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When New York Attorney General Andrew Cuomo on Monday sued broker Charles Schwab (Nasdaq: SCHW ) for allegedly misrepresenting the risks inherent with auction-rate securities, he sent a message: Take care to warn investors early and often, or suffer the consequences.
How good an idea is this? Below, we'll examine what Cuomo and Schwab founder and CEO Chuck Schwab say about the case, with my commentary sprinkled throughout.
When brokers check their brains at the door
Cuomo accuses Schwab's brokers of giving clients misleading pitches that obscured the risks of auction-rate securities, or ARS, as they're known. He says Schwab's upper management knew, or should have known, that the market for ARS was falling apart, but did little or nothing to protect their clients.
For the unfamiliar, ARS are debt securities -- bonds, basically, but with a unique and interesting type of interest rate. Instead of fixing a rate over the life of the bond, auction-rate securities reset according to market demand; namely, every time there's a new "auction." At the height of the market, these securities were auctioned as often as once a week.
That didn't last. In early 2008, underwriters such as UBS (NYSE: UBS ) and Goldman Sachs (NYSE: GS ) began to have a hard time finding buyers. Auctions began to fail. Securities billed as liquid were suddenly anything but.
According to The Wall Street Journal, Cuomo says that Schwab saw the mess coming in late 2007, when the underwriters supplying the auction-rate securities Schwab sold said that inventories were rising. Brokers, meanwhile, reportedly continued to pitch them to clients.
Welcome to the stock market history channel
There's precedent for Cuomo's argument. Remember Henry Blodget? In 2002, Cuomo's predecessor, former New York Governor Eliot Spitzer, published emails that suggested Blodget was obscuring the risks related with buying and holding then-hot Internet issues such as Amazon.com (Nasdaq: AMZN ) and CMGI. Within a year, Blodget had settled civil fraud charges with the SEC and accepted a lifetime ban from the securities trading industry.
Cuomo also appears to be following the same game plan as his predecessor. Just as Spitzer pursued firms such as Bank of America (NYSE: BAC ) and Janus Capital Group (NYSE: JNS ) for alleged shady mutual fund practices, Cuomo has already reached agreements with more than a dozen banks and underwriters to repurchase $61 billion worth of auction-rate securities, the Journal reports. Cuomo has also settled with TD AMERITRADE (Nasdaq: AMTD ) , a broker like Schwab that distributed ARS, and which has agreed to buy back $456 million worth of the not-so-liquid bonds.
Yet Schwab may not be so quick to capitulate.
Do you want Wall Street as your nanny?
Faith Gay, one of Schwab's lawyers, called Cuomo's pursuit of the brokerage firm "unjust" in a letter to the Journal. She wrote that the suit seeks to accomplish a "self-imposed mandate" forcing anyone who had an interest in creating or distributing auction-rate securities to make clients whole.
To be fair, Gay's finger-pointing is self-serving; she's defending her client. At the same time, she's right. In effect, Cuomo is treating ARS like the feds are treating toxic bank assets. Only Cuomo has no TARP funds -- he's forcing the industry that sold auction-rate securities to pony up funds and buy back what they sold.
Chuck Schwab, in an editorial response in the pages of yesterday's edition of the Journal, argues that Cuomo's suit is dangerous. "We are now seeing a conscious effort to limit -- if not eliminate -- all risks for the individual investor, whether through consumer 'protection,' fiduciary liability for brokers, or the threat of litigation that attempts to make our firm, and others like us, more like an insurance company than a broker."
Yet Schwab may have a point. Auction-rate securities don't carry the same default risk as the credit derivatives that led to the bailout. Unfortunately, until auctions restart -- until there's a market again -- investors who bought auction-rate securities will be forced to continue to hold and collect interest. Is that so awful? Do you really believe there will never again be a market for auction-rate securities?
Schwab also skewers the logic of Cuomo's complaint. "The implication of this lawsuit is that firms like ours should have known that the market would fail," he writes:
Should we also have known that Lehman Brothers or Bear Stearns were going to go under and compensate clients who bought their equity or debt? Should we have been able to predict which financial institutions would be the beneficiaries of government bailouts and which would not? I think it's fair to say we have all been surprised by many events this past year.
I think so, too. But I've had my say. Now it's your turn. What do you think of Andrew Cuomo's pursuit of Schwab? Is it rightful protection of duped investors, a classic case of governmental overreaching, or somewhere in between? Please take a moment to leave us a thought or two about this case in the comments section below.