Monday, July 20, 2009

Cuomo goes after Chuck

The WSJ Reports:

In an official notice sent to Charles Schwab & Co. Friday, Attorney General Andrew Cuomo warned that his office plans to sue the largest online brokerage firm for civil fraud over its marketing and sales of auction-rate securities to clients. Emails and testimony cited in the letter show Schwab's brokers had little idea of what they were selling and later failed to tell clients that the market was collapsing.

Auction-rate securities -- short-term debt instruments whose prices reset in periodic auctions -- caused billions in losses for investors after the $330 billion market collapsed in early 2008.

Mr. Cuomo writes in the letter that his office would be open to a settlement with Schwab, but it must agree to buy back the securities from investors still stuck with them.

More than a dozen Wall Street firms and small brokerages agreed to pay more than $60 billion to buy back the securities from investors.... Schwab is among a handful that haven't settled.

"The Attorney General's allegations are without merit," Schwab said in a statement. "They unfairly lay blame on our company for an illiquid market and improper behavior by the large Wall Street firms that created" and then stopped supporting the market....

The attorney general's investigation of Schwab found that brokers were unaware of and misleading about the risks of the securities -- promoting them to customers as cash-like investments, according to the letter. It also found that some traders and executives knew the market was cracking as early as the autumn of 2007 and took steps to protect the company, but didn't disclose those problems to customers....

Charles Schwab executives received daily reports showing in the fall of 2007 that demand for the instruments was declining rapidly, but it didn't make that information available to clients, said the letter.

I'm not entirely sure how I stand on Cuomo's Spitzer-esq activism. On the one hand, the market collapsed and people a lot smarter than Schwab's retail brokers misread it. There was a pervasive view in the financial community that "innovations" like ARS's and sub-prime MBS's were relatively safe investments. I'm not sure how fair it is to sue Schwab for giving wrong advice. After all, they were in some pretty good company with that one.

However, there's an admittedly hazy line between simply being wrong and negligently wrong. It's one thing if they were sold as pretty safe, and should give you a good return, and a much different thing if they were sold as " cash-like investments." I suspect most of them were sold with a line similar to the first, and Cuomo cherry-picked a particularly bad statement to include in the press release.

Also, the fact that the company "took steps to protect the company, but didn't disclose those problems to customers" should surprise no one. The company made the decision to protect themselves instead of their customers, and I don't know if that warrants state and court intervention.

Was it bad business to protect the company instead of the investors? Maybe. Was it wrong to sell the ABS's to relatively unsophisticated investors? Probably. To the extent that they told them the investments were "cash-like" or near risk free the company should be held liable. Anything past that and I'm not sure why stupid advise should leave them liable in court. I'm not a lawyer, but this seems like a pretty thin case mainly designed to help Mr. Cuomo in his gubernatorial run.

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