Is Schwab to blame for investments gone bad?

Who should be held responsible when an investment goes sour: the investor who chose the investment? Or the broker who provided the trading platform that allowed the investor to buy?

That's the bottom-line question in a lawsuit (text in PDF) filed last week by New York Attorney General Andrew Cuomo against Charles Schwab Corporation.

The suit alleges that the company "misrepresented auction rate securities to...customers as safe, liquid investments that were suitable for their short-term, cash management purposes.... Schwab also failed to ensure that its sales force was properly equipped with knowledge about the features and liquidity risks of auction rate securities."

Auction-rate securities are debt instruments with interest rates that are reset at daily, weekly or monthly auctions. In February 2008, several auctions failed. The result: supposedly liquid investments quickly became illiquid (and some investors became very unhappy).

In response to the New York AG's lawsuit, Charles Schwab, the founder of Charles Schwab Corp., has written a column for the Wall Street Journal, arguing that the suit seems to be based on the popular but unrealistic idea that investing should not involve risk.

[At Charles Schwab, w]e serve almost 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 have never guaranteed individual success. Our investors understand that along with investing comes risk, as well as potential reward. Unfortunately, we are now seeing a conscious effort to limit - if not eliminate - all risks for the individual investor, whether through consumer "protection," fiduciary liability for brokers, or the threat of litigation that attempts to make our firm, and others like us, more like an insurance company than a broker....

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 guarantee against market risk through regulation or lawsuits like the attorney 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.... The logical outcome would be that individual investors would be constrained to a small set of plain vanilla investments - Treasurys for all.

Of course, there are at least two sides to every story - and the AG's office does seem to have credible evidence that, at a minimum, some Schwab employees who talked with customers about auction-rate securities were themselves ill-informed about the risks.

Still Mr. Schwab makes a credible point about the potentially chilling effect of "the government try[ing] to enforce a guarantee against market risk" - especially when it comes to independent investors who use companies such as Schwab (or TD Ameritrade or other brokers) primarily as a means of accessing the investing marketplace.

This New York v. Schwab case bears watching. The outcome could very well affect the universe of investing options available to all of us "do-it-yourselfers" in the future.

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Joseph Slife is a contributing author and editor for SMI. Visit www.soundmindinvesting.com to learn more.