Protecting Investors - Leveraged ETFs, Inverse ETFs, Lehman Brothers Principal Protected Notes, Structured Products, REITs, Bonds

Investor losses in leveraged ETFs and inverse ETFs or Exchange-Traded Funds prompt investigation by Vernon Healy and McCabe Rabin law firms

Following recent warnings from the SEC and the Financial Industry Regulatory Authority (FINRA) regarding the dangers of leveraged and inverse exchange-traded funds (ETFs), the law firms of Vernon Healy and McCabe Rabin, P.A., announced that they are investigating investor losses in these complex and dangerous financial products.

 

ETFs are investment vehicles that track an underlying benchmark or index, much like a traditional mutual fund. Unlike mutual funds, non-traditional ETFs typically trade throughout the day on securities exchanges like stocks. Over the last several years, ETFs have become more common, but also more complex. Rather than merely track underlying indices or benchmarks, some non-traditional ETFs have been devised to multiply or return the opposite of a given benchmark.

 

Thus, leveraged ETFs use futures or derivatives to multiply the daily return of a given index, such as the S&P 500, and sometimes strive to double or even triple the daily return. Leveraged ETFs are frequently marketed with the term “Ultra” or “2X” in their ETF trade name. Likewise, inverse ETFs seek to return the opposite of a given index, or double or triple the opposite of an index. Inverse ETFs are often marketed as a way to hedge an investment strategy and they frequently carry the term “Short” or “Ultra Short” in their ETF trade names.

 

The SEC and FINRA recently warned that leveraged ETFs and inverse ETFs are extremely complex products that carry a great deal of risk. These products are typically designed to meet their stated objectives on a daily basis.

 

They are not designed to be held for long periods of time, and FINRA has warned that inverse ETFs and leveraged ETFs may not be suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.

 

Leveraged and inverse ETF’s suffered dramatic losses following the market volatility of 2008 and 2009.  Commonly sold ETFs during this time included the following:

 

ProShares Ultra Short Real Estate Fund (SRS)

ProShares UltraShort Dow 30 ETF (DXD)

ProShares UltraShort Financials ETF (SKF)

ProShares UltraShort FTSE/Xinhua China 25 ETF (FXP)

ProShares UltraShort Gold ETF (GLL)

ProShares UltraShort DJ-AIG Crude Oil ETF (SCO)

ProShares UltraShort Oil & Gas ETF (DUG)

ProShares UltraShort MSCI Emerging Markets ETF (EEV)

ProShares Ultra Financials ETF (UYG)

 

ETF trading losses have spawned numerous class action suits involving individual ETFs.  In addition to class action suits, investors who suffered losses in leveraged or inverse ETFs may have individual arbitration claims against the brokers and financial advisors who sold the investments.  Such claims are typically brought before FINRA and are based upon misconduct committed at the time of sale.

 

Misconduct might include misrepresenting the risks involved with these ETFs, failing to fully explain the risks and how ETFs work, and recommending ETFs to clients for whom the investment was not suitable. 

 

If you would like to speak to an attorney for a free consultation regarding a potential claim for losses, please call Chris Vernon at (239) 649-5390 or e-mail info@vernonhealy.com.

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 the underwriter, 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 Healy by email at cvernon@vernonhealy.com or by phone at  (239) 649-5390.

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 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 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
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 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 Healy by email at cvernon@vernonhealy.com or by phone at  (239) 649-5390. 

Schwab YieldPlus Fund Was NOT An Ultra Short-Term Bond Fund

When reporting bond maturity dates to the public and Securities and Exchange Commission for investments held in the Schwab YieldPlus Fund, the fund managers chose a different method than their peers.

Although Schwab disclosed this peculiar manner for reporting maturity dates for certain types of  bonds in the Schwab YieldPlus Fund’s portfolio, Schwab’s diversion from the normal manner in which bond funds report maturity dates understated maturity dates for some of the individual investments held in the Schwab YieldPlus Fund’s portfolio by many years in some cases.

