Schwab Targeted in Cuomo Lawsuit

Brokerage Misled Bond Investors, N.Y. Attorney General Says

NEW YORK, Aug. 17 -- New York Attorney General Andrew M. Cuomo sued the brokerage firm Charles Schwab on Monday, charging that it misled investors about the risks of unconventional bonds called auction-rate securities.

The San Francisco firm, Cuomo said, repeatedly told customers that the auction-rate securities -- used by hospitals, local governments and schools to raise funds -- carried similar risks as money-market funds or certificates of deposit and that investors would be able to retrieve their cash whenever they wanted.

"Charles Schwab owed its customers a duty to properly understand and make accurate representations concerning auction rate securities," Cuomo said in a statement. "Today we commenced a lawsuit to remedy Schwab's repeated breach of that duty. This filing should send a signal that anyone in the industry who misrepresented the risks of investing in auction rate securities will be held accountable."

The lawsuit seeks to compel Schwab to buy back the securities from investors at face value. It claims that Schwab knew or was reckless or negligent in not knowing about growing problems in the auction-rate securities market that surfaced in the summer of 2007.

The company vowed to fight the charges. "We believe the suit is unfair," said Greg Gable, a spokesman for Schwab. "We'll look forward to reviewing the facts in court."

Auction-rate securities are long-term, variable-rate bonds that are repeatedly put up for bid, as often as once a week, to determine their interest rates. Investors regarded them as a safe bet, and issuers considered them a reliable source of funding, in part because large banks that underwrote the securities and ran the auctions typically stepped in to support the market.

But the auction-rate market -- once worth $330 billion -- froze early last year during the wider credit crisis. Buyers all but disappeared, and investors were left holding securities they could not sell. Large banks stopped buying the unwanted debt. Issuers across the country, including the District, faced soaring interest rates.

The collapse of the auction-rate securities market has been the subject of scrutiny by Cuomo, the Securities and Exchange Commission and other authorities. As a result, more than a dozen financial institutions, including Goldman Sachs, UBS, Merrill Lynch, Citigroup and J.P. Morgan Chase, have agreed to buy back billions of dollars in securities from investors.

Gable said Schwab's retail clients hold about $100 million of the securities sold by the company. Cuomo's office confirmed that figure and said it wants Schwab to buy back the full amount.

Cuomo's office said subpoenaed records of audio conversations with clients show that Schwab brokers routinely misrepresented the securities. One Schwab broker "guaranteed" that a customer would be able to get out of the investment, while another said the hardest part of investing in the securities was "getting into it . . . I mean, getting out is something as easy as just selling it."

Cuomo also accused Schwab of failing to ensure that its brokers "had even a basic understanding" of the securities.

In a recent letter to Cuomo's office that Schwab released Monday, the company criticized Cuomo for what it called an "indiscriminate, outcome-driven" investigation.

Like its customers, Schwab said, it was misled by large Wall Street firms that created the securities.

"The Attorney General's decision to sue Schwab for a market calamity that it neither caused nor could have foreseen is the foregone conclusion of an investigation that was driven from the outset by a self-imposed mandate to reach a predetermined result: nationwide buybacks of illiquid ARS by every firm, regardless of fault and despite major differences in the roles that each firm played in the ARS market," Faith Gay, an attorney for Schwab, wrote in the letter.

On Monday, Lasana K. Mack, the District's treasurer, said in an interview that he did not think he was misled by the large Wall Street firms that underwrote the District's securities.

"I think the market fundamentally changed due to the events and dynamics in the marketplace," said Mack, who added that the District had gotten out of auction-rate securities altogether as of this spring, by converting or refunding them.