SAN FRANCISCO--(BUSINESS WIRE)--Charles Schwab & Co., Inc. filed its written response on Friday, July 24, 2009, to allegations by the Attorney General of New York (NYAG) concerning the company’s sale of Auction Rate Securities (ARS) to retail clients. The letter is available at www.aboutschwab.com.
“does not apply to securities transactions, even when those actions are brought as claims by 'holders' of shares”
The full text of the letter, submitted to the NYAG on behalf of Schwab by outside counsel, follows below and is also attached to this news release as an imaged copy.
Letter to the Office of the New York Attorney General from Schwab’s Outside Counsel Quinn Emanuel Urquhart Oliver & Hedges, LLP
VIA CERTIFIED MAIL AND EMAIL
David A. Markowitz, Esq.
Investor Protection Bureau
Office of the Attorney General
State of New York
New York, NY 10271
Re: Auction Rate Securities
Dear Mr. Markowitz:
This responds to your July 17, 2009 letter to Carrie Dwyer at Charles Schwab & Co., Inc. (“Schwab” or “the Company”) sent via certified mail and overnight delivery. The letter purports to be a 5-day notice letter under GBL 349(c), even though, for the reasons stated below, that section does not apply to the subject of your Office’s investigation and threatened suit.
We are disappointed that your Office has now publicly announced its intention to file unwarranted charges against Schwab in connection with auction rate securities (“ARS”) that suddenly became illiquid when the lead ARS managers that underwrote, launched, and supported those securities suddenly backed away from that market and allowed their auctions to fail. The Attorney General’s decision to sue Schwab for a market calamity that it neither caused nor could have foreseen is the foregone conclusion of an investigation that was driven from the outset by a self-imposed mandate to reach a predetermined result: nationwide buybacks of illiquid ARS by every firm, regardless of fault and despite major differences in the roles that each firm played in the ARS market.
The chain of events that brought us to the present impasse began last summer when the Attorney General permitted the major Wall Street securities firms that controlled the ARS market to buy back ARS only from investors who held the securities at those firms rather than from all investors who owned ARS that those firms underwrote. Having agreed to a settlement template for the “upstream” firms that created, sustained, and finally abandoned the ARS market, your Office then sought to impose the same outcome on “downstream” firms such as Schwab that merely made ARS available to their clients. Such an indiscriminate, outcome-driven approach necessarily ignores crucial distinctions among the various actors, the drawing of which lies at the very heart of the proper exercise of prosecutorial power and discretion. That your Office’s limited settlements with the upstream firms left out an entire class of investors harmed by their misconduct does not now justify going after innocent downstream firms to rectify that omission.
As your Office learned during its investigation, unlike other firms, Schwab did not underwrite any ARS, did not actively market ARS to its customers, did not buy ARS for its own account, did not enter support bids in any auction, did not pay its representatives any compensation for ARS transactions or otherwise induce them to sell the product, and did not make and then break commitments to support the ARS market. The Attorney General’s refusal to take these very significant differences into consideration in this case is unjust. Schwab cannot agree to a prepackaged resolution that unfairly punishes it and its shareholders for events over which it had no control or ability to predict.
After taking one-sided testimony (during which Schwab’s counsel was not permitted to ask questions or even request a transcript), selectively picking through tens of thousands of subpoenaed emails and numerous recorded telephone calls,1 and initiating contact with Schwab customers in an effort to solicit complaints from customers who had not previously complained, your Office evidently believes that it has come up with instances of minor failings on the part of Schwab representatives to disclose some of the risks of ARS to this or that customer. You seek to use those isolated instances as conclusive proof that Schwab violated New York law and in service of your predetermined goal to force every firm to buy back frozen ARS from customers across the country, regardless of the facts.
There are several fundamental flaws with your approach, including the reliance on faulty “fraud by hindsight” analysis; the failure to acknowledge that Schwab and its customers were misled by the ARS underwriters; the misuse of interactions with a handful of customers to draw conclusions about a much larger universe of transactions; the fact that one of the statutes you rely on, New York’s Consumer Protection law, does not even apply to securities transactions; and your audacious assertion of nationwide jurisdiction over transactions that have no substantive connection to New York State. We briefly address each of these issues below.
