As Underwriter of the Schwab YieldPlus Fund, Charles Schwab Had a Due Diligence Duty to Ensure the Accuracy and Completeness of the Representations Made in the Prospectus

On Sept. 30, 1999, Charles Schwab acted as the sole underwriter in the initial public offering of the Schwab YieldPlus Fund.

Schwab Investments, Inc., the issuer of the Schwab YieldPlus Fund and an affiliate of Charles Schwab, revises and disseminates an updated prospectus for the Schwab YieldPlus Fund at least annually.

At all relevant times, Charles Schwab, as the underwriter of the Schwab YieldPlus Fund, had an ongoing due diligence duty to make a reasonable investigation to assure itself that the representations made in the fund’s registration statement and prospectus were accurate and complete. See, e.g., In re Brown, Barton & Engel, 43 S.E.C. 43 (1966); In re Amos Treat & Co., Inc., 42 S.E.C. 99 (1964). The Securities and Exchange Commission has set forth the following guidance regarding the due diligence duties of underwriters:

“It is a well established practice, and a standard of the business, for underwriters to exercise diligence and care in examining into an issuer’s business and the accuracy and adequacy of the information contained in the registration statement. By associating himself with a proposed offering, an underwriter impliedly represents that he has made such an investigation in accordance with professional standards. Investors properly rely on this added protection which has a direct bearing on their appraisal of the reliability of the representations in the prospectus.  The underwriter who does not make a reasonable investigation is derelict in his responsibilities to deal fairly with the public.” In re Richmond Corporation, 41 S.E.C. 398, 406 (1963).

“[An underwriter] owe[s] a duty to the investing public to exercise a degree of care reasonable under the circumstances of th[e] offering to assure the substantial accuracy of representations made in the prospectus and other sales literature.” In re Charles E. Bailey & Company, 35 S.E.C. 33, 41 (1953).

The Seventh Circuit Court of Appeals in Sanders v. John Nuveen & Co., 524 F.2d 1064, 1069-70 (7th Cir. 1975), vacated and remanded on other grounds, 425 U.S. 929, 96 S.Ct. 1659, 48 L. Ed. 2nd 172 (1976), further elaborated upon the rationale for imposing upon underwriters the due diligence duty to investigate the accuracy and completeness of the issuer’s representations as follows:

“An underwriter’s relations with the issuer gives the underwriter access to facts that are not equally available to members of the public who must rely on published information. And the relationship between the underwriter and its customers implicitly involves a favorable recommendation of the issued security. 

Because the public relies on the integrity, independence and expertise of theunderwriter, the underwriter’s participation significantly enhances the marketability of the security. And since the underwriter is unquestionably aware of the nature of the public’s reliance on his participation in the sale of the issue, the mere fact that he has underwritten it is an implied representation that he has met the standards of his profession in his investigation of the issuer. (Emphasis supplied.)”

On Aug. 17, 2009, the State of New York Attorney General brought an enforcement action against Charles Schwab in connection with the firm’s sales of auction-rate securities to its customers. People of the State of New York by Andrew M. Cuomo, Attorney General of the State of New York against Charles Schwab & Co., Inc. (Aug. 17, 2009). The markets for auction-rate securities began to fail in August 2007 and experienced widespread failures in mid-February 2008.

These failures have prevented Charles Schwab customers who purchased these securities from selling them and accessing money that they invested based upon representations that the securities were highly liquid.

The New York Attorney General’s complaint alleges that Charles Schwab engaged in misleading sales practices by describing auction-rate securities to prospective investors as safe, liquid, short-term investments that were suitable for investors to use for their cash management purposes. Complaint at paragraph 30.

The State of New York also alleged that Charles Schwab misrepresented or failed to disclose to investors the liquidity risks associated with auction-rate securities. Id. Charles Schwab has vigorously denied any wrongdoing in this case.

Although the Schwab YieldPlus Fund did not hold any auction rate securities in its portfolio, Charles Schwab’s responses to the allegations made by the State of New York are highly relevant to the factual and legal issues being contested in the Schwab YieldPlus Fund cases.

