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Schwab refusing to pay off clients in 'auction-rate' issues

July 20, 2009 |  7:08 pm

Instead of the carrot-and-stick approach, New York Atty. Gen. Andrew Cuomo on Monday used two sticks in his campaign to force Charles Schwab Corp. to pay off clients in those notorious auction-rate preferred securities.

For stick No. 1, Cuomo threatened Schwab with a lawsuit if the discount brokerage fails to agree to buy back the offending securities.

For stick No. 2 , Cuomo resorted to peer pressure: He announced that Schwab rival TD Ameritrade Inc. settled a similar case and will repurchase $456 million of the securities. The Securities and Exchange Commission also announced a settlement with TD Ameritrade, which won’t pay any fines as part of the deals.

So far, Schwab isn’t budging. It issued a long statement defending itself and chastising Cuomo for deciding to "try cases in the press."

Cuomo Auction-rate securities, popular with many individual investors before the credit markets collapsed in 2008, were essentially long-term debt instruments masquerading as short-term securities.

They were pitched by brokers to yield-hungry small investors as safe and easily redeemable -- which they were, until demand for all such engineered securities dried up. That left investors stranded in about $330 billion of auction-rate issues, unable to sell (although still earning interest).

Cuomo, the SEC and other securities regulators have since negotiated buy-back settlements with 20 brokerages and other financial firms that were selling auction-rate preferred debt, including Goldman Sachs, Merrill Lynch and Deutsche Bank.

To compel settlements, regulators have asserted that the brokerages misrepresented the safety of the securities.

In a letter to Schwab warning of a lawsuit, Cuomo excerpted from interviews his office did with Schwab brokers as part of his probe and from audio recordings of Schwab sales pitches. One broker allegedly told a client that getting into the securities "is the tough part. Getting out of it is easy as just selling."

In its rebuttal, Schwab said that its brokers, "while trained to levels beyond industry standards, could not be expected to foresee and disclose market risks that even regulators and market experts did not foresee."

Schwab asserts that the big brokerages that created the securities should have been forced to buy them back from all investors who purchased them, including investors who bought the issues from third parties such as Schwab.

But Cuomo’s settlement with TD Ameritrade, following a settlement last year with Fidelity Investments’ brokerage unit, stands to put more pressure on Schwab. TD Ameritrade CEO Fred Tomczyk said the buyback was "the right thing to do for our clients."

A person familiar with Schwab’s exposure said its clients still own about $100 million of auction-rate securities, much less than what TD Ameritrade will repurchase.

That begs the question: Is it really worth a game of hardball with Cuomo -- and a potential fat fine -- or better to just settle up and move on?

-- Tom Petruno

Photo: Andrew Cuomo. Credit: Louis Lanzano / Associated Press