Suit Claims UBS Misled Investors

The top securities regulator in Massachusetts has sued UBS on the grounds of fraud, saying that the firm misled clients when it sold them auction-rate securities and that it pushed the increasingly risky instruments on individual investors to reduce its own potential losses.

The roughly $300 billion market for auction-rate securities ground to a halt last February when buyers all but vanished. Existing holders were locked into shares and notes issued by municipalities, tax-exempt institutions, student loan companies and closed-end funds. Many of these investors say they were told that the securities were as safe and liquid as cash and had no idea that their holdings could be tied up indefinitely.

In the complaint, William F. Galvin, secretary of the Commonwealth of Massachusetts, cited numerous and sometimes urgent e-mail messages indicating that as early as last August UBS executives knew the market was imperiled. As sellers began to outnumber buyers, the messages show, UBS executives urged the sales force to promote the notes and shares as aggressively and widely as possible.

“The thing that is most amazing to me is what a comprehensive and deliberate strategy this was by UBS,” Mr. Galvin said. “They wanted to reduce their inventory, so they decided to gear up their sales campaign using cashlike arguments deliberately.”

Mr. Galvin wants UBS to buy investors out at the prices they paid for the securities and to make up any losses for clients who have sold their stakes.

A UBS spokeswoman expressed disappointment that the lawsuit had been filed Thursday and said the firm was working on solutions to the frozen market for auction-rate securities. “We will defend the specific allegations of the complaint,” the firm said in a statement. “Contrary to the allegations, UBS is committed to serving the best interests of our clients.”

Many Wall Street firms sold auction-rate securities to clients and acted as underwriter to issuers that needed capital. Recently, some of the issuers, including Eaton Vance and John Hancock, have bought investors out of their frozen holdings. But the only relief offered by Wall Street firms like UBS has been to allow their clients to borrow against the value of their holdings.

Auction rate securities are debt obligations whose interest rates are set at auctions every 7 to 35 days. The bonds typically have maturities of 30 years, but the preferred shares have no maturity dates.

A true auction, however, involves a meeting of buyers and sellers to determine the price and yield of the securities. But Wall Street firms in charge of the auctions had stepped in with their own capital in recent years; it was easier than locating thousands of buyers to meet up with sellers every week or so.

As the credit crisis deepened last year, the firms no longer had as much capital to devote to keeping the auctions going. Investors were stuck.

According to a Dec. 15 e-mail message attached to the complaint, UBS underwrote $43 billion of the securities, or about 14 percent of the total market. That message also estimated that the wealth management unit of UBS, which includes individual investors, held $33 billion of auction-rate securities.

The Massachusetts complaint identified David Shulman, UBS’s global head of fixed income distribution, as a major participant in the firm’s effort last fall to unload its inventory of auction-rate securities. But in August, even as he was urging employees to drum up clients to buy the securities, Mr. Shulman began selling his personal stake in the instruments, the complaint said. By Dec. 12, Mr. Shulman had sold his entire position in the securities.

In testimony before Massachusetts investigators, Mr. Shulman said that his “risk tolerance” drove him to sell. He said he replaced the securities with issues that were more liquid and that seemed to offer “more protection,” according to the complaint.

UBS said Mr. Shulman would not be available for comment.

The internal UBS documents released by Mr. Galvin show that the stress in the market for auction-rate securities began last August and continued through the fall as the firm’s institutional customers moved to sell their holdings. This required UBS to find buyers for the securities or to take them onto its books.

“It is critical that we reach out on a wholesale basis away from our traditional buying base to recognize this value and similarly understand the credit dynamics,” a Sept. 12 e-mail message stated. “I want to broaden our distribution base and need us to better market this product and educate our groups.”

The firm’s individual investor clients were a target, the complaint contends. An August e-mail message said: “We have encouraged” wealth management partners “to mobilize the troops internally to focus on value so that we can move more product through the system.”

But as the year was ending, the problem was unresolved. Asking for a sales force call on the matter on Dec. 11, Mr. Shulman wrote: “We need to move this paper and have to explore all angles possible. ... we need to do this as quickly as possible. ... please work on this priority.”

So far, almost 100 investor arbitration cases have been filed against UBS and other firms that sold these securities. Stuart D. Meissner, a New York lawyer, represents a handful of investors who have brought such cases. He said the messages attached to the Massachusetts complaint should help investors who have sued UBS. “What they released today opens up the window toward punitive damages in any arbitrations filed against UBS,” he said. “There are smoking guns in this report that UBS will have a difficult time circumventing.”