Tuesday, January 11, 2011
A Schwab EVP is Among Those Charged by the SEC in Bond Fund Case
Reported by Armie Margaret Lee
The SEC has charged Charles Schwab Investment Management
(CSIM) and Charles Schwab Corp.
(CS& Co.) with making misleading statements about the YieldPlus
ultra-short bond mutual fund, and veering away from the fund's concentration policy without getting shareholder approval. CSIM and CS& Co. agreed to pay more than $118 million to settle the charges.
| Randall Merk |
Charles Schwab & Co.
The commission also filed suit against Randy Merk
, an EVP at CS& Co. and former president of CSIM, and CSIM's former CIO for fixed income Kimon Daifotis
. The SEC alleges that the two committed fraud in connection with the offer, sale and management of the YieldPlus fund. The SEC's case against Merk and Daifotis continues.
Last month, Merk
from his post as president and CEO of CSIM and
took on a special project role at Schwab. Marie Chandoha replaced him at the helm of CSIM.
In an e-mailed statement to The MFWire.com
on Tuesday, Merk's attorney, Susan Brune, wrote: "Mr. Merk will fight the SEC's civil lawsuit. The SEC's claims are infected by hindsight bias and are not supported by the actual evidence. We look forward to presenting all of the facts in court."
A representative for Daifotis was not immediately available for comment.
As for CSIM and CS& Co., the entities agreed to settle without admitting or denying the allegations. Of the settlement, Schwab Corp. issued a statement saying that it "believes that resolving it in this way is in the best interests of the company, its stockholders, and clients who experienced losses in the YieldPlus Fund as a result of the global financial crisis."
"Schwab would never seek to profit at the expense of its clients. We regret that fund shareholders lost money in YieldPlus," according to the statement. "Indeed, Charles R. Schwab, the company’s founder and chairman, was one of the largest investors in the fund. The decline in the YieldPlus fund was the result of an unprecedented and unforeseeable credit crisis and market collapse. Until the credit crisis, the YieldPlus Fund was consistently one of the top performing funds in its category for eight years and held a Morningstar 5-star rating from December 2004 through September 2007."
Click here to view the SEC order
Click here to view the complaint against Schwab Corp. and CSIM
Click here to view complaint against the executives
SEC Press Release
SEC CHARGES SCHWAB ENTITIES AND TWO EXECUTIVES WITH MAKING MISLEADING STATEMENTS
Schwab Entities to Pay More Than $118 Million to Settle SEC Charges
Washington, D.C., Jan. 11, 2011 – The Securities and Exchange Commission today 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.
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.
CSIM and CS&Co. agreed to pay more than $118 million to settle the SEC’s charges. The SEC’s case continues against the executives.
Robert Khuzami, Director of the Division of Enforcement said, “All financial firms and professionals – including large mutual fund providers – must be vigilant in accurately describing the risks of the products they sell to the public, especially the widely-held mutual funds that are the bread-and-butter investments of retail investors.”
Antonia Chion, Associate Director of the SEC’s Division of Enforcement, said, “Schwab marketed the fund as a cash alternative with only slightly more risk than a money market fund even though, at one point, half of the fund’s assets were invested in private-issuer, mortgage-backed and other securities with maturities and credit quality that were significantly different than investments made by money market funds.”
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.
CSIM, CS&Co. and Schwab Investments also consented to an SEC order requiring them to cease and desist from committing or causing future violations of the federal securities laws. The SEC order also requires them to comply with certain undertakings, including correction of all disclosures regarding the funds’ concentration policy. In addition, the Commission censured CSIM and CS&Co., and required them to retain an independent consultant to review and make recommendations about their policies and procedures to prevent the misuse of material, nonpublic information.
In its order, the Commission found that:
CSIM and CS&Co. willfully violated anti-fraud provisions of the Securities Act of 1933, Sections 17(a)(2) and (3).
CSIM willfully violated anti-fraud provisions of the Investment Advisers Act of 1940, Section 206(4) and Rule 206(4)-8.
Schwab Investments willfully violated Section 13(a) of the Investment Company Act of 1940 by deviating from its concentration policy, and CSIM willfully aided and abetted and caused the violation.
CSIM and CS&Co. willfully aided and abetted and caused violations of the false filings provision of the Investment Company Act, Section 34(b).
