Charles Schwab Corp was sued by New York Attorney General Andrew Cuomo, who accused the discount brokerage of fraudulently misleading investors about the safety of auction-rate securities.

The civil lawsuit filed Monday in New York State Supreme Court in Manhattan was expected, after Cuomo's office announced its intent to sue Schwab on July 20.

It represents an escalation of Cuomo's efforts to punish brokerages and force them to repurchase the debt at face value from investors who were misled into believing the securities were as solid as cash.

Much of the debt became illiquid in February 2008 when dealers stopped supporting the $330 billion market. Cuomo has already gotten more than a dozen other banks and brokerages to buy back more than $61 billion of the debt.

This may be a strategic move to get Schwab to agree to a more pro-investor settlement, said James Cox, a law professor at Duke University in Durham, North Carolina. Schwab has built a foundation as the broker for the middle-class and would not want its reputation harmed by letting the lawsuit fester.

Thousands of customers of San Francisco-based Schwab held about $787.9 million of auction-rate securities as of February 13, 2008, Cuomo's office estimated.

Schwab said the lawsuit lacks merit.

The New York Attorney General's lawsuit casts blame for a bad situation in the wrong direction, spokeswoman Sarah Bulgatz said. She said Cuomo should instead punish underwriters that deceived brokers on the safety of auction-rate debt.

GREAT ALTERNATIVE TO CASH, BROKER SAYS

According to the complaint, which cited recordings of brokers' conversations with clients, one broker labeled auction-rate securities great alternatives to cash, frankly.

Another called an investor who was planning to buy a home and had been keeping cash in a money market fund. Expressing a humble opinion, the broker told the investor that auction-rate debt would be a very safe place for that money.

Schwab owed its customers a duty to properly understand and make accurate representations, Cuomo said. Anyone in the industry who misrepresented the risks of investing in auction-rate securities will be held accountable.

Two brokerages that, like San Francisco-based Schwab, only sold the securities, Fidelity Investments and TD Ameritrade Holding Corp , have settled with Cuomo's office.

Underwriters that settled with Cuomo include Bank of America Corp , Citigroup Inc , Goldman Sachs Group Inc , JPMorgan Chase & Co and Royal Bank of Canada , among others.

Cuomo charged Schwab with four counts of fraud, including action under the state's Martin Act, which gives Cuomo wide powers to fight financial fraud.

He wants Schwab to buy back auction-rate debt from clients at face value and pay penalties, among other remedies.

The Martin Act is an extraordinarily broadly written statute, Cox said. It essentially gives Cuomo carte blanche.

FRAUD ALLEGED

According to the complaint, Schwab sold customers a product it did not fully understand and could not properly explain, despite advertisements promising expertise.

The company also knew, or was reckless or negligent in not knowing, of the market's problems in the summer of 2007, when auctions began to fail, the complaint said.

In a July 24 letter to Cuomo, released Monday, Schwab said it did not actively market or induce the sale of auction-rate debt, and never made any commitment to support that market.

Cuomo'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, wrote Faith Gay, a partner at the law firm Quinn Emanuel Urquhart Oliver & Hedges LLP.

In afternoon trading, Schwab shares were down 82 cents, or 4.5 percent, at $17.44 on the Nasdaq.

The case is Cuomo v. Charles Schwab & Co, Supreme Court of the State of New York, County of New York.

(Reporting by Jonathan Stempel; Editing by Phil Berlowitz and Gerald E. McCormick)

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