Tuesday, January 11, 2011
The SEC charged Charles Schwab Investment Management (CSIM) and Charles Schwab & Co., Inc. (CS&Co.) with making misleading statements regarding the Schwab YieldPlus Fund and failing to establish, maintain and enforce policies and procedures to prevent the misuse of material, nonpublic information. The SEC also charged CSIM and Schwab Investments with deviating from the YieldPlus fund's concentration policy without obtaining the required shareholder approval. CSIM and CS&Co. agreed to pay more than $118 million to settle the SEC's charges. SEC Order; SEC complaint
The SEC also filed a complaint in federal court against CSIM's former chief investment officer for fixed income Kimon Daifotis as well as Schwab official Randall Merk, who is an executive vice president at CS&Co. and was president of CSIM and a trustee of the YieldPlus and other Schwab funds. The SEC alleges that Daifotis and Merk committed fraud and other securities law violations in connection with the offer, sale and management of the YieldPlus Fund. The SEC's case continues against the executives. SEC Complaint
The YieldPlus Fund is an ultra-short bond fund that, at its peak in 2007, had $13.5 billion in assets and more than 200,000 accounts, making it the largest ultra-short bond fund in the category. The fund suffered a significant decline during the credit crisis of 2007 and 2008. Its assets fell from $13.5 billion to $1.8 billion during an eight-month period due to redemptions and declining asset values.
According to an administrative order issued by the SEC against the Schwab entities and the SEC's related complaints against the entities and the two executives filed in federal court in San Francisco, they failed to inform investors adequately about the risks of investing in the YieldPlus Fund. For example, they described the fund as a cash alternative that had only slightly higher risk than a money market fund. The statements were misleading because the fund was more than slightly riskier than money market funds, and the Schwab entities and Merk and Daifotis did not adequately inform investors about the differences between YieldPlus and money market funds.
The SEC found that the YieldPlus Fund deviated from its concentration policy when it invested more than 25 percent of fund assets in private-issuer mortgage-backed securities (MBS). Mutual funds and other registered investment companies are required to state certain investment policies in their SEC filings, including a policy regarding concentration of investments. Once established, a fund may not deviate from its concentration policy without shareholder approval. Schwab's bond funds, including the YieldPlus Fund and the Total Bond Market Fund, had a policy of not concentrating more than 25 percent of assets in any one industry, including private-issuer MBS. The funds violated this policy, and the Investment Company Act, by investing approximately 50 percent of the assets of the YieldPlus Fund and more than 25 percent of the Total Bond Fund's assets in private-issuer MBS without obtaining shareholder approval.
According to the SEC's order and complaints, the YieldPlus Fund's NAV began to decline and many investors redeemed their holdings as the credit crisis unfolded in mid-2007. Unlike a money market fund, few of the fund's assets were scheduled to mature within the next several months. As a result, the fund had to sell assets in a depressed market to raise cash. While the YieldPlus Fund's NAV declined, CSIM, CS&Co., Merk, and Daifotis held conference calls, issued written materials, and had other communications with investors that contained a number of material misstatements and omissions concerning the fund. For example, in two conference calls, Daifotis made false and misleading statements that the fund was experiencing "very, very, very slight" and "minimal" investor redemptions. In fact, Daifotis knew that YieldPlus had experienced more than $1.2 billion in redemptions during the two weeks prior to the calls, which caused YieldPlus to sell more than $2.1 billion of its securities. Similarly, Merk authored, reviewed and approved misleading statements about the fund, such as a false claim that the fund had a "short maturity structure" that "mitigated much of the price erosion" experienced by its peers.
The SEC also found that CSIM and CS&Co. did not have policies and procedures reasonably designed — given the nature of their businesses — to prevent the misuse of material, nonpublic information about the fund. For example, they did not have specific policies and procedures governing redemptions by portfolio managers who advised Schwab funds of funds, and did not have appropriate information barriers concerning nonpublic and potentially material information about the fund. As a result, several Schwab-related funds and individuals were free to redeem their own investments in YieldPlus during the fund's decline.
Without admitting or denying the findings in the SEC's order or the allegations in the SEC's complaint, CSIM and CS&Co. agreed to pay a total of $118,944,996, including $52,327,149 in disgorgement of fees by CSIM, a $52,327,149 penalty against CSIM, a $5 million penalty against CS&Co., and pre-judgment interest of $9,290,698. Some of CSIM's disgorgement may be deemed satisfied up to a maximum of $26,944,996 for payments made within the next 60 days to settle related investigations by FINRA or state securities regulators.
The SEC seeks to have payments placed in a Fair Fund for distribution to harmed investors, and the related recoveries by other regulators, such as FINRA, may be contributed to the Fair Fund. The payments and any Fair Fund are subject to approval by the U.S. District Court for the Northern District of California.