Charles Schwab settles SEC allegations that it misled investors about risks of bond fund

Three years after a supposedly safe bond fund plunged in value, Charles Schwab Corp. agreed to pay $119 million to settle government allegations that it misled investors about the risks of the portfolio’s mortgage-related holdings.

The Securities and Exchange Commission’s suit against Schwab, which was filed as well as settled Tuesday, depicts a microcosm of the mortgage meltdown and financial crisis, with plenty of blame to go around.

Regulators had expressed concern as early as 2004 that Schwab’s disclosures about its YieldPlus bond fund were insufficient, but the resulting changes weren’t enough to warn investors in time.

The San Francisco brokerage aggressively marketed the fund to individual investors as a conservative but higher-yielding alternative to money market funds.


The SEC’s suit, filed in federal court in San Francisco, alleges that Schwab played down the fund’s risks in ads and sales materials, and violated federal law by placing too much cash in a single sector. It also misled investors about the magnitude of investor redemptions after the losses struck, the complaint says.

The fund lost hundreds of millions of dollars in early 2008 — one of the largest losses borne by individual investors in the crisis — when the value of the many mortgage bonds in its portfolio collapsed.

“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,” Robert Khuzami, SEC enforcement chief, said in a statement.

As interest rates fell in the period leading up to the financial crisis, investors — especially older people living on fixed incomes — scrambled for alternatives to low-yielding money market funds and bank certificates of deposit. Brokerage firms pitched several varieties of short-term funds as appropriate substitutes.


YieldPlus was a so-called ultra-short bond fund that had notched strong returns in the years leading up to the financial crisis. Fund tracker Morningstar Inc. gave the fund its highest performance rating in late 2004.

But YieldPlus’ heavy reliance on mortgage-related securities left it with far larger losses than other ultra-short bond funds. It lost 35.4% in 2008 and 10.5% in 2009, Morningstar said. Investors stampeded out, and the fund shriveled to less than $150million in assets today from $13.5 billion at its peak.

If the settlement is approved by a judge, as much as $110 million would be returned to aggrieved investors.

Schwab agreed last year to pay $225 million to settle a federal class action representing YieldPlus investors. That settlement has received preliminary court approval. That suit estimates 250,000 investors lost about $800 million in the fund, according to lawyers for the plaintiffs in the class action.


Schwab, which agreed to settle the SEC suit without admitting or denying liability, issued a statement Tuesday saying it regretted the customer losses and that company founder Charles Schwab was one of the fund’s largest investors.

The brokerage attributed the losses to “an unprecedented and unforeseeable credit crisis and market collapse.” It also criticized the investment banks that created the mortgage bonds and the Wall Street rating firms that opined favorably on the securities.

“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,” Schwab said.

Schwab’s statement rang hollow to Tissa Hami, a San Francisco stand-up comic who waged a two-year legal battle to recoup $13,000 in YieldPlus losses.


After repeated phone solicitations, a Schwab financial advisor persuaded Hami to move $50,000 out of a money market fund in late 2007, Hami said in an interview Tuesday. Hami said she told the advisor she was an extremely cautious investor — “I have to tell 200,000 jokes to make $50,000" — and that the advisor stressed that the fund was safe, she said. Her investment shrank to less than $37,000 by the following March.

When she complained to Schwab, the brokerage said it had been her decision to invest in the fund, Hami said.

“I said ‘You people called me. You pursued me,’” she said.

Hami said she was disappointed that Schwab did not admit wrongdoing in its SEC settlement.


“Take some responsibility. Show me that this isn’t who you are as a company. Show me that you won’t do this to other people.”

Hami eventually won an arbitration case against the company, receiving $9,356 plus interest, according to arbitration records.

The SEC’s lawsuit says Schwab consistently overstated the fund’s safety.

A brokerage industry regulator expressed concern about risk disclosures in 2004. The SEC raised similar issues two years later. Schwab responded by adding warnings to the fund’s prospectus but didn’t include them in ads and other marketing materials until after the fund began to weaken in 2007, the SEC’s suit says.


John Coffee, a securities law professor at Columbia University, said the SEC should have acted more strongly.

“They didn’t move forcefully to change the overall marketing of this overly risky security,” Coffee said.

An SEC spokesman declined to comment.

The SEC on Tuesday also sued Schwab executive Randall Merk and Kimon Daifotis, the YieldPlus fund’s former portfolio manager, alleging they misled investors about the risks of the fund. Those suits are pending.


Lawyers for the executives denied the allegations.

“The SEC’s claims are infected by hindsight bias and are not supported by the actual evidence,” Merk’s attorney said in a statement.

Daifotis’ attorney said his client “did nothing wrong,” had “invested a significant amount of his own money” in the fund and “has never sold a single share.”