November 13, 2009
Timothy J. Dennin, Esq., a former attorney in the Division of Enforcement with the Securities and Exchange Commission in Washington, D.C., comments on the undisclosed liquidity risks in the Schwab YieldPlus Fund.
Charles Schwab Knew Or Should Have Known About The Liquidity Risks Of Asset-Backed And Mortgage-Backed Securities And Did Not Disclose These Risks To Schwab YieldPlus Fund Investors.
In June and July 2007, the failure and forced liquidation of two Bear, Stearns & Co., Inc. hedge funds, which were invested primarily in mortgage-backed securities bonds backed by pools of sub-prime mortgages, focused attention on the liquidity risks associated with the securities that had assumed an inappropriately large role in the Schwab YieldPlus Fund. As will be discussed below, these were risks that had previously been highlighted by bank and securities regulators during the 1990s.
As of July 31, 2007, the Schwab YieldPlus Fund was the largest ultrashort bond fund in its Morningstar category with the fund's total net assets having grown to approximately $13.4 billion. As of that date, the Schwab YieldPlus Fund's asset allocation consisted of asset-backed obligations (approximately 12%), collateralized mortgage obligations (CMOs) and other mortgage-backed securities (approximately 44%), corporate bonds (roughly 43% of total net assets) and less than 2% collectively in preferred stock, commercial paper and other obligations, U.S. Treasury obligations and short sales, swap agreements and futures contracts.
The Schwab YieldPlus Fund experienced net shareholder redemptions in August 2007 of almost $2.4 Billion. These massive redemptions, combined with the low cash equivalent balances that the fund was maintaining to boost its performance relative to its ultrashort bond fund category peers, forced the Schwab YieldPlus Fund portfolio managers to sell asset-backed obligations, mortgage-backed securities and corporate bonds into an illiquid market at distressed prices to generate cash. The realized and unrealized losses that the Schwab YieldPlus Fund sustained on these August 2007 sales resulted in the fund's net asset value price ("NAV") per share declining from $9.67 to $9.42 per share during the period from July 31 through August 31, 2007.
Schwab YieldPlus Fund shareholders continued to redeem their shares over the next nine months which forced the fund's portfolio managers to sell asset-backed obligations and mortgage-backed securities into an illiquid market at steadily mounting losses and corresponding declines in the NAV price of the fund. By May 31, 2008, the Schwab YieldPlus Fund's NAV had declined in market value to $6.31 per share and its total net assets had plummeted to $689 million, down to 94.9% from the $13.4 Billion in total net assets managed by the fund on July 31, 2007.
The law firm of Timothy J. Dennin, P.C., in its representation of Schwab YieldPlus Fund investors, has alleged that Charles Schwab failed to disclose to investors the liquidity risks associated with asset-backed obligations and mortgage-backed securities. Banks and broker-dealers had not only previously had been alerted to these risks by bank and securities regulators in the 1990s, but the risks were routinely described in the prospectuses for the individual bonds held by the Schwab YieldPlus Fund portfolio.
Bank Regulator Guidance - 1992
The Office of the Comptroller of the Currency (the "OCC") regulates and supervises national banks. On January 10, 1992, the OCC published and distributed to banks revised Banking Circular 228 ("BC-228"), which is an official policy statement of the OCC. Pursuant to its issuance of BC-228, the OCC made it clear that mortgage derivative products are "complex" instruments requiring "a high degree of technical expertise . . . to understand how their prices and cash flows may behave in various interest rate and prepayment environments." The OCC further advised banks that since the secondary market for some of the mortgage derivative products is relatively thin, they may be difficult to liquidate should the need arise. OCC Banking Circular 228 at pp. 58-59, 61 (January 10, 1992).
Self-Regulatory Organization Securities Regulator Guidance - 1993 and 2003
The Financial Industry Regulatory Authority ("FINRA," which was formerly known as the National Association of Securities Dealers, Inc. "NASD") is the broker-dealer self-regulatory organization in which brokerage firms such as Charles Schwab are members. FINRA frequently provides legal and regulatory guidance to its broker-dealer member firms through Notices To Members ("NTMs") that it promulgates and disseminates. In October 1993, the NASD issued NASD NTM 93-73 ("Members Obligations to Customers When Selling Collateralized Mortgage Obligations (CMOs)") which reminded member brokerage firms of their obligations when recommending CMOs to their customers. The NASD in this notice warned brokerage firms about the liquidity risks associated with CMOs as follows:
Condition of the Secondary Market/Liquidity
While there is a sizeable secondary market for CMOs generally, there is less of a market for the more risky and complex tranches. CMOs are less uniform than traditional mortgage-backed securities and more expensive to trade. It is also harder to obtain current pricing information. Matching up buyers and sellers is often difficult, especially for the more esoteric tranches . . . In addition, members, should clearly inform investors of extra costs or commissions associated with CMO transactions.
