Auction-Rate Securites: A $20 Billion Legal Headache For Banks

April 8, 2008 by Douglas A. McIntyre

Palm (PALM) took a $25 million write-off yesterday due to the falling value of the auction-rate securities on its balance sheet.

Diamond, Kaplan, and Rothstein is the first law firm to file suit against a major bank, USB, for mis-representing the "cash" nature of auction-rate paper. Jeff Kaplan, who leads the legal action, says that even some brokers will testify against the banks. Their customers are than upset and may sue the brokers themselves.

The auction-rate market froze when several large banks and brokerages stopped underwriting the auctions, something which they had done since 1985. Kaplan says the market, at $360 billion, could take a haircut of at least 10%, of $36 billion if and when the securities start to trade again.

The case against the banks is for fraud and abandoning their fiduciary obligation for putting customers first. If the series of lawsuits against the banks is successful as many as 50% to 60% of the people and companies who were sold the paper under the impression that it was as liquid as cash, will have claims. That put potential bank liability at $20 billion.

At the core of the case is a simple principle. Banks must put customer interests ahead of their own. In this case that probably didn’t happen.

Douglas A. McIntyre