Take for example the Schwab YieldPlus Fund’s substantial portfolio holding of an asset-backed obligation called the SLM Student Loan Trust Series 2005-5, Class A2: Schwab reported on its May 31, 2007 Form NQ filing with the SEC that this investment had a “maturity date” of Oct. 25, 2007.  However, this contradicts SEC filings by the SLM Student Loan Trusts and understates the actual legal stated maturity date for this investment by 14 years. 

SLM Student Loan Trusts prospectus supplements filed with the SEC disclose that the actual maturity date of the SLM Student Loan Trust Series 2005-5, Class A2 is Oct. 25, 2021.    

Schwab Investments’ practice has been to report the next interest rate reset date rather than the actual legal stated final maturity date of the security for floating and variable rate obligations. Schwab Investments discloses this practice on the first page of the descriptions of the individual securities held in each of its bond fund portfolios.

This practice lured investors into purchasing a much riskier bond mutual fund than advertised. Calculations by the Shine Vernon legal team show that Schwab’s YieldPlus Fund was not an “ultra short-term” bond fund.   
 
Understanding Bond Maturities

Bond investors generally understand that a AAA rated corporate or municipal bond that will mature in six months is a much safer investment than a AAA rated bond that will mature in five years, both in terms of default risk and in terms of interest rate risk/price sensitivity.  With respect to default risk, this understanding is based upon the much lower probability that the issuer of a six month bond might default on its obligation to pay investors the par value of the bond prior to the maturity date.

As the term to maturity of bonds lengthen, investors typically demand higher rates of return as compensation for the increased probability or risk that the issuer of the bonds might encounter financial difficulties prior to the bond’s maturity date and be unable to pay back the principal owed to bondholders.

With respect to interest rate risk, shorter term bonds have lower interest rate risk than longer term bonds because short-term bondholders receive their bond principal back earlier than long-term bondholders.  Short-term bondholders can then reinvest the par value of their recently matured bonds into new or outstanding bonds that pay the higher prevailing market interest rates.

The Schwab YieldPlus Fund in its initial public offering (IPO) prospectus dated July 21, 1999 represented that the fund would be investing in investment grade (high and certain medium quality) bonds.  Investment grade bonds have Standard & Poor’s ratings that include AAA (highest quality/safest), AA, A and BBB.  The Schwab YieldPlus Fund IPO prospectus’ emphasis on safety is reflected in the following excerpt:

. . .  To help maintain a very high degree of share price stability and preserve investors’ capital, the fund seeks to keep the average effective maturity of its overall portfolio at one year or less. . . .  (Emphasis and underlining supplied.)  Schwab YieldPlus Fund Prospectus Dated July 21, 1999 at p. 4.
 

Schwab Investments, the issuer of the Schwab YieldPlus Fund, revises and disseminates an updated prospectus for the Schwab YieldPlus Fund at least annually.  The Schwab YieldPlus Fund prospectus dated Nov. 15, 2000 subtly changed the above quoted language as follows:

. . .  To help maintain a very high degree of share price stability and preserve investors’ capital, the fund seeks to keep the average effective duration of its overall portfolio at one year or less. . . .  (Emphasis supplied.)  Schwab YieldPlus Fund Prospectus Dated Nov. 15, 2000 at p. 4.
 

Duration is another measure of interest rate risk, that is, how sensitive a bond’s market value is to a  1 percent change in market interest rates.  For example, if a bond has a duration of 2.5, and interest rates change by 1 percent, this bond could be expected to decrease in value by 2.5 percent in the case of an interest rate increase or increase in value by the same amount in the event of an interest rate decrease.

As will be discussed below, a floating or variable rate bond which periodically adjusts its coupon interest payment to reflect current prevailing market interest rates can simultaneously have a low duration (low interest rate volatility) and a long-term maturity.

Calling Schwab YieldPlus an “Ultra Short-term Bond Fund”

Beginning in November 2004, Schwab YieldPlus prospectuses represented that the fund was both an “ultra short-term bond fund” and a fund that had “an average duration of one year or less.”  Simple calculations based upon Schwab Investments’ descriptions contained in its quarterly, semiannual and annual reports of the individual bonds held by the Schwab YieldPlus Fund indicate that the fund was not really an ultra short-term bond fund, as represented by Schwab Investments and Charles Schwab, but an intermediate to long-term bond fund.