In November 2003, the NASD issued NASD NTM 03-71 ("Non-Conventional Investments") which grouped asset-backed securities with two other products and described them as "non-conventional investments" or "NCIs." NASD NTM 03-71 indicated that these products had "complex terms and features that are not easily understood" and warned its members that these products also tend to have less market liquidity, less transparency as to their pricing and value and may entail significant credit risks that are difficult to understand and assess."
SEC Enforcement Action - 1998, 2000 and 2003
On July 28, 1998, the SEC brought an administrative proceeding enforcement action against Piper Capital Management ("PCM"), an investment adviser, and Worth Bruntjen ("Bruntjen"), its portfolio manager, alleging that the defendants committed fraud by making false and misleading statements to investors regarding the risks associated with investing in the Piper Jaffray Institutional Government Income Portfolio fixed income mutual fund. In the Matter of Piper Capital Management et al., Admin. Proc. File No. 3-9657 (July 28, 1998). The fund had a stated investment objective of "a high level of current income consistent with the preservation of capital." The SEC alleged that despite the fund's conservative investment objective, the fund was in fact a high risk investment as a result of PCM's and Bruntjen's investment of the fund's assets in interest rate-sensitive collateralized mortgage obligation derivatives.
The Initial Administrative Decision of the SEC Administrative Law Judge in the Piper Capital Management case was published on November 30, 2000. The administrative law judge found liability on the part of Piper Capital Management and various individuals associated with the firm. The administrative law judge's summary of the CMO market from 1991 through early 1994 is revealing:
3. Financial Market Climate and Circumstances
Interest rates affecting the CMO market declined from late 1991 through early 1994. Although the decline was steady throughout the period, it produced little volatility in the market. . . . Early in 1994, however, the Federal Reserve Board initiated a series of interest rate increases. These increases had a negative impact on CMO values. CMO securities, and the funds holding them, suffered significant losses. The losses caused concomitant sell-offs, depressing values even further as CMO securities flooded the market. The situation turned critical when Askin Capital Management, Inc. ("Askin"), a large hedge fund manager, was unable to satisfy broker-dealer margin calls beginning on March 30, 1994. As a consequence, broker-dealers liquidated several hundred million dollars in CMOs from Askin's funds, precipitating extreme price volatility and what generally is regarded as a "crash" in the CMO securities market.
The SEC affirmed the SEC Administrative Law Judge's Piper Capital Management Decision on August 26, 2003. 56 S.E.C. Reports 1033 (Aug. 26, 2003). The Commission also noted the role that CMOs played in the performance of the Piper Jaffray Institutional Government Income Portfolio and commented on CMO market conditions in 1994.
Following the Fund's increased investment in CMOs, its returns significantly increased and it received increased publicity. This in turn attracted a large influx of new investor money. Between January 1992 and September 1993, the Fund's net assets increased by more than $500 million and the Fund broke multiple sales records.
However, as described in Section IV.B. below, in 1994, the CMO market collapsed, and the Fund suffered significant losses. . . . Id. at 1045.
The Wall Street Journal Article - 1994
The turmoil that the CMO market was experiencing in April 1994 was contemporaneously chronicled by The Wall Street Journal. On April 20, 2004, The Wall Street Journal published a story titled "Mortgage Derivatives Claim Victims Big and Small," by Laura Jereski. Ms. Jereski reported that rising interest rates had caused the mortgage-backed securities market to unravel unpredictably across the board with Wall Street dealers becoming "reluctant to make markets in these esoteric securities because they're afraid of additional losses." Jereski reported that the reluctance of dealers to quote prices for many CMOs out of fear that investors will demand to trade at those prices had caused bid-offer spreads on these securities to widen to 10 points, or $100 on a bond with a $1,000 face value.
