Aug. 21 (Bloomberg) -- U.S. regulators will start on-site inspections next week of about 40 brokerages involved in sales of auction-rate securities, stepping up a nationwide inquiry into whether the firms failed to warn clients the market was collapsing, a person familiar with the matter said.

The Financial Industry Regulator Authority, which regulates almost 5,100 brokerages, wrote to the firms this month seeking detailed records, said the person, who reviewed the letters. New York Attorney General Andrew Cuomo said yesterday he had subpoenaed firms including Fidelity Investments, Charles Schwab Corp. and Oppenheimer Holdings Inc. in a parallel probe.

Financial regulators are shifting the focus to brokerages that sold the securities from banks that created them after wringing pledges from five Wall Street firms, including Citigroup Inc. and UBS AG, to repurchase about $35 billion of auction-rate debt. Like Cuomo, Finra has uncovered evidence that firms improperly sold the instruments, the person said.

``If downstream brokerages deliberately stuck their heads in the sand but continued to actively market these products to unknowing investors, that will certainly be relevant to our calculus of our firms' culpability,'' Cuomo's office said in a letter to the Regional Bond Dealers Association yesterday.

Finra spokesman Herb Perone declined to comment.

Firms Under Investigation

State and federal regulators, including the Securities and Exchange Commission, are looking at how brokerages sold auction- rate securities before the $330 billion market collapsed in February. That's when firms running the periodic auctions for the debt abandoned their routine role as buyers of last resort, leaving investors stuck with securities they couldn't sell.

Cuomo said today that Merrill Lynch & Co., which has announced a voluntary buyback of auction-rate debt, must reach a settlement today or face legal action.

``If we don't settle today, tomorrow at this time we'll be in court,'' Cuomo said. ``At some point, enough is enough.''

Finra's sweep focuses on firms that haven't yet settled regulatory probes and have the largest client holdings of auction-rate debt, the person said. That includes national, regional and boutique firms, as well as brokerages affiliated with banks or insurers.

The Washington-based watchdog is examining whether the companies conducted due diligence on the products, ensured that brokers understood them and explained risks to customers. Investigators are scrutinizing the firms' communications with banks that ran the auctions, following up on signs that brokerages placed bids to help support the sales.

Seeking Records

The regulator is demanding spreadsheets on bids submitted for the products and clients' holdings, the person said. It wants copies of training and marketing materials and is seeking the firms' risk analyses and the results of internal investigations. It would also like to know whether phone lines on auction-rate trading desks were recorded.

Firms may be punished if evidence shows they sold the debt while ignoring signs the market was weakening, Cuomo's office said in its letter yesterday. The attorney general has subpoenaed companies including TD Ameritrade Holding Corp. and E*Trade Financial Corp. Yesterday's letter urged the bond dealer's group to help clients unload their holdings.

The group's co-chief executive officers, Michael Decker and Mike Nicolas, said in response that they expect regulators to take ``full appropriate measure'' against any firms that broke securities laws. ``Our focus has been and remains on investors and ensuring they can liquidate their ARS positions as soon as possible.''

`Accommodation'

Schwab said in an Aug. 15 statement it was cooperating with regulators' requests for information, noting it didn't underwrite the securities or market them to clients. The firm said it acted as an agent ``as an accommodation when clients asked for them.''

Oppenheimer's Dennis McNamara, E*Trade spokeswoman Pam Erickson and TD Ameritrade's Kim Hillyer didn't return calls for comment.

Fidelity, the world's largest mutual-fund manager, has been targeted in the auction-rate probe. Massachusetts Secretary of State William Galvin urged Fidelity on Aug. 19 to buy back frozen auction-rate securities from individual investors who bought them through the company's brokerage unit.

``Fidelity is neither the issuer, underwriter or the sponsor'' of auction-rate securities, spokesman Vincent Loporchio said that day. ``We believe the underwriters should stand behind their securities.''

To contact the reporters on this story: David Scheer in New York at dscheer@bloomberg.net; Patricia Hurtado in New York State Supreme Court in Manhattan at pathurtado@bloomberg.net.

Last Updated: August 21, 2008 09:37 EDT