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Too Little Too Late: Fund Compies’ Attempts to Refinance Auction Rate Preferred Securities Using Leverate or Varible Rate Securities Unlikely

Some closed end funds which issued preferred shares in the auction rate market suggest they might obtain liquidity in Auction Rate Preferred Securities (ARPs) using leverage and Variable Rate Demand Preferred Securities. Such statements may give hope to those holding ARPs, yet we believe that these solutions unlikely create the liquidity sought.

This action by the closed-end fund companies is likely intended to benefit these companies and will not help the preferred share holders. If the goal were truly to benefit ARP holders, such action would have been initiated prior to the lock-up of the ARP market. As the broker-dealers actually increased sales to unwary investors, the fund companies were silent as risk to ARP investors grew and liquidity disappeared.

According to the Investment Company Institute, closed end fund companies manage a total of $314 billion dollars worth of assets for their common shareholder clients. Closed-end funds have borrowed about $60 billion of this total using preferred shares. The preferred shares were created to use a low rate paid to preferred holders in order to boost yield to common mutual fund shareholders. Risk to preferred shareholders could have been avoided by liquidating holdings within each respective fund when possible. This would have also greatly reduced risk to common fund shareholders by “getting them off margin.”

Reading between the lines of the press releases and deciphering feedback on industry conferences calls with the closed-end fund companies, it appears there is little that can now be done. The current credit crisis has made liquidity difficult for all market participants and fund companies missed the window of opportunity to assist ARP shareholders.

Perhaps the primary reason for funds companies to attempt to provide liquidity to ARP holders is to bale out brokerage firms who may otherwise never again sell the funds’ products. Or, it could be that it is no longer profitable to closed-end fund’s common shareholders to pay the interest rates to preferred shareholders.

Last week, Eaton Vance announced plans to redeem the preferred shares of three of its thirty closed end funds. All three are equity based funds. With the stock market performing poorly, it may no longer be profitable to continue the payments. Unlike municipal bond funds, there is no spread, or difference between what the funds were earning and what was paid to the preferred shareholders.

Eaton Vance is not alone. Of the fund companies who have discussed a solution, all have stated that the initial focus of their remedial efforts will be on the taxable closed end funds. Why? According to the Investment Company Institute ( the vast majority of taxable closed end funds are equity based. The figures for year end 2006 indicate there is about $203 billion in taxable closed end funds, about $122 billion of which are in equity funds. It should also be noted that a majority of funds that issued preferred shares were bond funds.

A third reason that a closed-end fund company may act is to issue a new product in furtherance of their business. At least one firm has suggested a new product called a Variable Rate Demand Preferred (VRDP). To date, this is the only solution suggested for tax free (bond) closed end funds. According to the industry, a VRDP is a “new financial instrument” which could potentially be sold to money market funds. Yet, on March 12, 2008, Nuveen issued a press release stating “we cannot be certain that VRDP will be a viable form of financing for our funds.”

The problem is that VRDP is yet another “contrived” product being floated, and at the worst possible time in a market understandably leery of anything associated with the terms “variable rate” and “preferred”. While money market funds could absorb a portion of this product, if news leaked that a particular money market fund held a product associated with the tainted ARS market it could hurt its standing as a cash equivalent. Further, before VRDP could be marketed to any money market fund, it would have to find third parties willing to provide “put commitments at a reasonable cost” or in other words, take on risk without charging an undue premium – a tall order in this economic environment.

We are of the belief that a credible solution is not yet in sight for holders of ARS securities, including ARPs, although limited liquidity may emerge in the near future.

The securities law firm of Shepherd Smith Edwards & Kantas LTD LLP has for decades handled claims by investors worldwide against brokerage and other financial firms. We are currently working on claims by investors whose funds now locked into ARS and ARP securities. Contact us to arrange a free, no obligation consultation with one of our attorneys regarding your situation or if you wish to receive our weekly newsletter regarding ARS securities.

LINK TO ARTICLE ON ARS SECURITIES: (Our firm does not endorse any opinions or allegations of the article’s author but believes the information and opinions stated therein are helpful in understanding the nature of this debacle.)

ARC and ARP Securities: How Wall Street Brokerage Firms May Have Defrauded Their Clients Out of Billions Overnight Trading, February 24, 2008 (Author’s name withheld by request)

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