Asset-Backed Obligation and Mortgage-Backed Securities Prospectuses
The disclosures by issuers of mortgage-backed and asset-backed securities regarding the liquidity risks of these types of securities are fairly standard. Two examples of the typical liquidity disclosures contained in prospectuses of securities owned by the Schwab YieldPlus Fund on July 31, 2007 are as follows:
Countrywide Home Loan, Series 2006-20, Class 1A36 (Mortgage-Backed Security)
Secondary Market For TheSecurities May Not Exist
The related prospectus supplement for each series will specify the classes in which the underwriter intends to make a secondary market, but no underwriter will have any obligation to do so. We can give no assurance that a secondary market for the securities will develop or, if it develops, that it will continue. Consequently, you may not be able to sell your securities readily or at prices that will enable you to realize your desired yield. The market values of the securities are likely to fluctuate. Fluctuations may be significant and could result in significant losses to you.
The secondary markets for mortgage backed securities have experienced periods of illiquidity and can be expected to do so in the future
HFC Home Equity Loan Trust Series 2006-4 (Asset-Backed Obligation)
Limited Liquidity may result in
delays in liquidations or lower
returns. There will be no market for the securities of any series prior to its issuance, and there can be no assurance that a secondary market will develop, or if one does develop, that it will provide holders with liquidity of investment or that any market will continue for the life of the securities. One or more underwriters, as specified in the prospectus supplement, may expect to make a secondary market in the securities, but they have no obligation do so. Absent a secondary market for the securities you may experience a delay if you choose to sell your securities and the price you receive may be less than that which is offered for a comparable liquid security. (Emphasis supplied.) Prospectus at p. 1.
The SEC, on numerous occasions, has stated that prior to making a recommendation to a customer, a broker-dealer and/or registered representative must: (1) have an adequate and reasonable basis for the recommendation based upon a reasonable investigation of that security; and (2) disclose to the customer material facts about the security which are known and are readily ascertainable, including adverse facts of which the broker-dealer or registered representative should be aware. The U.S. Supreme Court has held that under the federal securities laws, an omitted fact is deemed to be material if there is a substantial likelihood that, taking into account all of the circumstances, the omitted fact would have assumed actual significance in the deliberations of a reasonable shareholder. Basic, Inc. v. Levinson, 485 U.S. 224 (1988). State law definitions of what a material fact is can differ slightly from the U.S. Supreme Court's definition. For example, a material fact under New York state law is one of such importance that, but for the nondisclosure or misrepresentation, the complaining party would not have entered into the transaction.
Bank and securities regulators have been warning banks and broker-dealers since at least 1992 about the liquidity risks associated with mortgage-backed and asset-backed securities. The demise of the Schwab YieldPlus Fund is directly related to the portfolio managers' decision to maintain minimal cash equivalent securities available to satisfy shareholder redemptions, the fund's overconcentration of its assets in potentially illiquid asset-backed and mortgage-backed securities, and the fund's distressed sales of these illiquid securities when substantial shareholder redemptions actually occurred. Neither the Schwab YieldPlus Fund prospectuses nor any of Charles Schwab's other communications with public pertaining to the fund made any sort of equivalent disclosures regarding the liquidity risks of asset-backed and mortgage-backed securities or the fund's low levels of cash available to address the possibility of significant shareholder redemptions.
SWYSX/SWYSXLawCommentary110609
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Timothy J. Dennin, P.C. forms alliance with former SEC regulators to investigate Schwab YieldPlus Fund (SWYSX, SWYPX)
October 19, 2009
Timothy J. Dennin, P.C., a former attorney in the Division of Enforcement with the United States Securities and Exchange Commission in Washington, D.C., comments on the most recent regulatory action against Charles Schwab over Yield Plus misconduct.
New York, N.Y. - A Form 8-K dated October 14, 2009 filed by Charles Schwab with the SEC confirms that the SEC Enforcement Staff intends to file a Regulatory Enforcement Proceeding against Schwab Investments, Charles Schwab Investment Management, Charles Schwab & Co., Inc. and the President of the Funds for violations of the U.S. Securities laws. The SEC forwarded a Wells Notice to Schwab stating that the Enforcement Division intends to recommend to the Commission that legal action be instituted relating to the YieldPlus Fund.
A Wells Notice is notification from the SEC that it intends to recommend that Enforcement Proceedings be commenced. The Notice referenced, in broad strokes, the violations that the Staff believes to have occurred.
