Charles Schwab versus Andrew Cuomo Charles Schwab started the company that bears his name on an exceedingly small scale in 1963; his only product at the time was an investment advisory newsletter that was distributed to just 3,000 subscribers. Personal brokerage services were added in 1971, and then pushed along by a constant stream of innovations-discounted fees in 1975, computerized trades in 1978, 24-hour operations in 1980, and impartial investment recommendations from start to finish-his firm grew very rapidly. In 2009 it provided 7.5 million customers with individual brokerage accounts, served 1.5 million participants in corporate retirement programs, employed 12,500 persons, and had a widespread reputation for serving clients well. That reputation was brought into direct conflict with the Attorney General of the State of New York, Andrew Cuomo, by a suit over auction rate securities. Auction rate securities are an innovative form of investment-grade bonds, where the interest rates are set by periodic auctions. Most bonds, both corporate and municipal, have an interest rate that is set at the time of issuance, and that interest rate lasts throughout the life of the bond. Auction rate bonds do not have a set rate. Instead, the bonds are ranked by investment quality (AAA to C+), and existing holders and potential investors submit bids for the number of bonds within each quality rank they wish to repurchase (the existing holders) or newly purchase (the potential investors) and the minimum interest rate they are willing to accept as a condition of that purchase. Those interest rates are then ranked from low to high, and the highest interest rate at which all of the bonds within a given quality ranking will be purchased (in finance this is known as the "market clearing rate") become the rate for those bonds. For most auction rate securities, this bidding process was to be held at the end of each month, with settlement the next day, and interest to the prior holders to be paid at the same time. These auction rate securities became very popular with both corporate and municipal ssuers because they seemed to add the flexibility of short-term bonds to the steadiness f long-term securities. Individuals were attracted by the interest rates that so clearly eflected actual market demand and the periodic opportunities to get their money backwhenever they wished. By early 2008 , the auction mate security market had grown to pare than $200 billion. Because of the dual need to submit new bids each month and to proberage firms or investment houses to manage the auidual purchasers relied on their What went wrong? February 2008 marked the start of the rate securities they held. gedy, there were no bidders at the regularly. the start of the credit crunch crisis. Sudthe interest rates became zero, the market valucs bocamed auctions, and so essentially peable to dispose of their auction rate securities. became zero, and the holders were cers throughout the co.

1. Charles Schwab versus Andrew Cuomo Charles Schwab started the company that bears his
name on an exceedingly small scale in 1963; his only product at the time was an investment
advisory newsletter that was distributed to just 3,000 subscribers. Personal brokerage services
were added in 1971, and then pushed along by a constant stream of innovations-discounted fees
in 1975, computerized trades in 1978, 24-hour operations in 1980, and impartial investment
recommendations from start to finish-his firm grew very rapidly. In 2009 it provided 7.5 million
customers with individual brokerage accounts, served 1.5 million participants in corporate
retirement programs, employed 12,500 persons, and had a widespread reputation for serving
clients well. That reputation was brought into direct conflict with the Attorney General of the State
of New York, Andrew Cuomo, by a suit over auction rate securities. Auction rate securities are an
innovative form of investment-grade bonds, where the interest rates are set by periodic auctions.
