Charles Schwab Lawsuit Filed by New York AG Over Auction Rate Securities

New York Attorney General Andrew Cuomo filed a lawsuit against Charles Schwab Corp. on Monday, accusing the brokerage firm of defrauding customers by misrepresenting the level of risk associated with auction rate securities (ARS).

The Charles Schwab lawsuit, which was filed in New York State Supreme Court, alleges that the company promoted the auction-rate securities market as a conservative, low-risk, short-term investment that was an easy-to-sell alternative to cash. However, the auction-rate securities market froze in February 2008, preventing investors from accessing their capital and resulting in large losses.

Auction-rate securities are bonds that are bid on by investors and sold to those who will accept the lowest interest rate during auctions regularly held to determine the bonds’ rates. When banks withdrew their support for auction rate securities, investors were unable to sell the bonds, freezing their assets. Cuomo’s office estimates that Schwab customers held about $787.9 million in auction-rate securities before the market froze.

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Cuomo, the Securities Exchange Commission, and others have been pressuring brokerages to reimburse investors for the face value of losses they suffered as a result of investments in the ARS market. To date, Cuomo has convinced about a dozen banks and brokerages to compensate investors by buying back about $61 million in auction rate securities losses. The Schwab ARS lawsuit came after they refused to do the same.

Schwab has promised to fight the lawsuit, saying it was just as duped as its customers regarding the safety of the ARS market, indicating that Cuomo should be going after the underwriters.

According to the Wall Street Journal, Cuomo will likely introduce recorded conversations of Schwab representatives promoting the ARS investments as infallible cash equivalent investments as evidence of the misrepresentation. Cuomo has also said that the ignorance defense does not work for Schwab, as the company should have responsibly known the risks and should have trained its brokers accordingly.

The filing against Schwab comes about a month after the SEC filed a similar lawsuit against Morgan Keegan & Co. for defrauding customers who had almost $925 million invested into the ARS market. The Morgan Keegan auction rate securities lawsuit, filed in federal court in Alabama, seeks to force the company to buy back the frozen debt and to forfeit $4.3 million in profits made from underwriting, brokerage and distribution fees.

Following the market decline, Charles Schwab Corp. also faces a number of individual claims from investors lost money in the company’s ultra-short bond fund, Schwab YieldPlus. Although the fund was sold as a relatively conservative investment alternative to money market funds, it lost 31.7% of its value between June 2007 and June 2008, due to heavy investments in mortgage-backed securities. Plaintiffs in the Schwab YieldPlus lawsuits and arbitration claims allege that the company violated the fund’s prospectus by investing in the risky mortgage instruments and then failing to reveal the extent of the investments.


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