Charles Schwab Must Face Auction-Rate Suit, Court Says

Charles Schwab Corp. must face a lawsuit in which New York state accused it of falsely describing auction-rate securities as liquid investments without disclosing the risks, an appeals court ruled.

The San Francisco-based brokerage was sued by Andrew Cuomo in August 2009 when he was attorney general. A trial judge in Manhattan, Justice O. Peter Sherwood of state Supreme Court, granted Schwab’s motion to dismiss the case in 2011.

A four-judge appeals court panel today reinstated two of the four claims in the case, securities fraud allegations based on the state’s Martin Act, saying the attorney general’s office presented enough evidence for a trial.

The Martin Act “is remedial and should be broadly construed in order to attain its beneficial purpose,” Justice Richard Andrias wrote. “Under the statute, the word ‘fraud’ is broadly defined so as to embrace even acts which ‘tend to deceive the purchasing public.’ Based on this standard, the complaint sets forth actionable Martin Act claims notwithstanding the absence of a specific allegation that Schwab represented ARS to be liquid at times when they were illiquid.”

‘Deceptive Conduct’

Auction-rate securities are municipal bonds, corporate bonds and preferred stocks whose rates of return are periodically reset through auctions. The attorney general’s office sued on behalf of investors who bought the securities through Schwab.

The $330 billion worldwide market for auction-rate securities collapsed during the 2008 credit crunch as potential buyers vanished. The crisis sparked regulatory investigations and lawsuits alleging that underwriters and brokers had falsely promoted auction-rate securities as safe, cash-like investments.

Schwab was accused of engaging in “fraudulent and deceptive conduct” and failing to disclose the risks involved in the investments.

Schwab argued that the complaint didn’t allege statements that were false when made or identify who made the misstatements, when and where they were made or how they were misleading, according to Sherwood’s order.

Sherwood said the complaint is “devoid of any allegation of misrepresentations made that were untrue when made,” noting that the attorney general’s office spent more than a year investigating before filing the suit.

Company Response

The appeals court said Sherwood based its conclusion on a finding that there had been no failures in the auctions in the 20 years preceding August 2007 and erroneously evaluated the merits of the claims.

The company said in a statement that it will defend its position and is confident the court will rule in its favor. About 98 percent of the auction-rate securities held by Schwab clients have been redeemed at par value, the company said.

“Unlike some other downstream brokerage firms, Schwab did not market or promote ARS, market or sell them to clients online or compensate its registered representatives for ARS transactions,” the company said. “Schwab’s role in these transactions was simply to accommodate clients when they asked for these types of products.”

Attorney General Eric Schneiderman’s office is pleased that the appeals court ruled that its claims should proceed, spokesman Damien LaVera said in an e-mail.

“Schwab misled its customers in its marketing of auction rate securities and we look forward to proving those claims in the trial court,” LaVera said.

Other Claims

The appeals court upheld Sherwood’s decision to dismiss the first claim in the suit, saying that the statute upon which it is based only authorizes the attorney general to seek injunctive relief and other remedies in cases that involve persistent fraud or illegal activity. The appeals court also agreed with Sherwood on dismissal of the fourth claim, saying the state’s general business law doesn’t apply to securities transactions.

The Martin Act claims are restricted to activity that took place before September 2007, and everything Schwab said about the market before that date turned out to be “extremely accurate,” said Faith Gay, an attorney with Quinn Emanuel Urquhart & Sullivan LLP who is representing Charles Schwab.

“We are very comfortable with this ruling,” Gay said in a telephone interview. “The tiny piece of the case that’s left will go down.”

Shares of Charles Schwab fell as much as 4.3 percent in New York today before closing down 87 cents, or 4 percent, to $20.74. Before today, the stock had risen 50 percent this year.

The case is People of the State of New York v. Charles Schwab & Co. Inc., 453388/2009, New York State Supreme Court (Manhattan).

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