Charles Schwab settled claims with the Commission
relating to its YieldPlus Fund which at one time invested primarily in mortgage
backed securities, asset backed securities and corporate bonds. In the Mater
of Charles Schwab Investment Management, Adm. Proc. File No. 3-14184 (Jan.
11, 2011); SEC v. Charles Schwab Investment Management Inc., Civil
Action No. CV-11-0136 (N.D. Cal. Jan. 11, 2011). The company previously settled
civil damage actions based on similar claims (here).
The two Commission actions are against: Charles Schwab
Investment Management (CSIM), a registered investment adviser; Charles Schwab
& Co., Inc. (CS&Co.), the distributor and transfer agent for the
YieldPlus Fund; and Schwab Investments, a no-load, open ended management investment
company organized as a series investment company registered under the
Investment Company Act. The YieldPlus Fund is a series issued by Schwab
Investments.
The actions center on four primary claims. First, the SEC
alleged that investors were not properly informed about the risks of the Fund.
The YieldPlus Fund is an ultra-short bond fund. As such it is a fixed income
fund with durations typically less than one year. Duration reflects the Fund's
sensitivity to interest rate changes, not time. At its peak in 2007 the Fund
had $13.5 billion in assets and over 200,000 accounts. During the market crisis
of 2007 - 2008 the Fund's NAV dropped 28% and its assets under management fell
to $1.8 billion due to redemptions and declining assets values.
Prior to its decline the Fund was marketed as a cash
alternative that generated a higher yield with slightly more risk than a money
market fund. This claim was misleading according to the Commission because
investments in the Fund are not insured as are CDs and the maturity and credit
quality of the securities held by it were significantly different from those in
a money market fund.
Second, the Fund violated its concentration policy. Under
Section 8 of the Investment Company Act the registration statement for a fund
contains a recital of certain investment policies including one regarding
concentration of investments in particular industries. To change that policy
the fund must obtain shareholder approval. Here the Fund deviated from it
policy when it invested about 50% of it assets in private issuer mortgage
backed securities. The Fund policy limited concentrations in such securities to
no more than 25% of its assets.
Third, misrepresentations were made to investors about
the Fund as its NAV began to decline in mid-2007. For example, the number of
redemptions was materially understated.
Finally, the Commission claimed that there were
insufficient policies and procedures reasonably designed to prevent the misuse
of material, non-public information about the Fund. For example, while there
were general policies about such information, there were no specific policies
and procedures governing redemptions by portfolio mangers who advised Schwab
funds.
The Commission's complaint and the Order allege
violations by: CSIM and CS&CO. of Securities Act Sections 17(a)(2) and (3)
and aiding and abetting and causing violations of Investment Company Act
Section 34(b); by CSIM of Advisers Act Section 206(4); by Schwab Investments of
Investment Company Act Section 13(a); and by CS&Co. of Exchange Act Section
15(g).
To settle the civil action CSIM and CS& Co. agreed to
pay a total of $118,944,996 including $52,327,149 in disgorgement of fees by
CSIM, a penalty by CSIM of $52,327,149, a penalty of $5,000,000 by CS&Co.
and prejudgment interest. CSIM's disgorgement obligations can be satisfied in
part by payment within 60 days in a related FINRA proceeding of up to about
$26.9 million. The Commission is seeking to establish a Fair Fund.
In the related administrative proceeding CSIM, CS&Co.
and Schwab Investments consented to the entry of an order requiring them to
cease and desist from committing or causing future violations of the sections
cited above. CSIM and CS&Co, were also censured and required to retain an
independent consultant. Each Respondent was directed to comply with its
undertakings.
Two other related actions were brought based on similar
allegations. One names as defendant Kimon Daifotis, the former Senior Vice
President and Chief Investment Officer-Fixed Income of CSIM and Randall Merk, a
former Executive Vice President at Charles Schwab Corporation and an Executive
Vice President at CS&Co. The charges in the complaint include violations of
Exchange Act Section 10(b), Securities Act Section 17(a), Advisers Act Section
206(4) and Investment Company Act Section 34(b). The case is in litigation. SEC
v. Daifotis, Case No. CV-11-0137 (N.D. Cal. Jan. 11, 2011).
The second was brought by FINRA. It ordered Charles
Schwab & Company, Inc. to pay $18 million into a Fair Fund established by
the SEC. That sum represents the $17.5 million in fees Schwab collected on the
sales of Fund shares plus a fine of $500,000.
For more news involving securities issues, visit SEC Actions, a blog by Thomas
Gorman