For example, the Schwab Investments Annual Report for the period ending August 31, 2007 reported to the SEC and the public that the weighted average maturity of the bond fund’s portfolio was six months as of that date.  The Shine-Vernon legal team’s experts have analyzed the Schwab YieldPlus Fund portfolio holdings listed in the public SEC Annual Report filed by Schwab Investments and estimate that the fund’s weighted average maturity was more than six years as of the same date.

This “ultra short-term bond fund” misrepresentation regarding the weighted average maturity of the fund’s bond portfolio combined with additional specific misrepresentations  pertaining to the actual weighted average maturity of the fund at various points in time (See weighted average maturity calculations for Feb. 28, 2007 and Aug. 31, 2007 below.) accomplished the following for Schwab’s benefit.  The misrepresentations:
■ lured investors into purchasing a product that was much riskier than advertised and;
■ encouraged existing Schwab YieldPlus Fund shareholders in 2007 and 2008 to hold their shares based upon their understanding that the net asset value price per share of the fund would imminently recover when the highly rated bonds in the portfolio (AA or high credit quality) matured at par value within the next six months.

Schwab Investments’ Reporting Method Obfuscates Investors’ Accurate Evaluations

Schwab Investments’ manner of reporting the maturity dates of the floating and variable rate securities in the Schwab YieldPlus Fund portfolio prevented investors from making an accurate evaluation of the weighted average maturity of the fund’s portfolio .

Schwab Investments began filing semiannual and annual reports for the Schwab YieldPlus Fund in 2000.  From the filing of its initial semiannual report for the period ending Feb. 29, 2000 through the present, Schwab Investments’ practice has been to report the next interest rate reset date rather than the actual legal stated final maturity date of the security for floating and variable rate obligations.  Schwab Investments discloses this practice on the first page of the descriptions of the individual securities held in each of its bond fund portfolios.

However, this manner of reporting gives the term to maturity of the individual security positions and the weighted average term to maturity of the portfolio as a whole the appearance of being much shorter than they actually are.  Schwab Investments’ practice of not reporting stated final maturity dates for floating and variable rate securities also makes it impossible to calculate a true weighted average maturity for the portfolio .  Schwab Investments’ practice was contrary to the manner in which other ultrashort bond funds reported the maturity dates of the floating and variable rate bonds in their portfolios (i.e., actual maturity dates were reported rather than interest rate reset dates).

The following example illustrates the disparity between the actual maturity dates of the variable rate securities owned by the Schwab YieldPlus Fund and the manner in which Schwab Investments reported the maturity dates to the public.  Schwab Investments reported in a Form NQ that, as of May 31, 2007, the Schwab YieldPlus Fund held a substantial position in the following asset-backed obligation issued by the SLM Student Loan Trust:

Schwab YieldPlus Fund
Portfolio Holdings (Unaudited) continued

Security   Face Amount   Value   
  Rate, Maturity Date    ($ x 1,000)    ($ x 1,000)

SLM Student Loan Trust
Series 2005-5 Class A2
   5.35%, 07/25/07 (a)(b)(d)   157,250 156,677 

Although the interest rate reset date of July 25, 2007 (65  days or less than 3  months) is  listed as the maturity date for this  bond in the Schwab Investments Form NQ, the SLM Student Loan Trust prospectus supplement filed with the SEC discloses that the actual maturity date of the SLM Student Loan Trust Series 2005-5, Class A2 asset-backed obligation is October 25, 2021.

(See SEC filing)

This maturity date is  fourteen years  more than the interest rate reset date listed as the maturity date by Schwab Investments in the Form NQ.