Most bonds, both corporate and municipal, have an interest rate that is set at the time of issuance,
and that interest rate lasts throughout the life of the bond. Auction rate bonds do not have a set
rate. Instead, the bonds are ranked by investment quality (AAA to C+), and existing holders and
potential investors submit bids for the number of bonds within each quality rank they wish to
repurchase (the existing holders) or newly purchase (the potential investors) and the minimum
interest rate they are willing to accept as a condition of that purchase. Those interest rates are
then ranked from low to high, and the highest interest rate at which all of the bonds within a given
quality ranking will be purchased (in finance this is known as the "market clearing rate") become
the rate for those bonds. For most auction rate securities, this bidding process was to be held at
the end of each month, with settlement the next day, and interest to the prior holders to be paid at
the same time. These auction rate securities became very popular with both corporate and
municipal ssuers because they seemed to add the flexibility of short-term bonds to the steadiness
f long-term securities. Individuals were attracted by the interest rates that so clearly eflected actual
market demand and the periodic opportunities to get their money backwhenever they wished. By
early 2008 , the auction mate security market had grown to pare than $200 billion. Because of the
dual need to submit new bids each month and to proberage firms or investment houses to manage
the auidual purchasers relied on their What went wrong? February 2008 marked the start of the
rate securities they held. gedy, there were no bidders at the regularly. the start of the credit crunch
crisis. Sudthe interest rates became zero, the market valucs bocamed auctions, and so essentially
peable to dispose of their auction rate securities. became zero, and the holders were cers
throughout the county, led by Andrew Cuomo, Under presoure from state legal offiof New York,
the investment banks that had Cuomo, the Attomey General of the State osl placement of these
securities agreed to repurchase about in the underwriting and origicitigroup, Morgan Chase,
Goldman Sachs, investment banks that participated in this repurch, and Mernill Lynch were among
the thyy would attempt to rework those securities irchase settlement. It was expected that
Settlements with the "downstream" adjustable rate bonds after the original brokerage firms that

2. were the marketers of the were harder to reach on legal grounds. They werwiting and placement
had been completed the designs, construct the bonds, or met they were able to claim that they did
not develop innovative financial product that or run the auctions, and thus were just marketing an
TDAmeritrade (the unusual name ref ereloped, constructed, and serviced by others. the only
brokerage firm that agreed refers to the Toronto Dominion Bank of Canada) was securities for
which they apparently to settle and buy back $457 million in auction rate On August 17,2009 the
W all Street J fosernal rement of responsibility. to sue Charles Schwab Corp's brokemeet Jotarnal
reported that Andrew Cuomo planned was negligent in mot knowing the brokerage division,
alleging that Schwab either knew or was negligent in not knowing the dangers that a credit crunch
crisis and the resultant lack of liquidity would bring to the regularly scheduled markets for auction
rate securities. Essentially the lawsuit claimed that the brokers working for Schwab should have
been trained to warn their clients of the dangers of a financial collapse. Two days later, Charles
Schwab responded with a letter to the editors of the Wall Street Journal that was published as an
"op-ed" piece on August 19, 2009. That letter is reproduced here: A blizzard of new proposed
regulation and overzealous litigation is poised to jeopardize the low-cost investing model that tens
of millions of investors have cajoyed for decades, In the last 30 years, individual investors have
benefitted from huge insovations, including low commissions, online investing, mutual fund
supermarkets, and the adveat of exchange traded funds. Individuals now have broad access to
domestic and global markets at costs lower than institutions enjoyed only a few years ago. This
has provided needed capital to our economy and enabled the creation of personal wealth for
average Americans. But today's extraordinary regulatory and political environment is putting all of
this at risk. My company, Charles Schwab, was founded 35 years ago as a reaction to the high
cost and inherent exclusivity of traditional Wall Street investing. Today we serve alimost. 10 million
accounts. The majority are what we refer to as self-directed: They make their own decisions about
what to buy, sell, or hold. We provide them with an efficient platform, tools, assistance, education,
and, of course, low costs.We are not alone. Our direct competitons serve millions of other
American investots 45 76 Chapter 3 are looking for essentially the same thang: the freedom to
inexpensively invest on their os inresting comes risk, as well as polential reward. Un rings for the
