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 forced liquidation of two Bear, Stearns & Co., Inc. hedge funds invested primarily in mortgage-backed securities bonds backed by pools of sub-prime mortgages, focused attention on the liquidity risks of securities that had assumed an inappropriately large role in the Schwab YieldPlus Fund. 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 have grown to approximately $13.4 billion.

As of that date, the Schwab YieldPlus Fund’s asset allocation consisted of asset-backed obligations (approximately 12 percent), collateralized mortgage obligations (CMOs) and other mortgage-backed securities (approximately 44 percent), and corporate bonds (roughly 43 percent of total net assets). The fund contained less than 2 percent 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 (almost 18% of total net assets). These redemptions, combined with the low cash equivalent balances that the fund was maintaining to boost its performance relative to its ultrashort bond fund category peer, 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 in order 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 Aug. 31, 2007.

Schwab YieldPlus Fund shareholders continued to redeem their shares over the next nine months. This forced the fund’s portfolio managers to continue 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 94.9 percent from the $13.4 billion in total net assets managed by the fund on July 31, 2007.

The Shine-Vernon legal team, 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 not only had been previously alerted to these risks by bank and securities regulators in the 1990s, but the risks were also 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 Jan. 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 was relatively thin, they might be difficult to liquidate should the need arise. OCC Banking Circular 228 at pp. 58-59, 61 (Jan. 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. or NASD) is the broker-dealer self-regulatory organization of 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 Nov. 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.” It warned its members that “[t]hese 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. The SEC alleged 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 Nov. 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 Aug. 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 because Wall Street dealers were becoming “reluctant to make markets in these esoteric securities because they’re afraid of additional losses.”

Jereski also reported that the reluctance of dealers to quote prices for many CMOs — out of fear that investors would 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 mortgage-backed and asset-backed securities owned by the Schwab YieldPlus Fund on July 31, 2007, are as follows:

Countrywide Home Loan, Series 2006-20, Class 1A36 Prospectus (Mortgage-Backed Security)

Secondary Market For The
Securities 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. Illiquidity can have a severely adverse effect on the prices of securities that are especially sensitive to prepayment credit or interest rate risk, or that have been structured to meet the investment requirements of limited categories of investors. (Emphasis supplied.) Prospectus at p. 10.

HFC Home Equity Loan Trust Series 2006-4 Prospectus (Asset-Backed Obligation)

Limited Liquidity may result in
delays in liquidations or lower

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 Florida 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 the public pertaining to the fund made any sort of equivalent disclosures regarding the liquidity risks of asset-backed and mortgage-backed securities. Neither did Schwab disclose the fund’s low levels of cash available to address the possibility of significant shareholder redemptions.

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

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