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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 (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. and Charles Schwab are Stock Advisor selections. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers owned shares of TD Ameritrade at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. The Fool's disclosure policy was kicked out of the last Sotheby's auction it attended. We don't like to talk about that day.

Read/Post Comments (13) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 20, 2009, at 12:54 PM, theHedgehog wrote:

    ARS's and CDS's and all the rest of the rot were nothing more than vehicles to move money from one hand to another. The risks not only weren't properly explained, they were essentially unknowable. And, being unknowable, alarm bells should have been going off in both the heads of the buyers AND the sellers.

    So, should Schwab pay back the buyers? I dunno - it depends on the conditions of the sale. If the company knew or had reason to know that they were selling something other than what the customer thought he was buying (or deliberately avoided knowing), then yes. If Schwab and the other brokers couldn't reasonably know (hard to say that with a straight face) then, no.

    Ultimately, it boils down to trust, though, doesn't it? And if the broker is deliberately not trustworthy, there should be consequences - other than broke and heart-broken customers.

  • Report this Comment On August 20, 2009, at 1:37 PM, kleeh1 wrote:

    I'm a computer programmer so I try to boil things down to the simplest terms. This article starts out with a simple premise and then, with the help of comments from the "defense", meanders all over the place with excuses about why brokers should not be held responsible for anything.

    I agree with theHedgehog.

    The simple premise in this article is: " Cuomo accuses Schwab's brokers of giving clients misleading pitches that obscured the risks of ARS. ... 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.". This is true -- Schwab and other brokers did indeed give misleading pitches to clients. I've had it done to me. It's not the first time a securities rep has done this. But when they do it, they should be punished. And if upper management claims to be unaware of these activities or the magnitude of risk of a product, then they are either simply too stupid to do the job or they are crooked. When you separate the facts from the bull, there is very little "grey area".

  • Report this Comment On August 20, 2009, at 2:21 PM, pinonranch wrote:

    I agree totally with the previous comments. I was told by the E-Trade and Ameritrade Brokers that these securities were like money market funds with availability of one's monies settled on a weekly basis, i.e. every Monday. Since the interest payments were only slightly better than a "regular" money market fund, as an investor I believed that the sellers of these securities were able to make their profits on the float. That was in fact the result for several months. Then when the Auctions failed and I attempted to learn who owned what, I was told two different stories from the Brokers, who in fact held some of these in their own accounts. That's OK; but why lie about it. At the same time, The Reserve Fund broke the buck and claimed that it was the result of loaning $1B to Lehman. Pardon my naivete, but does one loan that sum to anyone else without knowing any of the risk? I doubt it. What really bothers me is the fact that Financial Instituions are contributing to their own downfall. That is a bad result. Howie

  • Report this Comment On August 20, 2009, at 3:43 PM, kc130r wrote:

    Here is the crux, in my view. Is the broker a supermarket or an advisor?? If they are an advisor, then what is REASONABLE in this case?

    Now, myself, I look at my OLB as a supermarket. I buy and sell stocks all on my own volition. I do no deal with a broker per se'. I do not solicit advice. In my view, as soon as I solicit advice, than I am dealing with an ADVISOR (astute, huh).

    The key to come out of this: should brokers be responsible for warning us of failing markets, of failing companies??? What constitutes 'reasonable' in such an environment?

    BTW, I don't necessarily believe SCHW is guilty in this case. I do not know when SCHW knew the auctions where failing.

  • Report this Comment On August 20, 2009, at 3:51 PM, kc130r wrote:

    BTW, no offense to anyone who got burned by a broker. Everyone in the industry works hard (the media, the brokers) to convince you 'all is safe;.

    It would help the industry itself if they did a better job of rating assets they are allowing to pass through their shops. After all, to grow, the brokerage business more and more has to deal with consumers who have NO WAY of knowing the ins and outs, of what is low-risk and what is questionable.

  • Report this Comment On August 20, 2009, at 4:40 PM, plange01 wrote:

    that would be nice!!

  • Report this Comment On August 20, 2009, at 7:30 PM, mac2352 wrote:


  • Report this Comment On August 20, 2009, at 8:08 PM, Lalkala wrote:

    Very savy people believed Madoff ., Is there much difference between him and a Schwab broker who a customer puts his faith for sound advice in. A broker has a duty to perform due dilligence and seek suitablility of investment for his clients. According to MR SCHWAB the public acts in a buyer beware marketplace. Of course the market is not guaranteed but a brokers advice MUST be based on dilligent truthful investigation, otherwise why use a broker? Why else are they paid, surely not merely to take orders and collect commissions. A paid broker adds value to the transaction..Now, as ususal,,it's not my fault... it's not my job when trust is breached.....RESPONSIBILITY is tough to take..