Fraud by Hindsight
Your “fraud by hindsight” analysis takes the occurrence of an event that is unfortunate but was entirely unforeseen by Schwab and improperly uses it to assign liability to Schwab for failing to disclose the unknown risk of that event. This is a widely discredited technique, depending as it does on using after-the-fact knowledge to judge events that took place before those facts became known. See, e.g., Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978).
As you are well aware, prior to February 2008, there had been only a handful of scattered auction failures in a retail ARS market that had seen hundreds of thousands of successful auctions over more than two decades. At that time, Schwab was not aware that the lead underwriters were routinely propping up the auction market by submitting cover bids to prevent auctions from failing. Nearly all ARS were receiving AAA ratings and these securities were very popular cash management investments for investors of all types, from the largest and most sophisticated corporate cash managers to ordinary retail investors. Securities regulators such as the SEC, FINRA, and your own Office evidently shared this view, as not one of them issued any warning about the risks of owning ARS prior to the February 2008 market collapse. For these reasons, your criticism that Schwab’s representatives considered and represented ARS to be safe, liquid investments is unfair and misplaced. That is how everyone else viewed those securities, and Schwab’s representatives were in a far less advantageous position than were many others to draw any different conclusion.
Also wide of the mark is your suggestion that the August 2007 failures in CDO-backed ARS constituted notice of “rising problems” in the retail ARS market. Certain individuals at Schwab may have been aware of some of those failures, but they involved an entirely different market, one involving private placement ARS that were backed by structured products, had significant sub-prime mortgage exposure, and could be sold only to Qualified Institutional Buyers (generally, large corporations that own at least $100 million in securities). As with any bond, liquidity problems due to credit concerns specific to that issue are always a possibility, but there was no concern then that those private placement ARS failures spelled trouble for the retail market and for high quality issues.
What does link the failures of those two entirely different ARS markets is a common cause that the Attorney General seems not to have considered at all: the global credit contagion and accompanying liquidity crisis that has held the world in its grip for the past two years. The crisis started as a nasty brushfire in the sub-prime mortgage field but soon blew up into a ferocious firestorm that has swept the globe. The present crisis has resulted in a litany of horribles that would have been, like the collapse of the entire ARS market, unthinkable only a few short years ago. To name but a few: a major money market fund “breaking the buck;” huge, unprecedented infusions of emergency capital by nearly every central bank; the failure of more than 80 domestic banks, blank check federal bailouts of several “too big to fail” enterprises; federal guarantees of money market funds to quell investor fears and thereby avoid a panic similar to that which occurred in the ARS market; and the bankruptcy of venerable giants such as General Motors. Stock markets have cratered and investment portfolios have been halved, or worse. (Ironically, retail ARS holdings, while illiquid, generally have continued to pay interest and have thus served as something of a forced safe harbor for the investors who own them, another fact that seems to have escaped the Attorney General’s notice.) In short, the failure of liquidity in the ARS market was but one of a series of unfortunate consequences of a global liquidity panic that was not foreseeable to Schwab, the regulators, or anyone else.
Schwab And Its Customers Were Deceived By The Underwriters/Lead Managers
Conspicuously missing from the Attorney General’s purported 5-day notice letter is the major role that the lead underwriters played in deceiving Schwab, withholding critical information regarding ARS from Schwab, and providing misleading information knowing that Schwab would rely on that information and pass it on to customers. As underwriters and "lead managers" of the auctions for the ARS they underwrote and brokered, these firms had information regarding the auction market, and their own manipulation of that market, that was not known to or knowable by Schwab or Schwab's clients. In particular, Schwab did not know that the lead underwriters were routinely submitting cover bids to prevent auctions from failing and then using their sales forces to find buyers for ARS they were forced to purchase in the auctions. Because this vital information was concealed by the lead underwriters who had enormous incentives to maintain the facade of a liquid market, Schwab had no reason to suspect that auctions were clearing due to artificial support, rather than normal marketplace demand, and no way of advising its clients regarding the true state of the market.
