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Judge Aslup for the Northern District of California denied Charles Schwab & Co.’s Motion for Summary Judgment filed in its efforts to escape liability for defrauding investors in connection with the sale of its proprietary YieldPlus Fund.
Schwab touted its YieldPlus Fund as a near cash equivalent or money market fund.
Unbeknownst to investors, on September 15, 2006, Schwab, in an effort to inflate the YieldPlus Fund’s yield and attract new investors, changed the YieldPlus Fund’s "Investment Limitations" to permit the concentration in excess of 25% of the Fund’s assets in otherwise risky Mortgage Backed Securities.
As a result, upon the collapse of the market for Mortgage backed securities, the share price of the YieldPlus Fund, and Claimants’ investment, tumbled more than 40% in April 2008.
Schwab has strongly defended the Class Action, and has been a party to many hundreds of customer initiated investment related claims in arbitration before the Financial Industry Regulatory Authority ("FINRA") arbitration. In defense of the customer arbitration cases, Schwab and their team of lawyers and expert witnesses have traveled around America, with mixed results, seeking to convince arbitration panels that they did no wrong.
During this same period, and as early as last year, Schwab disclosed that the SEC was also investigating Schwab’s fraud, with respect to the management and promotion of its YieldPlus product, and that Schwab had made a Wells Submission to the SEC, trying to convince the SEC that it had done no wrong and should not have an enforcement action initiated against it.
A "Wells Notice" is a notification from a regulator that it intends to recommend that enforcement proceedings be commenced against the prospective respondent. The notice references, the violation(s) that the Staff, here the U.S. Securities & Exchange Commission, believes has occurred. The enforcement staff generally notifies a person or entity of its intention to recommend the authorization of an enforcement action. The enforcement staff then invites the proposed defendant or respondent to make a Wells submission. A Wells submission is a document in which the proposed defendant or respondent explains why an enforcement action is not warranted.
While many cases resulting from the collapse of the financial markets have been dismissed based upon legal technicalities (i.e. someone was out lawyered on a particular issue and the Judge bought it), Judge Alsup’s decision is a breath of fresh air.
In re Charles Schwab Corp. Securities Litigation (No. C 08-01510 WHA, Apr. 8, 2010) provides an entertaining read and a rare victory for plaintiffs in defeating defendants' motion for summary judgment. Mutual fund holders alleged that the fund represented that the fund was diversified and never concentrated more than 25% in a single industry, but in fact it had concentrated more than 50% in residential housing and/or commercial real estate industry. Defendants' defense centered on a 3-sentence disclosure included in the SAI (which, you will recall, is not included in the prospectus but must be requested by investors):
The funds have determined that mortgage-backed securities
issued by private lenders do not have risk characteristics that are
correlated to any industry and, therefore, the funds have
determined that mortgage-backed securities issued by private
concentration policies. This means that a fund may invest more
than 25% of its total assets in privately-issued mortgage-backed
securities, which may cause the fund to be more sensitive to
adverse economic, business or political developments that affect
privately-issued mortgage-backed securities. Such developments
may include changes in interest rates, state or federal legislation
affecting residential mortgages and their issuers, and changes in
the overall economy.
The court placed these three sentences in the context of the 35-pages of "Investments, Risks and Limitations" contained in the SAI and found that, apart from the three sentences, the disclosure left the distinct impression that fund was diversified and that its plan was never to concentrate more than 25% in a single industry. Viewing the record most favorably to the plaintiffs, a jury could reasonably find that the three sentences had a low profile compared to the much higher profile of the attractive features of the fund. "In short, if defendants are going to define away the problem, a jury could reasonably find that they did not do so plainly enough."
The court also denied defendants' motion for summary judgment on loss causation. "If a mutual fund holds itself out as investing no more than 25% in a single industry but then, as actually planned, invests 50% in a single industry, there is no escape by blaming the industry rather than the promoter."
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