Legal Definitions - Investor Protection Guide: Auction Rate Securities

Auction Rate Securities (ARS) are a type of investment, typically debt instruments or preferred shares, whose interest rates are not fixed but are instead reset periodically through a unique auction process. These securities were designed to have long-term maturities, sometimes even in perpetuity, meaning they had no set end date for repayment.

Originally, ARS were promoted to investors as a secure and liquid alternative to traditional savings accounts or money market funds, offering potentially higher returns with the ability to easily sell their investments at regular intervals. The idea was that if an investor wanted to sell their ARS, they could do so during one of the frequent auctions (often held weekly or monthly), where new buyers would bid on the securities, thereby setting the new interest rate and providing an exit for existing holders.

However, the underlying investments were long-term, and their liquidity depended entirely on the success of these auctions. When the financial markets experienced stress in 2008, the auctions began to fail because there were no longer enough buyers. This left many investors holding illiquid, long-term securities that they could not sell, despite having been told they offered easy access to their funds. The market for ARS largely collapsed and is now defunct.

• Example 1: Municipal Infrastructure Project

  A state government issues ARS to finance the construction of a new public hospital, a project that will take many years to complete. Individual investors purchase these ARS, expecting that every 28 days, an auction will reset the interest rate they receive and allow them to sell their holdings if they need cash. When the ARS market collapses, these investors find themselves unable to sell their securities, even though the hospital project is still ongoing and the state is solvent. This illustrates how the long-term nature of the underlying asset (the hospital bond) was mismatched with the promised short-term liquidity provided by the auction mechanism, leading to investor distress when auctions failed.

• Example 2: Corporate Capital Raising

  A large utility company issues ARS in the form of preferred stock to raise capital for upgrading its power grid. An individual investor buys these preferred shares, attracted by the promise of a better yield than a traditional savings account and the ability to sell them easily in the weekly auctions. When the market for ARS collapses, the investor finds they cannot sell their shares, even though the utility company continues to operate and pay dividends (if an auction had successfully set a rate). This demonstrates how preferred equity could also be structured as ARS and how the unexpected illiquidity trapped investors in a long-term holding they believed was easily accessible.

• Example 3: Charitable Foundation Endowment

  A charitable foundation invests a portion of its endowment in ARS, seeking a stable income stream with the flexibility to access funds if needed for its programs. The foundation's financial advisors recommended ARS, emphasizing their perceived safety and liquidity. However, when the auctions for these specific securities fail, the foundation is unable to liquidate its investment to fund its planned charitable activities, such as grants or scholarships. This highlights how even sophisticated institutional investors were impacted by the market's collapse and the false promise of liquidity, demonstrating the widespread nature of the ARS market failure.