Charles Schwab has posted on its website a letter dated July 24, 2009, to the New York Attorney General’s Office from attorney Faith Gay of the law firm Quinn Emanuel, the New York law firm representing Charles Schwab in this matter. The letter sets forth Charles Schwab’s arguments regarding why the State of New York’s expected enforcement action would be both unjust and unwarranted.

Charles Schwab’s primary defense as set forth in its law firm’s July 24, 2009 letter is the fact that because it was not an underwriter of the auction-rate securities that it sold to its customers, it did not have access to the information about the serious difficulties that the auction-rate securities markets began to experience in August 2007. Charles Schwab asserts that it was, in fact, deceived by the underwriters of the ARS, as stated below in Faith Gay’s letter dated July 24, 2009 to the New York Attorney General’s Office:

Schwab And Its Customers Were  Deceived By The Underwriters/Lead  Managers

Conspicuously missing from the Attorney General’s purported 5-day notice letter is the major role that the lead underwriters played in deceiving Schwab, withholding critical information regarding ARS from Schwab, and providing misleading information knowing that Schwab would rely on that information and pass it on to customers.  As underwriters and “lead managers” of the auctions for the ARS they underwrote and brokered, these firms had information regarding the auction market, and their own manipulation of the market, that was not known to or knowable by Schwab or Schwab’s clients. . . .

With no role in the underwriting of ARS, Schwab relied on the lead underwriters for access to ARS and relied on information regarding ARS and the auction markets provided by these firms. . . .  Faith Gay/Quinn Emanuel Letter dated July 24, 2009 at p. 4.

The Shine-Vernon legal team in its representation of Schwab YieldPlus Fund investors has alleged that Charles Schwab did not live up to this standard when it acted as the sole underwriter of the Schwab YieldPlus Fund. The Shine-Vernon Team is alleging on behalf of its clients that Charles Schwab knew or was reckless or negligent in not knowing the liquidity risks associated with asset-backed and mortgage-backed securities held by the Schwab YieldPlus Fund.  [See Law Commentary dated November 18, 2009 for a detailed discussion pertaining to these risks.]

The Shine-Vernon Team has alleged that Charles Schwab and its affiliates failed to disclose these risks to prospective investors in the fund. The Shine-Vernon Team, which represents a number of Schwab YieldPlus Fund investors nationwide, is also alleging that Charles Schwab made a number of other misrepresentations and omissions of material fact in connection with its underwriting and marketing of the Schwab YieldPlus Fund to its customers.

These alleged misrepresentations and omissions included:

  • The fact that the Schwab YieldPlus Fund was not an ultra-short-term bond fund as stated in the fund’s prospectuses [See Law Commentary dated Nov. 17, 2009.];
  • The implementation of investment strategies of maintaining minimal proportional cash equivalent balances while contemporaneously and significantly increasing the fund’s concentration in higher-yielding and illiquid asset-backed and mortgage-backed securities. These strategies were inconsistent with the Schwab YieldPlus Fund’s stated investment objectives and level of risk which called for high current income with minimal changes in share price;
  • The overall level of safety of the Schwab YieldPlus Fund, in that, it was described and marketed to investors as an alternative to cash, and analogized to 1-year and 2-year certificates of deposit;
  • The true features of the fund, in that, Charles Schwab falsely classified it as “Portfolio Cash,” the same category assigned to 1-year and 2-year certificates of deposit; and
  • The fund’s lack of liquidity in July and August 2007 and at various times thereafter available to meet substantial redemptions in the fund.

The Charles Schwab response to the proposed (and later instituted) New York Attorney General’s auction rate securities enforcement action acknowledges and highlights the crucial due diligence investigation duties that Charles Schwab, acting as the sole underwriter of the Schwab YieldPlus Fund, owed to prospective investors prior to marketing this fund to the public.

For more information, please contact attorney Chris Vernon of Vernon Litigation Group by email at or by phone at  (239) 319-4434.

Related Posts
  • Estate Planning & Digital Assets: How to Securely Manage Your Online Presence Read More
  • Are Equity-Indexed Annuities a Good Investment? Read More
  • How To Avoid A Ponzi Scheme Read More