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Holding the Innocent Accountable

“You know, I’m not trying to make a ton of money. I just want to play it safe,” a customer told a retail broker at Charles Schwab & Co. The broker suggested auction-rate securities.

Investors at numerous brokerage firms across the country bought auction-rate securities in the middle part of this decade, believing that they were safe, liquid investments. Auctions would be held periodically, they were told, and, whenever they wanted to liquidate their securities, they just had to wait for the next auction.

Unfortunately, for many, that wait is turning out to be a lot longer than expected. In February 2008, the market froze and the auctions began to fail. Customers who were told they would have a chance to sell each week found themselves stuck holding the securities indefinitely.

Now, New York Attorney General Andrew Cuomo is suing Schwab, saying the firm misrepresented the liquidity and risks of the securities. Audio recordings of conversations between Schwab brokers and customers reveal that, in several conversations, brokers told customers that this was a safe way to earn a little bit more than they would from a traditional savings account or money market fund. Essentially, Schwab retail clients were being sold a security that purported to offer more reward without any additional risk. That investment theory rarely has a happy ending.

Several of the auction-rate securities’ lead managers who underwrote and supported the auctions have settled with the attorney general. However, the settlement forces the underwriters to buy back only the auction-rate securities held at those same firms rather than all of the auction-rate securities they sold. If you were foolish enough to continue to work with such a firm, you get bailed out. But, if you bought the security and housed it elsewhere, as Schwab’s customers did, no such luck.

Cuomo, a likely candidate for governor of New York next year, is taking a page from the playbook of his predecessor, Eliot Spitzer: Defend the Little Guy against the Big Guy even if the Big Guy did nothing wrong.

It appears to me that in Schwab’s case, its retail brokers, who sometimes provide advice to clients unaffiliated with an investment adviser, offered information they believed to be correct at the time. I have seen nothing that makes me believe that Schwab intentionally misled or deceived its clients.

In a letter released on Monday, the company claimed that the securities’ underwriters misled it along with its customers. According to the letter, during one November 2007 call, a major underwriter told Schwab that its auctions were not failing and were not likely to fail, while concealing its knowledge that its inventory of auction-rate securities was unsustainable and that it would be forced to withdraw from the auction market in the near future. The Schwab brokers who made the sales did so because they believed, based on what turned out to be inaccurate information, that the securities would benefit their customers. According to Faith Gay, a lawyer representing Schwab, the company did not in any way induce its representatives to sell the securities.

Schwab argues that brokerage firms cannot be expected to be perfect and should not be punished for failing to predict the unpredictable. Gay said the attorney general’s belief that Schwab should “act as an insurer against an unprecedented market collapse that it did not cause and could not predict is legally unsound.”

Legally unsound, perhaps, but not unprecedented. Last month, TD Ameritrade Inc, which acted as a distributor for the securities, agreed to repurchase $456 million of auction-rate securities as part of a settlement with Cuomo’s office.

Our firm houses the majority of its clients’ mutual fund assets at Schwab’s Institutional division. Although brokers from the retail division suggested what turned out to be an illiquid product, I believe it was bad judgment, not deceit. Cuomo’s allegations do not damage my confidence in Charles Schwab & Co. Our clients’ assets are in a safe place.

If you enjoyed this article, be sure to check out Palisades Hudson’s books, The High Achiever’s Guide To Wealth and Looking Ahead: Life, Family, Wealth and Business After 55. Both are available in paperback and as e-books.

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