Schwab, in the Form 8-K filed October 14, 2009, represented that it will file submission in response to the Wells Notice. According to Dennin this is significant since "the Wells Submission is not privileged, is not confidential, and anything that is alleged in the submission can be used against Schwab in an arbitration hearing".
Timothy J. Dennin, P.C. is part of a legal team that has interviewed more than 100 investors as part of its Schwab YieldPlus investigation. The legal team consists of three former SEC Regulators and two private attorneys and has filed arbitration claims on behalf of investors in Florida, California, Texas, New York, Missouri, Minnesota, Illinois, Alabama and Hawaii.
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YieldPlus Release October 15, 2009
Timothy J. Dennin, P.C. files new fraud claims today against Charles Schwab over YieldPlus Fund misconduct
New York, N.Y. -- Charles Schwab & Co. and its former high-profile fund manager engaged in deception and fraudulent conduct when they misrepresented the Schwab YieldPlus Fund as safe haven for investors while loading the fund with high concentrations of risky mortgage- and asset-backed securities that exposed fund investors to steep losses of their principal, according to claims filed today by Timothy J. Dennin, P.C. on behalf of New York investors with approximately $150,000 in losses.
The firm of Timothy J. Dennin, P.C., which is headed by former SEC enforcement attorney Timothy J. Dennin, has teamed up with two other former SEC attorneys as well as investor rights attorneys in California and Florida in representing individual investors who purchased the Schwab YieldPlus Fund (SWYPX, SWYSX, SCHW). The team has filed claims on behalf of Schwab YieldPlus investors with losses totaling almost $3 million since mid July.
Charles Schwab acknowledged yesterday that it has received a Wells Notice from the SEC, advising the company that the SEC's enforcement staff intends to recommend that the Commission institute legal action against Schwab related to the YieldPlus Fund. A Form 8-K dated October 14, 2009 filed by Charles Schwab with the SEC confirms that the SEC Enforcement staff intends to file a Regulatory Enforcement Proceeding against Schwab Investments, Charles Schwab Investment Management, Charles Schwab & Co., Inc. and the President of the Funds for violations of the U.S. Securities laws.
Charles Schwab compared its Schwab YieldPlus Fund to the safety of 1 and 2-year certificates of deposit and described it as "portfolio cash" on its website, but actually the bond mutual fund managers loaded the fund with high concentrations of risky mortgage- and asset-backed securities that exposed fund investors to the danger of substantial losses of their principal, the claims assert.
"The SEC enforcement staff's Wells Notice is not really a surprise. The breadth of misconduct our team has uncovered as part of our investigation is profoundly disturbing," Dennin said.
According to the arbitration claims filed today with the Financial Industry Regulatory Authority on behalf of individual investors:
-- Schwab embarked on a self-dealing "damage control" marketing campaign to discourage shareholder redemptions of Schwab YieldPlus by Charles Schwab retail clients, quietly selling almost 3.0 million Schwab YieldPlus Fund shares from other Schwab proprietary mutual funds during the period January 31, 2008 to April 1, 2008, while indicating in marketing materials, newsletters, talking points, and other investor communications that unwitting Schwab retail clients should hold their shares;
-- In SEC filings and direct communications with shareholders and prospective investors,
Schwab misrepresented the Schwab YieldPlus Fund as an "ultra short-term" bond fund. In reality, the fund was heavily weighted with floating and variable rate bonds with long-term maturities, which gave the fund a weighted average maturity equivalent to an intermediate term bond fund. During the second half of 2007 and in 2008, when the fund was declining in value, these misrepresentations created the false illusion that if investors held on to their positions for the next six months to a year, the bonds held in the fund's portfolio would mature at face or par value and the fund and its shareholders would recover most of their unrealized losses.