With no role in the underwriting of ARS, Schwab relied on the lead underwriters for access to ARS and relied on information regarding ARS and the auction markets provided by these firms. For example, during a November 2007 call, one major underwriter assured Schwab that its auctions were not failing and were not likely to fail. When this underwriter gave Schwab these false assurances, it knew, but concealed, that its inventory of ARS was no longer sustainable and would inevitably result in the firm’s withdrawal from the auction market in the near-term. Indeed, your Office has found that, during this period, this firm was aware of the increasing strains in the auction rate securities market and increasingly questioned the viability of the auction rate securities market, but did not disclose these increasing risks of owning or purchasing auction rate securities to all of its customers. In fact, this underwriter continued to deceive Schwab and conceal critical information right up to its complete withdrawal from the auction market. Just days before it withdrew completely from the auction market in February 2008, this firm gave Schwab more false assurances, emphasizing that it had experienced only one previous auction failure, back in 1990; but concealed the fact that it was planning, within days, to withdraw its supporting bids from all its ARS auctions.
As your Office concluded in your enforcement actions against that firm and the other underwriters through which Schwab accessed the ARS market, because investors could not ascertain how much of an auction was filled through ‘cover’ bids and proprietary trades, those investors could not determine if auctions were clearing because of normal marketplace demand, or because these firms were making up for the lack of demand through ‘cover’ bids and proprietary trades.
It is precisely this information that these same firms concealed from Schwab and Schwab's customers. Nevertheless, the Attorney General chose voluntarily to enter into Assurances of Discontinuance that released these underwriters from public responsibility for their role in deceiving Schwab's clients into purchasing the ARS products the underwriters created, propped up and then suddenly abandoned. Schwab submits that, having released the real culprits from responsibility for their acts, the Attorney General drop efforts to now shift that responsibility to Schwab.
Unwarranted Assumptions Based on Incomplete Facts
In any event, your demand that Schwab buy back without exception all outstanding ARS owned by its retail customers is based upon unwarranted assumptions drawn from a small number of transactions and an incomplete factual record. Indeed, contrary to your sweeping allegations, your own investigation elicited testimony from some Schwab representatives who did recall discussing with clients the remote risk of an auction failure for an individual issue and the consequences if that were to occur. Your theory fails to take these inconvenient facts into account.
Similarly, your theory completely ignores crucial factual variances, such as widely different levels of ARS experience on the part of Schwab’s customer base and whether ARS purchases were solicited or unsolicited. As you know from the records Schwab produced, the vast majority of Schwab’s ARS transactions were “unsolicited.” Your demand for a universal buy back simply disregards these highly relevant factual differences between clients and transactions.
The Consumer Protection Statute Does Not Apply to Securities Transactions
We are mystified by your stated intention to bring charges against Schwab under New York’s Consumer Protection law. Most courts that have considered the issue have ruled that the statute does not apply to securities transactions. See, e.g., In re Eaton Vance Mutual Funds Fee Litigation, 380 F.Supp.2d 222, 240 (S.D.N.Y. 2005) (holding Section 349 "does not apply to securities transactions, even when those actions are brought as claims by 'holders' of shares"); In re Evergreen Mut. Funds Fee Litigation, 423 F.Supp. 2d 249, 264 (S.D.N.Y. 2006); Gray v. Seaboard Securities, Inc., 14 A.D.3d 852, 788 N.Y.S.2d 471, 473 (3d Dept. 2005); Fesseha v. TD Waterhouse Investor Services, Inc., 761 N.Y.S.2d 22, 23-24 (1st Dept 2003).
Some New York plaintiffs have attempted to circumvent these precedents by arguing that their deceptive business practice claim relates to the service of providing investment advice and not to the purchase of securities themselves. Those efforts have not fared well. For example, the Gray court held that the promised advice and recommendations were clearly "ancillary to the purchase of securities." 788 N.Y.S.2d at 473 (quoting Berger v. E*Trade Group, 2000 WL 360092 (Sup. Ct., NY County, Mar. 28, 2000). The clear weight of authority holds that claims arising out of securities transactions are not covered by the Consumer Protection statute.
