Charles Schwab filed arguments in a federal court in San Francisco on March 19 to try to preclude the Securities and Exchange Commission (SEC) from suing it over its YieldPlus fund, which had nearly 50% of its assets in MBS, Bloomberg reports.
Once one of the biggest short-term bond funds in the world, with $13.5 billion at its peak in 2007, YieldPlus lost 35%, before dividends, in 2008. Today, a mere shell of its former self, it stands at a mere $184 million.
In a Wells notice, which is a letter that the SEC sends to people or firms when it is planning to bring an enforcement action against them, the SEC accused of Schwab of marketing the fund as being as safe as a money market fund and of withholding information about the fund’s risk from retail investors ahead of a rush of redemptions by Schwab proprietary mutual funds.
The two sides are now essentially arguing over the meaning of the word “industry," under Section 13(a) of the ’40 Act, in determining the fund’s investment mandate and whether the SEC will proceed with a suit.
Schwab argues that the SEC’s semantics over adhering to a cap of 25% on “industry” investments refers to industry, as in manufacturing, automobiles or steel, not the MBS industry. SEC rules preclude a fund from investing more than 25% in any one industry without a shareholder vote.
“The fund was free to make its own determination about what is, and is not, industry,” Schwab attorney Darryl Rains said in the court document. “It merely changed the way the word ‘industry,’ as under [the fund’s investment] policy is applied to a certain type of security.” In 2006, Schwab amended the YieldPlus prospectus to say that mortgage-backed securities would no longer classify as an industry.
“Whether certain types of mortgage-backed securities are an ‘industry’ is not, and never was, part of the fund’s fundamental policy,” added Schwab spokesman David Weiskopf.
“What occurred in 2006 was no mere ‘rejiggering,’” SEC lawyers argued in the court filing. “Schwab declared that billions of dollars of fund assets invested in mortgage-backed securities were not part of any ‘industry’ and then invested nearly 50% of the fund’s assets in mortgage-backed securities despite what it had previously recited in its registration statement.”
The SEC continued: “Shareholder approval was required [because] the fund invested more than 25% of its assets in mortgage-backed securities, not because the fund changed the classification of mortgage-backed securities as an industry.”
Schwab added that the SEC “has no legal support for its selective disclosure theory [and Schwab] has reasonable policies to protect against insider trading.”