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Schwab forking over $118 million to SEC

Fund giant Charles Schwab agreed to pay $118 million to settle a case accusing it of peddling risky bond funds as money market substitutes.

The Securities and Exchange Commission charged San Francisco-based Schwab (SCH) with making misleading statements, failing to prevent the misuse of nonpublic information and deviating from fund policies without shareholder approval.



And vice versa, it turns out.

Schwab neither admitted nor denied the allegations, which center around the SchwabYieldPlus fund, a short-term bond fund the firm marketed as an alternative to money market funds. The firm sold the fund as a cash alternative even as it held more than half its assets in private label mortgage-backed securities whose value collapsed in the credit meltdown of 2007-2008.

The SEC complaint describes how Schwab rode the fund during the bubble, by describing it as safe when in fact it was reaching for yield with the best of them.

From at least 2006 to 2008, [Schwab] described the Fund as a cash “alternative” that generated a higher yield with slightly higher risk than a money market fund. Some communications emphasized that the Fund’s NAV “may fluctuate minimally.” Others stated that the NAV “would fluctuate” but noted that it had fluctuated by only pennies in recent years.

Of course, the fund accomplished that low-risk, high-yield mix by pouring investor funds into securities that were highly rated but it turned out to be something other than sound.

In August 2006, [Schwab investment management] requested that the Schwab Investments board of trustees change the concentration policy to reclassify non-agency MBS such that it would not be an industry to allow more than 25% of Fund assets to be invested in non-agency MBS. Without the shareholder approval required by statute, the board of trustees voted on August 29, 2006, to approve the change. The YieldPlus Fund’s investment in non-agency MBS increased after the purported change to 50% of assets in the Fund’s portfolio, with nearly all of the MBS being rated AAA. By at least October 2006, the Total Bond Fund also invested more than 25% of its assets in non-agency MBS.

But when financing dried up in the summer of 2007, the run on risky assets meant these assets plunged in value, taking the fund down with them.

During an eight-month period, the Fund’s NAV dropped 28% and its assets under management fell from $13.5 billion to $1.8 billion due to redemptions and declining asset values.

Of course, no one ends up looking good in these scandals, least of all the regulators.

In 2004, the NASD raised concerns … about advertisements that compared the YieldPlus Fund to money market funds without adequate disclosure of the differences between the products. In response to the NASD’s concerns, [Schwab] added the word “slightly” to the advertisements.

Schwab, for its part, emphasizes that it didn’t just bungle the management of the funds. Why, its top executives managed to lose money in them!

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.

A lot of good it did investors.