Investors Scrutinizing the Regulators

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Brokerages face auction rate probe

August 20, 2008 at 6:10 PM EDT

NEW YORK — New York Attorney General Andrew Cuomo said Wednesday that smaller brokerage firms that acted as middlemen in sales of auction-rate securities will be held accountable for any losses suffered by investors.

Brokerages like Fidelity Investments, Charles Schwab Corp., TD Ameritrade Holding Corp., E*Trade Financial Corp. and Oppenheimer & Co. are being investigated over how they pitched the investments to clients, according to a letter obtained by The Associated Press. These firms, known as downstream brokerages, acted as secondary dealers by purchasing auction-rate securities from the major banks that packaged them.

“If downstream brokerages deliberately stuck their heads in the sand but continued to actively market these products to unknowing investors, that will certainly be relevant to our calculus of the firms' culpability,” Benjamin Lawsky, deputy counselor and special assistant in the attorney general's office, said in the letter. “These firms are licensed broker-dealers and were obviously well paid by their clients for their specialized knowledge and diligence regarding the appropriateness of various products as investments.”

The Regional Bond Dealers Association this week asked regulators to focus their attention on the primary dealers that first sold the securities. They believe that smaller brokerages should not be expected to buy back the investments from their customers, arguing that the major Wall Street banks that underwrote the securities should be held responsible.

Five major Wall Street firms including Citigroup Inc. and Switzerland's UBS AG have agreed to $42-billion (U.S.) in settlements with state and federal regulators over auction rate securities. The investigations are examining how brokerages sold auction-rate securities before the $330-billion market collapsed in February.

The Washington-based bond market trade group said that about $60-billion of the auction rate securities were sold through brokerages that didn't know the market was in danger of collapse.

The auction-rate securities market involved investors buying and selling instruments that resembled corporate debt, except the interest rates were reset at regular auctions, some as frequently as once a week. A number of companies and retail clients invested in the securities because they could treat their holdings almost like cash.

But the market for them collapsed in February amid the downturn in the broader credit markets.

Regulators have been investigating the collapse in the market to determine who was responsible for its demise and whether banks knowingly misrepresented the safety of the securities when selling them to investors.

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