AG's Claims Against Schwab Back On Track
(CN) - An appeals court revived claims from New York's top cop that Charles Schwab downplayed the risks of auction rate securities prior to the market's 2008 collapse.
Charles Schwab & Co. had been one of more than a dozen other broker-dealers that faced lawsuits under the Martin Act, a 1921 New York law that gives the state attorney general broad powers to prosecute financial crimes, even when there is no evidence of specific intent.
The 2009 complaint against Schwab said that sales staff for the brokerage firm had misrepresented auction rate securities as safe investments without fully disclosing to investors that their liquidity depends on the success of the auction process through which they are bought and sold.
The complaint notes that auction rate securities are long-term bonds that pay an interest rate that is periodically reset in a bidding procedure called a Dutch auction, which can be completed only if there are enough bidders to purchase all of the securities offered for sale.
In fall 2007, auctions for the securities began to fail. By early 2008, the market for auction rate securities had collapsed, leaving tens of thousands of investors who had purchased the securities through Schwab and other brokers holding hundreds of billions of dollars worth of bonds that they were unable to sell.
Merrill Lynch, Morgan Stanley, Goldman Sachs and most of the other brokerages sued by the attorney general settled the cases against them by agreeing to repurchase securities from their customers.
Schwab instead opted to fight the claim in court, a strategy that initially appeared to pay off.
Attorney General Eric Schneiderman took over the case against Schwab when he assumed office in 2011, replacing Andrew Cuomo who became the state's governor.
That year, New York County Supreme Court Justice O. Peter Sherwood dismissed the complaint against Schwab on grounds that the firm had no reason to suspect that the securities were unusually risky, given that there had been no failures in the auctions for 20 years prior to August 2007.
The Appellate Division's First Department reversed last week, finding that the Martin Act is broad enough to support an enforcement action even though there are no allegations that Schwab's sales staff continued to assert that the securities could readily be sold after it became apparent that ARS auctions were failing.
In conducting his own research before ruling on Schwab's motion to dismiss for failure to state a cause of action, Justice Sherwood overstepped his authority, according to the ruling from a unanimous four-judge panel.
Sherwood "erroneously engaged in an evaluation of the merits of the Martin Act causes of action," the unsigned five-page opinion stats.
Regardless of whether the attorney general will ultimately prevail on the merits, the complaint certainly states actionable claims under the law, the judges found.
"We find the Martin Act causes of action to be sufficiently pleaded given the fact that the statute is remedial and should be broadly construed in order to attain its beneficent purpose," they wrote. "Under the statute, the word 'fraud' is broadly defined so as to embrace even acts which 'tend to deceive or mislead 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."
Since the complaint does not allege that Schwab employees engaged in any actionable conduct after an auction for a Schwab-issued ARS failed for the first time on September 5, 2007, the suit is limited to conduct that occurred before that date, the ruling notes. They also found that Sherwood properly dismissed two other claims that were based on statutes that do not apply to the facts of the case.
Justices Richard Andrias, David Friedman, Leland DeGrasse and Helen Freedman signed the decision.