity with a modest rate of return. Id. at ¶¶ 25-26. Following PNC and NatCity's recommendations, Fulton purchased the ARS for which Defendant UBS Securities served as auction manager. Id. at ¶ 29.

The plaintiff's student loan ARC were not redeemed for the most part, because their maximum rates were below market rates. Id. at ¶¶ 69-70. The plaintiff sold certain ARC at a discount of 10% or more and continues to hold more than $249 million of ARC whose auctions were managed by UBS Securities. Id. at ¶ 115. After the auction failures of February 2008, several regulators commenced investigations of many financial firms involved with ARS, including the defendants. Id. at ¶ 99. The investigation of the defendants focused on their marketing and sales of ARS to clients who purchased ARS directly from the defendants. Id. at ¶¶ 100, 107(a). The regulators and the defendants eventually reached settlements in which the defendants essentially agreed to offer to repurchase ARS held by their own clients. None of the agreements involved the defendants offering to repurchase ARS from other securities firms' clients whose auctions were only managed by the defendants. Because the plaintiff was a client of PNC and NatCity, the defendants' settlements with regulators did not involve the plaintiff.

On May 31, 2006, following an investigation into certain practices by broker-dealers, underwriters, and auction managers in the ARS market, the SEC issued a consent cease-and-desist order concerning some of the activities that form the basis of this action (the "2006 SEC Order"). The 2006 SEC Order is a matter of public record and is available online at the SEC's website: Neither defendant was a party to the 2006 proceedings before the SEC or the 2006 SEC Order.

Among other things, the 2006 SEC Order described the practice by certain broker-dealers of submitting support bids to prevent auction failures. In its findings, the SEC noted, without adequate disclosure, certain auctioneers and brokers bid to prevent auctions from failing. Failed auctions occur when there are more securities for sale than there are bids for securities and result in an above-market rate described in the disclosure documents. These Respondents submitted bids to ensure that all of the securities would be purchased to avoid failed auctions and thereby, in certain instances, affected the clearing rate. To the extent that certain practices affected the clearing rate, investors may not have been aware of the liquidity and credit risks associated with certain securities. 2006 SEC Order, at 6 & n.5.

The 2006 SEC Order "does not prohibit broker-dealers from bidding for their proprietary accounts when properly disclosed." See id. at 6 n.6. One of the parties to the 2006 SEC Order was Merrill Lynch, from whom Dow Corning also claims to have purchased ARS. Dow Corning has a separate lawsuit against Merrill Lynch pending in the Southern District of New York.

The plaintiff also brought actions against PNC and NatCity alleging that they were fully aware of the risks of ARS, that they misrepresented those risks to the plaintiff, and that they failed to inform the plaintiff of ARS's incompatibility with its investment goals. Months later, the plaintiffbrought this action against the defendants in the Court of Common Pleas of Lancaster County, alleging that the defendants had the same duties to the plaintiff as PNC and NatCity had to the plaintiff, and that the defendants had also failed to inform the plaintiff of the risks of ARS. The defendants removed the action to this court, citing the court's diversity jurisdiction.

The plaintiff alleges that there has been a widespread and long-running fraud involving every one of the major securities firms in the United States, including the defendants. Defendant UBS Securities acted as the underwriter and broker-dealer/manager of the auctions for the auction rate securities, and UBS Financial Services was the retail broker-dealer that distributed those auction rate securities to the public. See Compl. ¶¶ 2-3.

Material Omissions and False Representations by UBS

UBS knew from at least August 2007 through February 2008 that without its massive intervention in, and support bids for its ARC auctions, the auctions would routinely fail. Id. at ¶ 88. It also knew that those auctions which succeeded would clear at a higher rate of interest, to the dissatisfaction of UBS's issuer clients. UBS knew that the failure of its ARC auctions would dramatically damage its ARC underwriting business and its investment banking relationships with the issuers of ARC it had underwritten, and would result in illiquidity and a steep decline in the value of ARC held by UBS in its proprietary capacity. Id. Finally, UBS knew if the auctions it managed failed its reputation as a reliable provider of investment banking services to issuers and as a reliable broker-dealer for securities, purchaser-customers would be damaged. Id. This knowledge gave UBS strong motivation to manipulatively prop up the auction markets and to conceal that the risk of market failure was skyrocketing and that the markets were moving towards catastrophic failure. Indeed, UBS's David Shulman wrote a number of emails from the late summer of 2007 through early 2008 citing "reputation risk," "market risk," and "franchise risk" as reasons for continuing its manipulative trading in the ARC markets. These included a February 8, 2008 email to Robert Wolf, Chairman, and CEO of UBS Group. Id.

UBS failed to disclose the following material information in connection with the purchase and/or sale of its ARC to the plaintiff:

(1) There was insufficient legitimate independent investor demand to avoid failure of the UBS ARC auctions in the period from August 2007 and thereafter.

(2) UBS placed proprietary support bids in the auctions it managed for the entire amount of the issue. UBS had no independent investment purpose in placing these bids, but placed them to generate fees, maintain its investment banking clients, to protect the value of its own ARC holdings, and to deceive ARC purchasers by maintaining the increasingly illusory appearance of an independent, liquid, efficient, and reliable ARC market.

(3) The success of the UBS ARC auctions was entirely dependent on UBS's support bids. Without the proprietary bids placed by UBS, the demand for the UBS ARC's was far lower than necessary for auctions to succeed, and those ARC could not have been sold at par or at any price other than a steep discount.

(4) UBS utilized inside information about the demand for ARC and the orders submitted by others to purchase ARC in determining rates and amounts at which to bid for its own account, thereby permitted it to manipulate the auctions.

(5) UBS controlled the rates at which the auctions would clear and engaged in conduct that both manipulatively depressed and manipulatively inflated those rates.

(6) The bids entered on behalf of UBS in auctions for the UBS ARC reduced the interest rate that would have otherwise resulted from the auctions.

(7) Without the manipulative bids placed by UBS for its own account, there was no liquid or functioning market for the UBS ARC.

(8) UBS owned a substantial inventory of the UBS ARC which, if offered for sale at auction, in the absence of manipulative UBS support bids, would result in almost universal failure of the UBS ARC auctions.

(9) By early fall 2007, UBS's proprietary inventories of UBS ARC were rising rapidly, it was unwilling to continue to place proprietary orders to prevent auction failures indefinitely, and the risk that the auctions ...

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