Schwab Hit with $119M in Fines

A Securities and Exchange Commission (SEC) news release said Charles Schwab Investment Management (CSIM) and Charles Schwab & Co., Inc. (CS&Co.) made misleading statements about the fund and did not establish policies to prevent the misuse of material non-public information. Schwab also deviated from the fund’s concentration policy without first getting the required shareholder approval, the SEC alleged.

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 said

The agency also filed a federal court complaint against CSIM’s former chief investment officer for fixed income, Kimon Daifotis, as well as Schwab official Randall Merk, 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 said it is continuing to pursue its case against the two executives despite having reached a settlement with the company.

“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,” said Robert Khuzami, Director of the SEC’s Division of Enforcement, in the news release.

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Claims of Low Risk  

According to the SEC, Schwab and the executives 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 SEC found that the YieldPlus Fund deviated from its concentration policy when it invested more than 25% of fund assets in private-issuer mortgage-backed securities (MBS). Schwab's bond funds, including the YieldPlus Fund and the Total Bond Market Fund, had a policy of not concentrating more than 25% of assets in any one industry, including private-issuer MBS. The funds violated this policy, and the Investment Company Act, by investing approximately 50% of the assets of the YieldPlus Fund and more than 25% of the Total Bond Fund's assets in private-issuer MBS without obtaining shareholder approval.

Furthermore, according to the SEC, the YieldPlus Fund's NAV began to decline, and many investors redeemed their holdings as the credit crisis unfolded in mid-2007. 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, the SEC said Daifotis made false and misleading statements that the fund was experiencing "very, very, very slight" and "minimal" investor redemptions. 

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, regulators alleged.

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FINRA Allegations  

In a related case, the Financial Industry Regulatory Authority (FINRA) also announced Tuesday that it has ordered Charles Schwab & Company, Inc., to pay $18 million to repay investors in YieldPlus. The $18 million consists of the $17.5 million in fees that Schwab collected for sales of the fund, plus a fine of $500,000, both of which will have been designated as restitution to customers.

FINRA's investigation found that despite changes in YieldPlus' portfolio that caused the fund to be disproportionately affected by the turmoil in the mortgage-backed securities market, Schwab failed to change its marketing of the fund. In written materials and in conversations with customers, some Schwab representatives omitted or provided incomplete or inaccurate material information relating to the fund's characteristics, risk and diversification, and continued to represent YieldPlus as a relatively low-risk alternative to money market funds and other cash alternative investments that had minimal fluctuations in net asset value (NAV).

More information about the SEC charges is at http://sec.gov/news/press/2011/2011-7.htm, while additional details of the FINRA allegations is at
http://www.finra.org/Newsroom/NewsReleases/2011/P122755.

Schwab announced late last year it was pulling out of a settlement of a number of lawsuits arising from the YieldPlus sales (see Schwab Withdraws Approval for YieldPlus Suit Settlements).