-- Schwab's senior management changed the Schwab YieldPlus Fund's investment policy in September 2006 to allow for a higher concentration in riskier mortgage-backed securities and asset-backed securities, without obtaining shareholder approval or clearly disclosing this major shift to investors;
-- Schwab ignored the warnings of securities and banking regulators about the risky nature of mortgage-backed securities and collateralized mortgage obligations, including warnings to refrain from deceptive advertising of such securities including comparisons to certificates of deposits;
-- Schwab's management failed to adequately disclose that investors had withdrawn $2.8 billion from the YieldPlus Fund in August 2007. Full and explicit disclosure didn't come until November 30, 2007 -- by which time the Fund's net assets had dropped to $8 billion, down from $13.5 billion as of July 31, 2007;
-- Unlike its peers in the Morningstar ultra short bond fund category, the Schwab YieldPlus Fund failed to maintain adequate cash on hand to meet investor redemptions. Schwab YieldPlus Fund had only 6.5 percent of its portfolio in cash, while its peers in the ultra short-term bond fund category averaged 27 percent of their positions in cash. As more and more investors sought to sell their shares, Schwab had to sell illiquid securities held in the portfolio at distressed prices;
The Schwab YieldPlus Fund saw a catastrophic freefall, as net assets plunged from a high of $13.5 billion in July 2007 to just $679 million on May 31, 2008. Schwab reports that as of May 31, 2009, the YieldPlus Fund's assets were at $161.72 million.
The legal team has interviewed more than 100 investors as part of its Schwab YieldPlus investigation and filed arbitration claims on behalf of investors in Florida, California, Texas, New York, Missouri, Minnesota, Illinois, Alabama and Hawaii.
For information, contact:
- Thomas F. Shine, a former Securities and Exchange Commission Division of
Enforcement attorney (Florida, 800-838-8320, www.thomasfshinelaw.com);
- Christopher T. Vernon, an investor rights attorney who represents investors throughout the United States (Florida, 239-649-5390, www.vernonhealy.com)
- Thomas D. Mauriello, an investor rights attorney who represents investors throughout the United States (California, 888-612-1961, www.maurlaw.com)
- Timothy J. Dennin, a former Securities and Exchange Commission Division of Enforcement attorney and former assistant district attorney (New York, 212-826-1500, www.denninlaw.com);
Keywords: Charles Schwab, Schwab YieldPlus Fund, SEC, Yield Plus, SWYSX, SWYPX, SWYCX, negligence, securities attorney, arbitration, mortgage-backed securities, bond fund.
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By Hubie February 12, 2009 7:53 PM | Permalink
New York, NY - Timothy J. Dennin, P.C.has formed a coast-to-coast alliance with other former Securities and Exchange Commission regulators, former prosecutors and investor advocates to investigate misconduct and seek recovery of losses for purchasers of the Schwab YieldPlus Fund.
Securities fraud litigators in the alliance have now filed claims concerning the Schwab Yield Plus Fund on behalf of both corporate and individual investor clients in California, New York, Texas, Florida, Missouri, Minnesota, Illinois and Hawaii, and are currently investigating claims on behalf of investors in multiple other states.
Charles Schwab & Co. marketed its Schwab YieldPlus Fund as a safe "cash alternative" to retirees and others around the country, but that safety was a charade: The Schwab YieldPlus Fund has lost more than 40 percent of its value in the past 18 months because of the reckless concentration of mortgage and asset-backed securities in the fund by former high-profile fund manager Kimon Daifotis.
According to claims filed on behalf of investors, Charles Schwab issued inaccurate statements or omitted information regarding material facts about the fund's lack of diversification and deceived Schwab YieldPlus Fund investors by concentrating the fund in mortgage and asset-backed securities while it touted the fund's safety on its web site and to financial advisors who recommended the fund. Charles Schwab compared the safety of its Schwab YieldPlus Fund to that of one and two-year certificates of deposit.
The alliance includes:
- Christopher Bebel, a former Securities and Exchange Commission Division of Enforcement attorney, former regulator with the Financial Industry Regulatory Association (aka NASD) and former federal prosecutor, (Texas, 281-348-2572, www.chrisbebel.com);
- Timothy Dennin, a former Securities and Exchange Commission Division of Enforcement attorney and former assistant district attorney, (New York, 212-826-1500, www.denninlaw.com);
- Thomas Mauriello, an investor rights attorney who represents investors throughout the United States, (California, 888-612-1961, www.maurlaw.com);
- Howard Prossnitz, an investor rights attorney who represents investors throughout the United States (Illinois, 312-960-1800, www.prossnitzlaw.com);
- Thomas Shine, a former Securities and Exchange Commission Division of Enforcement attorney (Florida, 321-724-4445, www.thomasfshinelaw.com);
- Christopher Vernon, an investor rights attorney who represents investors throughout the United States (Florida, 239-649-5390, www.vernonhealy.com)