CS&Co. violated Section 15(g) (formerly Section 15(f)) of the Securities Exchange Act of 1934, and CSIM violated Section 204A of the Advisers Act, both of which require policies and procedures that are reasonably designed, taking into consideration the nature of the entities’ businesses, to prevent the misuse of material, nonpublic information.
The SEC's complaint against Daifotis and Merk alleges violations and aiding and abetting violations of the anti-fraud provisions of the Securities Act, Exchange Act, and Investment Advisers Act, including Section 10(b) and Rule 10b-5 of the Exchange Act, and other violations, including Sections 13(a) and 34(b) of the Investment Company Act.
Melissa Hodgman, David Mendel and Robert Cohen in the SEC’s Division of Enforcement conducted the investigation. The SEC’s litigation against the executives will be led by David Gottesman and Frederick Block. The SEC acknowledges the assistance of FINRA in this matter.
Press Release from Schwab
Schwab Statement on Resolution Related to the YieldPlus Fund
SAN FRANCISCO-- The Charles Schwab Corporation today announced that two of its subsidiaries have entered into a resolution with the U.S. Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and Illinois regulators related to previously disclosed investigations of the company’s Schwab YieldPlus Fund®. The company released the following statement.
Schwab has worked closely with these parties to bring this matter to a constructive conclusion, and believes that resolving it in this way is in the best interests of the company, its stockholders, and clients who experienced losses in the YieldPlus Fund as a result of the global financial crisis.
Schwab would never seek to profit at the expense of its clients. We regret that fund shareholders lost money in YieldPlus. Indeed, Charles R. Schwab, the company’s founder and chairman, was one of the largest investors in the fund. The decline in the YieldPlus fund was the result of an unprecedented and unforeseeable credit crisis and market collapse. Until the credit crisis, the YieldPlus Fund was consistently one of the top performing funds in its category for eight years and held a Morningstar 5-star rating from December 2004 through September 2007.
Schwab has acted in good faith by working with the SEC and FINRA to address their concerns as well as by resolving most client claims including entering into a substantial settlement of a federal class action lawsuit. We are pleased that the bulk of associated payments will go directly to YieldPlus shareholders, further reducing the impact of the credit crisis on them. Ultimately, our goal is to move forward and maintain our focus on our core purpose of providing individuals with the help they need to meet their investment objectives.
To provide future protection for individual investors from similar market crises, the company hopes that greater focus and attention will ultimately be given to the investment banks that created mortgage-backed securities and the ratings agencies that legitimized them with triple-A ratings, which have so far largely escaped scrutiny and accountability.
Charles Schwab Investment Management, a registered investment advisor, Charles Schwab & Co., Inc., a broker-dealer, and Schwab Investments, a Massachusetts business trust that issued the YieldPlus Fund shares, entered into the settlement without admitting or denying the allegations in the order. The settlement entered into with the SEC is subject to approval by a U.S. District Court.
The company is aware that the SEC has brought complaints today against two individuals associated with the firm, and its understanding is that each of those individuals intends to pursue a vigorous defense fully contesting the allegations.
As part of the settlement agreements, the company has agreed to pay a total of $119 million to the SEC, FINRA and Illinois regulators. The company expects to include an after tax charge of $97 million in its fourth quarter financial results relating to these settlements.
About Charles Schwab
The Charles Schwab Corporation (NYSE: SCHW) is a leading provider of financial services, with more than 300 offices and 8.0 million client brokerage accounts, 1.5 million corporate retirement plan participants, 681,000 banking accounts, and $1.5 trillion in client assets. Through its operating subsidiaries, the company provides a full range of securities brokerage, banking, money management and financial advisory services to individual investors and independent investment advisors. Its broker-dealer subsidiary, Charles Schwab & Co., Inc. (member SIPC, www.sipc.org), and affiliates offer a complete range of investment services and products including an extensive selection of mutual funds; financial planning and investment advice; retirement plan and equity compensation plan services; referrals to independent fee-based investment advisors; and custodial, operational and trading support for independent, fee-based investment advisors through its Advisor Services division. Its banking subsidiary, Charles Schwab Bank (member FDIC and an Equal Housing Lender), provides banking and mortgage services and products. More information is available at www.schwab.com and www.aboutschwab.com.
Stay ahead of the news ... Sign up for our email alerts now
Do You Recommend This Story?