FINRA Press Release: Improper Marketing

FINRA Orders Schwab to Pay $18 Million to Investors for Improper Marketing of YieldPlus Bond Fund

The Financial Industry Regulatory Authority (FINRA) issued a press release today announcing that

"it has ordered Charles Schwab & Company, Inc., to pay $18 million into a Fair Fund to be established by the Securities and Exchange Commission (SEC) to repay investors in YieldPlus, an ultra short-term bond fund managed by Schwab's affiliate, Charles Schwab Investment Management. The $18 million consists of the $17.5 million in fees that Schwab collected for sales of the fund, plus a fine of $500,000, both of which will have been designated as restitution to customers."

The settlement is detailed in the FINRA AWC No. 2008012876902.

Concurrently, the SEC charged Schwab entities and two executives for making misleading statements about YieldPlus. Schwab settled with the SEC and agreed to pay a fine of more than $118 million.

From June 2007 through June 2008, the total return on Schwab's YieldPlus fund (SWYPX and SWYSX) was -31.7% when other ultra short bond funds had little or no losses. These large losses occurred because Schwab's YieldPlus fund was not an ultra short bond fund as claimed by Schwab. It was instead an ultra long bond fund.

YieldPlus held large amounts of securities backed by illiquid, long-term, private label mortgages. It also held long maturity corporate bonds and trust preferred securities. In doing so, Schwab's fund violated concentration and illiquidity limits stated in its prospectus and had much more credit and liquidity risk than it disclosed in its SEC filings and marketing materials. YieldPlus' long term securities including private label mortgage backed securities gave it a slight advantage over its peers prior to 2007. Unfortunately, the extra yield was an order of magnitude smaller than the losses that followed when credit and liquidity spreads widened and the value of its long term holdings dropped significantly in 2007 and 2008.

YieldPlus's heaviest reported losses occurred in early 2008, yet Schwab still appears to have understated these losses by significantly inflating the value of the fund's holdings and therefore its net asset value (NAV).

For additional information:

• Wall-Street Journal article on the SEC and Schwab settlement.
• Related SLCG paper on Schwab YieldPlus.
• Related SLCG paper on mutual funds' average term.
• Related SLCG paper on mutual funds' average credit quality.