Attorney General Cuomo Brings Martin Act Fraud Case Against Charles Schwab & Co. For Fraudulent Sales Of Auction Rate Securities

NEW YORK, NY (August 17, 2009) - Attorney General Andrew M. Cuomo today filed a lawsuit against Charles Schwab & Co. (“Schwab”) charging the discount brokerage firm for falsely representing 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.

Auction rate securities are long-term bonds that rely on the successful operation of a periodic auction for short-term liquidity. Schwab brokers repeatedly and persistently misrepresented the liquidity risks in auction rate securities, comparing them to money market funds or certificates of deposit, selling auction rates as suitable for cash management purposes, or otherwise telling customers they would always be able to retrieve their cash.

“Charles Schwab owed its customers a duty to properly understand and make accurate representations concerning auction rate securities,” said Attorney General Cuomo, “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.”

Audio recordings obtained during the investigation confirm that Schwab brokers repeatedly misled investors about the risks of investing in auction rate securities. One Schwab broker “guaranteed” that his customer would be able to “get out of [his auction rate security] on the auction date.” Another assured a customer that she just needed to “call me … and then the next month I’ll stop the auction and all the cash [invested in auction rate securities] will come back to your account.” Another Schwab broker described preferred auction rate securities as a “short-term institutional holding instrument” that was particularly suitable for managing the customer’s cash balances:

If you need to have that access to them at any time, that’s a good place for those to be. You know if you think you might need to get into that money, that’s probably as good a place if not better than anywhere to leave them.

Another broker represented that the hardest part of investing in an auction rate security “is getting into it. That would be the tough part. I mean, getting out is something as easy as just selling it.”

While Schwab publicly touted its “extensive fixed-income research,” “expertise” and “seasoned bond traders, who have an average of 15 years of industry experience,” Schwab’s persistent fraud was possible because Schwab failed to train or otherwise ensure that its brokers had even a basic understanding of auction rate securities. Brokers interviewed during the investigation all confirmed that they received no formal training from Schwab relating to auction rate securities. As a result, many Schwab brokers misunderstood or knew little about the auction rate securities they were selling to Schwab’s customers. While Schwab sold customers on its fixed income “expertise,” one broker stated: “I don’t know what measuring scale you would want to use to assess my knowledge about auction rate securities … but on whatever measuring scale my knowledge was pretty low.” The lack of training and understanding at Schwab proved devastating to Schwab’s customers. When one broker was asked if his customers adequately understood the risks of auction rate securities, the broker replied: “No. . . . They probably didn’t know that here is a product you might not be able to sell. It wasn’t conveyed by myself or the financial consultant because we didn’t know either.” Just one week before the auction rate securities market collapsed, during a call with another broker-dealer, one Schwab broker still did not understand the risks that were about to haunt Schwab’s customers, asking “how could an auction fail?”

Schwab knew, or was reckless or negligent in not knowing, about rising problems in the auction rate securities market beginning in August 2007. Schwab received daily reports from the major underwriter broker-dealers, which showed that the inventories of those underwriter broker-dealers were increasing dramatically starting in the final months of 2007. This information, indicating a steep decline in demand for auction rate securities, was unavailable to the public. Significantly, Schwab also knew about auction failures in the auction rate market as early as August 2007, when certain broker-dealers decided to stop submitting support bids. Although these incidents attracted the attention of senior Schwab managers, Schwab focused on public relations risks, not the implications to the market for auction rate securities. Regarding an early auction failure, one Schwab executive asked “[w]hat’s our exposure in this development, if any?” Another responded that there was a “brand risk of course” if Schwab customers “can’t get … access to their funds.”

Today’s action seeks, among other things, to compel Schwab to buy-back auction rate securities from the Schwab investors still holding illiquid securities, penalties, costs, disgorgement, restitution, and other equitable relief.

From the beginning of his investigation into the auction rate market, the Attorney General’s objective has been to bring relief to investors stuck with illiquid auction rate securities. To date, regulatory settlements called for over $61 billion in investor buy-backs, representing the largest return on behalf of investors ever. The case against Schwab is Attorney General Cuomo’s latest action in his ongoing effort to restore liquidity to investors caught in the collapse of the auction rate securities market.

The Attorney General thanked the Financial Industry Regulatory Authority (FINRA) and the State of California, Department of Corporations for their assistance during the investigation of Schwab.

Assistant Attorneys General Armen Morian and Peter Dean conducted the investigation under the supervision of David A. Markowitz, Chief of the Investor Protection Bureau, and Eric Corngold, Executive Deputy Attorney General for Economic Justice.

A copy of the complaint can be found on the Attorney General's website: www.ag.ny.gov

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