individual investor, whether the alt reys scious effort to limit - if not cling liability for brokers, or the
threat of litigation that atternite consumer "frotection," fiduciary liability for broke ohers like us,
more like an insumance company than a broker. to make our fimm, and others like us, montly
being sued by New York Attorney General Andrea Cuomo, who alleges that we should have
known beforehand that the Auction Rate Securities market would freeze. Auction Rate Securities
are generally high-quality. long-term bonds that can be bought and sold on a weekly or monthly
basis through an auction process. The interest rate paid on the bonds was reset at each auction
accoediog te iavesior demand. The auction process has largely been frozen since February 2008,
legv. iag investoss holding quality long-term, but illiquid bonds. Though this market operated
smoothly and reliably for over 20 years, it is a market that ne had no direct involvement in
establishing or maintaining. It's a market where roughly 90 pereent of the clients who imvested in
these securities came to Schwab arking as to locate and make available these investments for
them. We did not create the prod. ucts, actively market them, and had no involvement in the
events that led to the collepie of the Auction Rate Secunities market. The implication of this lawsuit

3. is that fims like ours should have known that the mageker would fail. Shoald we also have known
that Lehman Brothers or Bear Stearns were going to go under, and compensate clients who
bought their equity or debt? Should ae have been able to predict which financial institutions would
be the beneficiaries of gor. emment bailouts and which would not? I think it's fair to say we have
all been supprised by many events this past yoar. The issue at stake here is whether independent
investors should be allowed the freedom to choose what they are allowed to buy, sell, or hold. Or
should the government try to enforce a guanntee against market risk through regulation or lawsuits
like the attomey general has brought against us? If Schwab is going to be held responsible for
guaranteeing every decision an investor makes, we'd need to severely limit what they purchase.
Would we tell them they couldn't buy Google or IBM stock because regulators or politicians don't
think they are smart enough to assess the risks and could hold us accountable for any losses?
The logicel outcome would be that individual investors would be constrained to a small set of plain
vanilla investments - Treasurys for all-or would be forced to pay us a fee to manage their account.
To be sure, we are happy to manage money for our clients. But millions of investors have decided
that their needs are best served when they direct their own finances. Foreing them to pay an
advisory fee would be a significant new cost to them and the fees would likely shut many small
investors out of the capital markets altogether. I've always believed in the power of the market to
drive innovation and drive dowa cost. 1 also believe in the individeal and his or her ability to make
reasoned decisions. I don't think our clients, or our competitors' clients, are looking for regulators
or politicians to protect them from risk by constraining their choices. Today Schwab clients can
open an account with as little as S1,000. If they invest their S1,000 in an S&.S00 Index fund, they
would pay no commission and their total cost of nanagement would be 90 cents per anmum. For
90 cents a year they can access cveryhing Schwab has to offer inchuding education, tools, our
Web site, 24/7 live phone serrice, as well as suppont from one of our approximately 300 branches
across the country.This is an incredibly powerful model that I'm proud of, and a model that I think
is good for this country and the market. Don't let litigators and politicians jeopardize it. If they
succeed, the individual investor will pay a heavy price. 1 Class Assignment This dispute between
Charles Schwab and Andrew Cuomo goes to the heart of both our market-based economy and
our law-based society. Address those issues through the following four questions: 1. Which side of
the dispute between Charles Schwab and Andrew Cuomo are you on? Charles Schwab
expressed his thoughts in an exceedingly articulate "op-ed" letter that was published in the New
York Times. Andrew Cuomo did not respond because he is by tradition (don't taint the jury pool,
and don't warn the opposing counsel) your opinion will Andrew Cuomo make at that trial, and-if
you were a member of the jury - what would be your verdict? Why? 2. What are the assumptions
of a market-based economy that as an attorney for one of the sides you would be either be certain
to bring before the jury or be prepared to counter if your opponent brought them before the jury? 3.
What are the assumptions of a law-based society that as an attorney for one of the sides you
would be either be certain to bring before the jury or be prepared to counter if your opponent
brought them before the jury? 4. Lastly, go back to Chapter 1 and review the section on ethical
duties. Are there any arguments expressed here that would help you to convince members of the
jury that your side was the most equitable and fair-to-all?