    MAN UP MR. SCHWAB...Earn your clients trust. Do the right thing and stand behind your image of intergrity

  • Report this Comment On August 20, 2009, at 11:29 PM, raccoon22 wrote:




    ALL WALL STREET BROKER ARE THREE STEPS BELOW POND SCUM. Schwan scammed customers on its Yield Plus Fund alos, sold as safe and down 50%.

    Scarlet letters to all of them, and a pox on ol' Chuck, lying scum bag.

    Talk to Chuck, so he can cheat you!

    Mr. Donald H. Layton ,

    CEO E*Trade Financial Corp.

    E*TRADE Financial Corporation

    135 East 57th Street

    New York, NY 10022

    Re: Fraudulent Marketing of Advent Claymore ARPS and related ARPS (Auction Rate Preferred Securities) by E*Trade Securities

    Dear Mr. Layton,

    July 10, 2009

    Mr. Donald H. Layton ,

    CEO E*Trade Financial Corp.

    E*TRADE Financial Corporation

    135 East 57th Street

    New York, NY 10022

    Re: Fraudulent Marketing of Advent Claymore ARPS and related ARPS (Auction Rate Preferred Securities) by E*Trade Securities

    Dear Mr. Layton,

    In November & December 2007 I was solicited by an account representative, XXXXX XXXX XXXXX, aided and abetted by a XXXX XXXXXXXXX, of E*Trade Securities who requested, SOLICITED, an opportunity to provide a higher interest earning “security” for my retirement fund account with your firm. I did not initiate this idea to buy ARPS nor have I ever sought investment advice from your firm. As a result this same individual recommended that I shift the money market funds and treasury bill funds in my account to ARPS Funds. I was told that these funds were “safe, cash equivalent investments comparable to money market accounts with a seven-day weekly redemption option, or at most a thirty day option”

    Less than five weeks later, the market for Auction Rate Securities collapsed and part of my retirement funds have been frozen ever since. It turns out that your advisor gave me especially poor and what appears to be fraudulent information and direction.

    The core of my complaint is that E*Trade Securities representatives targeted me based on my account cash holdings. Your representative recommended that I move those funds based on the fraudulent description that ARPS were safe, cash-equivalent investments, comparable to money market accounts, which could redeemed weekly at face value. Your representatives failed to disclose that auction rate securities which comprised these funds were only “liquid” because broker-dealers had created an artificial market which would dry up as soon as these broker-dealers withdrew from the market. Moreover, the ARPS funds were described as comparable to “mutual funds” with a “sell on demand feature every seven days”, with no disclosure that the funds actually were comprised of auction rate securities.

    During January 2008 after these auction rate preferred shares were sold to me by E*Trade Securities, your account representatives clearly knew that such funds were neither cash-equivalent investments nor safe and liquid investments comparable to money market accounts. E*Trade Securities and other brokers were aware that such auctions failed at various times over the years, and began increasingly failing again in August 2007. Despite the fact that failed auctions increased in the fourth quarter of 2007, E*Trade Securities did not disclose these failed auctions to me when soliciting me in Nov./Dec. 2007 to move my funds from money market funds to ARPS funds.

    Additionally, your representative said he would follow-up with me on a regular basis as to the status of these ARPS. He never did, and even “left” your firm in Feb 2008 for CitiGroup.

    Industry dealers, of which E*Trade Securities is a part, had also been warned as early as 2003 by outside financial advisors of the fatal flaws in the design of auction rate securities and the limited market for such securities to ensure liquidity so that these securities are in fact safe, liquid cash-equivalent investments comparable to money market funds as promised. See for example, the 2003, 2004, 2005, and 2006 analyses of the auction rate securities market issued by Capital Advisors Group. On March 1, 2005, the Capital Advisors Group predicted the systematic melt down of the auction rate securities market, which actually occurred in mid February 2008. This report cited the Price Coopers’ February 2005 accounting opinion, supported by the three other national accounting firms, that auction rate securities should not be classified as “cash equivalents” under SFAS 95 issued by the Financial Accounting Standards Board in 1987. The report predicted the corporate flight from auction rate securities market and also noted the SEC’s probe into the auction rate securities market. This probe led to the SEC’s May 31, 2006 Cease and Desist Order and Remedial Sanctions against 19 major broker dealers resulting from the broker-dealers’ failure to adequately disclose to investors the risks of auction rate securities.

    As E*Trade Securities directly solicited me to shift my cash from money market funds to ARPS funds, none of this information included in your solicitation.

    In August 2007, SVB Financial Group based in Santa Clara, California, warned corporate clients of the liquidity risks in the auction rate securities market. E*Trade Securities and their broker dealers were also aware that corporate investors, who formed a substantial part of the auction rate market, began selling off their auction rate securities in 2006. This corporate sell off escalated in the last quarter of 2007 when corporations reduced their investment in such securities from $170 billion in July 2007 to only $98 billion in January 2008.

