Monday, August 17, 2009

NY Sues Schwab Over ARS Sales

New York Attorney General Andrew Cuomo filed a lawsuit today against The Charles Schwab Corp., claiming the brokerage firm misled customers about the safety of auction rate securities — and the firm is digging in for a fight.

“The [attorney general’s] lawsuit casts blame for a bad situation in the wrong direction. Clients who purchased these products, and companies like Schwab that filled client orders, were misled by the major Wall Street underwriters who concealed the degree to which the auction rate securities market was so dependent on their support, Schwab spokeswoman Sarah Bulgatz wrote in an e-mail.

On its face, this appears to be over-reaching by the AG. There is a flow to these cases, and the early cases were relatively easy for the regulators. Get some customers together, tell their story, use the firm's documents, and soon enough you have a good case for misleading sales material or failing to disclose risks to investors.

Assuming that to be the case, those claims work with a firm that actually made representations or recommendations. Unless there is something odd about this case, it is difficult to see Schwab's liability here. Schwab claims that did not underwrite any of these securities, and did not market them.

So why is the NYAG going after Schwab? Well, it has a different set of allegations, and according to the press release, the AG is alleging that firm falsely represented auction rate securities as liquid, short-term investments without discussing the risks. These representations gave investors a false sense of security that their investments would always be liquid when auction rate securities, in fact, faced significant, inherent liquidity risks.

The press release also alleges that there are tape recordings of telephone calls where Schwab brokers make such statements and recommendations.

It will be an interesting battle, made more so by the fact that another discount broker, TD Waterhouse, settled similar allegations.

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