The Shine-Vernon legal team’s expert witnesses have calculated the weighted average term to maturity of the Schwab YieldPlus Fund portfolio for the periods ending Feb. 28, 2007 (Semiannual Report), May 31, 2007 (Form NQ) and Aug. 31, 2007 (Annual Report).  We have assumed that, for the purposes of making these calculations, the interest rate reset dates for the floating and variable rate obligations are the actual final maturity dates (i.e., Schwab Investments’ custom and practice).  The Schwab Investments calculations and the Shine-Vernon team calculations of Weighted Average Maturity are as follows:

Schwab Inv. Reported Shine-Vernon Team Calculation
   Weighted Aver. Mat.  Weighted Aver. Mat.

Feb. 28, 2007   2.9 years    6.96 years

May 31, 2007   Not Reported    6.46 years

Aug. 31, 2007   0.5 years    6.17 years

The Shine-Vernon Team experts’ calculations of the Schwab YieldPlus Fund’s weighted average maturities, which most likely significantly understate the true weighted average maturities of the fund, indicate that the Schwab YieldPlus Fund was actually an intermediate and possibly a long-term bond fund with respect to term of maturity.  The Schwab YieldPlus Fund may have been an ultrashort duration bond fund only in terms of interest rate volatility, due to the portfolio’s high proportional asset concentration in floating and variable rate securities.

The Shine-Vernon Team’s review of annual, semiannual and quarterly reports filed during 2007 by more than ten other ultrashort bond funds reveals that, unlike Schwab Investments, these funds, without exception, report the actual final term to maturity dates of all floating or variable rate securities, rather than the interest rate reset dates.

As described above, the Schwab YieldPlus Fund’s investment strategies contained in the fund’s prospectuses indicate that the fund changed the manner in which it would minimize price fluctuations associated with interest rate risk from maintaining a portfolio with an ultra short-term maturity to maintaining a portfolio with an ultrashort duration.  This subtle language change points to a significant shift in the investment strategies of Schwab YieldPlus Fund portfolio managers to increase the fund’s concentration in longer-term floating and variable rate securities that had low effective durations due to the periodic interest rate reset feature of the securities (i.e., low interest rate volatility/risk).

These floating or variable rate securities had long-term final maturity dates, which means that they would need to be held much longer than ultra short-term securities in order for the Schwab YieldPlus Fund and its shareholders to receive the returns of the face or par value of the securities.

These longer-term floating and variable rate securities, which Schwab Investments represented as being of high credit quality (AA or low default risk), would mature at face value assuming that there were no defaults by the issuers.  Although this new strategy may have been effective for limiting interest rate risk, it was ill-suited to limiting the fund’s liquidity risk.  For example, this strategy left the fund without sufficient cash equivalents available to satisfy shareholder redemptions.

Indeed, it had disastrous effects in 2007 and 2008 when the fund’s portfolio managers were forced to sell these longer term and illiquid securities at distressed prices prior to their maturity dates in order to raise cash to meet ever-escalating cumulative shareholder redemptions.

Nonetheless, in the face of this situation, Schwab YieldPlus Fund lead portfolio manager Kimon Daifotis and Charles Schwab in their communications to Schwab YieldPlus Fund shareholders repeatedly represented during the last four months of 2007 and in early 2008 that substantial portions of the Schwab YieldPlus Fund’s losses were “unrealized.”  These representations led shareholders to believe that:
■ The fund would recover all or a significant portion of these unrealized losses as long as the fund was able to hold the bonds that it currently owned for six months or a year; and
■ That the net asset value price per share of the Schwab YieldPlus Fund would recover within the next six months to a year as the bonds in the portfolio matured at par value.

Such statements were false and misleading.  The actual weighted average maturity of the fund was far in excess of the six months that Schwab Investments reported to the SEC and to the public in the fund’s Annual Report for the period ending Aug. 31, 2007.  The deception of shareholders through these sorts of communications is even more egregious given that Charles Schwab and Mr. Daifotis contemporaneously knew that the fund was experiencing steady and substantial net redemptions, which made it almost certain that the fund would not be able to hold a significant portion of the long-term bonds in the portfolio until they matured.

For more information, please contact attorney Chris Vernon of Vernon Healy by email at cvernon@vernonhealy.com or by phone at  (239) 649-5390.