The New York Attorney General Does Not Have Nationwide Jurisdiction
We are equally mystified by your Office’s assertion that it can assert jurisdiction over all of Schwab’s ARS transactions, regardless of whether they involve New York customers or New York representatives. When Schwab raised this issue, you said you planned to rely on the fact that the third-party agents who conducted the auctions for ARS are located in New York. That is a tenuous -- and untenable -- basis for asserting jurisdiction over transactions by an out-of-state corporation that did not involve either New York residents or New York sales representatives. Your Office has attempted, without success, to employ a nearly identical tactic before. State v. Samaritan Asset Mgmt. Servs., Inc., 874 N.Y.S.2d 698, 702-04 (N.Y. Sup. 2008).
Executive Law § 63(12) Was Not Intended to Be Used in Cases Such as This
While there is not a clear statement from the legislature regarding the intended use of Executive Law § 63(12), a fair reading of the legislative history suggests that the purpose of permitting the Attorney General to commence a special proceeding under that statute was to provide a mechanism for remedying quickly any ongoing course of fraudulent conduct. We believe, and will argue in court, that the expedited procedure set forth in § 63(12) should be reserved for instances of repeated or imminent fraudulent conduct, not wielded as a tactical weapon to cut off a defendant’s right to defend itself.
As suggested above, there are numerous material issues, both factual and legal, upon which the parties fundamentally disagree. We do not believe that a court will look with favor on the Attorney General conducting a year-long investigation of a past market event and then rushing into court demanding immediate adjudication without the defendant being afforded any discovery or a meaningful opportunity to prepare and present a defense. There is no ongoing course of fraudulent conduct here that warrants stripping Schwab of the basic due process rights that any citizen deserves.
The Attorney General’s demand that Schwab act as an insurer against an unprecedented market collapse that it did not cause and could not predict is legally unsound. More than that, it is unjust and a dangerous precedent. The filing of any charges against Schwab is totally unwarranted, and the Company will vigorously defend itself in court.
Very truly yours,
Quinn Emanuel Urquhart Oliver & Hedges, LLP
1 We cannot let pass without comment the suggestion that Schwab has been anything less than completely cooperative with your Office. Schwab has responded to even “informal” requests from your Staff that arrived by email or orally over the telephone. We assume that your erroneous assertion that Schwab failed to provide tapes of recorded telephone calls arises from a misunderstanding of the agreement that your Staff and Schwab’s attorneys negotiated regarding the production of tape recordings. As was explained then, not every conversation between a Schwab registered representative and a customer is or was recorded. Many other broker-dealers do not record any customer calls. Those calls that are recorded by Schwab are indexed by name of representative, date, and time, rather than by account number. Because of the periodic nature of the ARS market, unlike an equity trade which usually occurs at the same time as the customer phone call, significant time might pass between the time of the call and when an ARS trade ticket is entered. These factors make it laborious, time consuming, and sometimes not possible to find particular calls. When this was explained to your Staff, they agreed to permit Schwab to produce, to the extent they could be located, calls associated with the first two ARS purchases for any retail New York customers holding ARS positions at Schwab as of April 13, 2009. Schwab fully complied with that agreement and never heard a hint of dissatisfaction on that score from your Office until your July 17th letter.
About Charles Schwab
The Charles Schwab Corporation (Nasdaq: SCHW) is a leading provider of financial services, with more than 300 offices and 7.6 million client brokerage accounts, 1.5 million corporate retirement plan participants, 619,000 banking accounts, and $1.3 trillion in client assets. Through its operating subsidiaries, the company provides a full range of securities brokerage, banking, money management and financial advisory services to individual investors and independent investment advisors. Its broker-dealer subsidiary, Charles Schwab & Co., Inc. (member SIPC, http://www.sipc.org), and affiliates offer a complete range of investment services and products including an extensive selection of mutual funds; financial planning and investment advice; retirement plan and equity compensation plan services; referrals to independent fee-based investment advisors; and custodial, operational and trading support for independent, fee-based investment advisors through its Advisor Services division. The Charles Schwab Bank (member FDIC) provides banking and mortgage services and products. More information is available at www.schwab.com.
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