People v. Schwab

• Decision Date: 27 August 2013
• Citation: 971 N.Y.S.2d 267,2013 N.Y. Slip Op. 05722,109 A.D.3d 445
• Parties: The PEOPLE of the State of New York by Andrew W. CUOMO, etc., Plaintiff–Appellant, v. CHARLES SCHWAB & CO., INC., Defendant–Respondent.
• Court: New York Supreme Court — Appellate Division

109 A.D.3d 445

971 N.Y.S.2d 267

2013 N.Y. Slip Op. 05722

The PEOPLE of the State of New York by Andrew W. CUOMO, etc., Plaintiff–Appellant,

v.CHARLES SCHWAB & CO., INC., Defendant–Respondent.

Supreme Court, Appellate Division, First Department, New York.

Aug. 27, 2013.

Eric T. Schneiderman, Attorney General, New York (Brian A. Sutherland of counsel), for appellant.

Quinn Emanuel Urquhart & Sullivan, LLP, New York (Faith E. Gay of counsel), for respondent.

ANDRIAS, J.P., FRIEDMAN, DeGRASSE, FREEDMAN, JJ.

Appeal from order, Supreme Court, New York County (O. Peter Sherwood, J.), entered October 31, 2011, which granted defendant's motion to dismiss the complaint pursuant to CPLR 3211(a)(7), deemed appeal from judgment, same court and Justice, entered April 4, 2012, dismissing the complaint, and, so considered, said judgment unanimously modified, on the law, to deny the motion as to the second and third causes of action insofar as they are based upon conduct that took place prior to September 5, 2007, and otherwise affirmed, without costs.

This is an enforcement action brought by the Attorney General under the Martin Act (General Business Law art. 23–A) and General Business Law § 349 as well as Executive Law § 63(12). The Martin Act causes of action are based on General Business Law § 352–c(1)(a), which, where applicable, prohibits fraud, concealment, suppression or false pretense, and General Business Law § 352–c(1)(c), which prohibits false representations or statements to induce or promote the issuance, purchase or sale of securities within or from the State. It is alleged in the complaint that defendant, Charles Schwab & Co., Inc. (Schwab), a registered securities broker-dealer, engaged in fraudulent and deceptive conduct in the sale of auction rate securities (ARS) to the investing public. The Attorney General asserts that Schwab misrepresented ARS to its customers as safe, liquid investments while concealing the fact that they were complex financial instruments with significant, inherent and increasing liquidity risks.

An explanation of the Attorney General's claims requires a description of the ARS market, which is set forth in the complaint as follows:

“17. Auction rate securities are long-term bonds issued by municipalities, corporations and student loan companies, or perpetual equity instruments issued by closed end mutual funds, which pay variable interest rates that reset periodically through a bidding process known as a Dutch auction. The auctions also serve as the mechanism by which auction rate securities are bought and sold.

“18. At a Dutch auction, bidders generally state the number of auction rate securities they wish to purchase and the minimum interest rate they are willing to accept. Bids are ranked, from lowest to highest, according to the minimum interest rate specified by each bidder. The lowest interest rate required to sell all of the auction rate securities available at auction, known as the ‘clearing rate,’ becomes the rate payable to all holders of that particular security until the next auction. Depending on the structure of the auction rate security specified in the offering documents, auctions are typically held every 7, 28 or 35 days.

“19. When there are an insufficient number [ sic ] of buyers participating in an auction to purchase all of the securities being offered for sale, the auction ‘fails' and typically no orders to buy or sell are fulfilled. As auction rate securities can only be bought or sold when auctions clear, the most immediate and obvious consequence of an auction failure is that current holders of that issue of auction rate securities are unable to sell their holdings, and suffer a loss of liquidity. If auctions fail repeatedly, investors are left with no option but to hold the securities to maturity—potentially as long as 30 years, or in the case of auction rate preferred securities, perpetually—with no ability to access their money.

“20. During the period when auctions are not clearing, investors are paid a default rate of interest, called a ‘fail rate,’ which is specified in the origination documents.

“21. Until February 2008, underwriter broker-dealers generally supported the auction rate securities market by systematically purchasing auction rate securities into their own inventories in order to make up for shortfalls in natural demand that would have, in the absence of such support, caused the auctions for those securities to fail. These proprietary bids placed by the underwriter broker-dealers for their own accounts were known as ‘support bids.’

“22. The underwriter broker-dealers were under no legal obligation to place such support bids, and could refrain from doing so at any time in their sole discretion.” ¹

The complaint alleges that Schwab became aware of failures in the ARS market and associated liquidity risks as early as August 2007. In February 2008, broker-dealers had stopped making support bids, causing a wholesale failure in the market for ARS. At that time, Schwab directed that its sales force advise its customers that ARS did not carry a 100% certainty of liquidity. Accordingly, investors who had purchased ARS from Schwab found themselves holding investments that were not as liquid as they had been purportedly led to believe.² The complaint alleges that “Schwab persistently failed to disclose, or made representations that concealed, the risk that customers could lose liquidity should auctions fail.”

In dismissing the Martin Act causes of action, the court concluded that the “misrepresentations alleged were true when made and the complaint contains no allegations that ARS were liquid at a time when they were illiquid.” The court based this conclusion on its own finding that there had been no failures in the auctions in the 20 years preceding August 2007. In reaching this conclusion, the court erroneously engaged in an evaluation of the merits of the Martin Act causes of action. On a ...