    Again, none of this information was disclosed by E*Trade Securities representatives in Nov./Dec 2007 when your firm was soliciting me to shift my funds from safe money market funds and U.S. Treasury Bills to ARPS Closed End funds.

    In response to this substantial sell off of auction rate securities by corporate investors and to stem the tide of failed auctions beginning in August 2007, public records document that the marketing of auction rate securities to individual, retail investors like me increased to replace the investment in such securities by corporate and other institutional investors, who had fled the market.

    This information was also not disclosed to me by E*Trade Securities.

    E*Trade Securities failed to directly inform me when marketing these products that even though your financial advisors recommended these securities as “safe, liquid, cash-equivalent investments comparable to money market accounts,” that liquidity in the market was dependent on broker-dealers’ willingness to continue to purchase shares for their proprietary accounts to prevent failed auctions. E*Trade Securities also failed to advise me that broker dealers were reaching their limit for buying and placing these securities on their own balance sheets, and that the market would totally collapse without these supports, which in fact happened during the week of February 13, 2008 when broker dealers simultaneously withdrew their support for the auctions. This failure to properly disclose the liquidity risks of auction rate securities violated the May 31, 2006 SEC cease and desist order.

    Since February 13, 2008, E*Trade Securities has failed to provide me with any information about how the company will facilitate the redemption of the auction rate securities sold to me as “safe, liquid, cash equivalent investments comparable to money market funds” which have been frozen since mid-February 2008. Despite the enormous adverse impact on small retail investors like me, caused by the collapse of the auction rate securities market, E*Trade Securities has still taken no tangible action to resolve this crisis. Instead, your company continues to hide behind a shield of silence while continuing to collect fees for selling ARPS products I am unable to sell.

    Therefore, I formally request that E*Trade Securities be brought to justice and ordered to rescind within 10 business days fro receipt of the letter my purchase of ALL remaining closed end funds in my IRA account and immediately provide at par redemption by restoring the money market cash balance of $100,000 to my retirement account.


    xxxx XXXXXXXXX

    CC: FINRA Zaidi, Naveen <>

    Cc: Colorado Attorney General’s office

    CC: SEC

    Cc: Carolyn Mendelson, Div. of Enforcement & Compliance, Pennsylvania Securities Commission

    Cc: Lahr, Judi <>

  • Report this Comment On August 21, 2009, at 5:39 AM, worhawk wrote:

    Schwab has always preached conservative investing. For decades the auction rate securities were regarded by EVERYONE as conservative safe investments because of their history and triple A ratings. Again, THE ARS market was around for more than 20 years without any signs of problems. There was no way for Schwab or any brokerage not directly involved in the underwriting of the securities to know that there was anything potentially toxic about them. The regulators and rating agencies didn't know and the underwriters weren't telling. It was the underwriters, not brokers like Schwab that proped up the market. The fact that the rating agencies had the ARS securities listed with a triple AAA rating shows that no one knew. How is a broker supposed to know that a AAA rated security, that has been performing as it should for more than 20 years was all of a sudden going to go bad within a matter of days. They had no way of knowing. They didn't create them or act as market makers for them and when they did inquire about their liquidity, the underwriters told them all was good. Cuomo screwed up when he made the deal with the underwriters since he only made them compensate only THEIR customers, and not the customers of other companies.

  • Report this Comment On August 21, 2009, at 2:09 PM, rhfiii wrote:

    Worhawk's got it right - go after the underwriters and rating agencies, not the brokers

  • Report this Comment On August 21, 2009, at 9:04 PM, Lot7 wrote:

    The brokers who were selling auction rate securities made representations to customers that were false. Customers were solicited. Prospectuses were not provided. They represented that the principle could be returned within a week. Some brokerages had internal warnings of an imminent failure of the ARS market, but continued to market these products.

    There is a big difference between how stocks and funds are sold and how these were sold. The ARS's were marketed and pitched to customers by salesmen representing themselves as advisors or brokers, making false statements in the process. Their behavior is unacceptable and should be prosecuted.

    I have no disagreement with one asking that the underwriters be pursued, but the brokerages have the right to seek compensation from the underwriters. I would not hold my breath on this one. These underwriters and broker-salesmen are in cahoots together.

    This is not about compensating bad judgement. The brokerages violated the law.

  • Report this Comment On August 22, 2009, at 9:38 PM, arpholder wrote:

    The broker's represented these securities as redeemed and comparable to money market funds with the only difference that it takes seven days to redeem. The auctions failed because these securities had articifially low interest rate ceilings that were bound to fail in a market disruption. During the disruption of the 1990s, these securities did not fail because they did not have this artificially low interest rate ceiling. The market functioned with these ceilings for maybe ten years. They were bound to fail. But most customers were told that they were redeemed.

    If Schwab thinks that the wholesalers are to blaim, let Schwab pay back their customers and sue the wholesalers. It should be their problem. Totally misrepresenting a security is not a guaranty against loss.

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