DOB: Charles Schwab Consent Order

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IN THE MATTER OF:

CHARLES SCHWAB & CO., INC. 
   CRD No. 5393 ("CSCO")

CHARLES SCHWAB INVESTMENT
MANAGEMENT, INC.
   IARD No. 106753 ("CSIM") 

(Collectively "Respondents")


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CONSENT ORDER

DOCKET NO. CO-10-7548-S

I. PRELIMINARY STATEMENT

WHEREAS, the Banking Commissioner (“Commissioner”) is charged with the administration of Chapter 672a of the General Statutes of Connecticut, the Connecticut Uniform Securities Act (“Act”), and Sections 36b-31-2 to 36b-31-33, inclusive, of the Regulations of Connecticut State Agencies promulgated under the Act (“Regulations”);
 
WHEREAS, CSCO has been registered as a broker-dealer in Connecticut since 1976;
 
WHEREAS, CSIM is federally registered investment adviser;
 
WHEREAS, the Commissioner, through the Securities and Business Investments Division of the Department of Banking (“Department”), conducted an investigation pursuant to Section 36b-26(a) of the Act into the activities of Respondents to determine whether they had violated, were violating or were about to violate any provisions of the Act or Regulations (“Investigation”);
 
WHEREAS, Respondents have provided documentary evidence and other materials, and have provided the Department with access to information relevant to their investigations;
 
WHEREAS, Respondents have advised the Department of its agreement to resolve the investigations relating to its marketing and sale of The Schwab YieldPlus Fund (“Fund”) to certain investors;
 
WHEREAS, as result of the Findings of Fact and Conclusions of Law contained in this Consent Order, Respondents agree, inter alia, to compensate certain eligible purchasers of the Fund, and to pay a total fine of Three Hundred Thousand Dollars ($300,000) to the Department;
 
WHEREAS, Section 36b-15(a) of the 2010 Supplement to the General Statutes (“2010 Supplement”), as amended by Public Act 10-141, authorizes the Commissioner to deny, suspend or revoke any registration if, inter alia, the Commissioner finds that (1) the order is in the public interest, (2) the Respondents have failed to reasonably supervise its [sic] agents, or (3) failed to maintain and enforce written procedures that are reasonably designed to achieve compliance with applicable securities laws and regulations;
 
WHEREAS, Section 36b-27(a) of the 2010 Supplement, as amended by Public Act 10-141, authorizes the Commissioner to order any person who has violated, is violating or is about to violate any provision of the Act or any regulation, rule or order adopted or issued under the Act to cease and desist from such violation;
 
WHEREAS, Section 36b-27(d) of the of the 2010 Supplement, as amended by Public Act 10-141, authorizes the Commissioner to impose a fine of up to One Hundred Thousand Dollars ($100,000) per violation against any person who has violated any provision of the Act or any regulation, rule or order adopted or issued under the Act;
 
WHEREAS, Section 36b-31(a) of the Act, as amended by Public Act 10-141, provides, in relevant part, that “[t]he commissioner may from time to time make . . . such . . . orders as are necessary to carry out the provisions of sections 36b-2 to 36b-34, inclusive”;
 
WHEREAS, Section 36b-31(b) of the Act, as amended by Public Act 10-141, provides, in relevant part, that “[n]o . . . order may be made . . . unless the commissioner finds that the action is necessary or appropriate in the public interest or for the protection of investors and consistent with the purposes fairly intended by the policy and provisions of sections 36b-2 to 36b-34, inclusive”;
 
WHEREAS, an administrative proceeding initiated under Sections 36b-15 and 36b-27 of the 2010 Supplement, as amended, would constitute a “contested case” within the meaning of Section 4-166(2) of the General Statutes of Connecticut;
 
AND WHEREAS, Section 4-177(c) of the General Statutes of Connecticut and Section 36a-1-55(a) of the Regulations of Connecticut State Agencies provide that a contested case may be resolved by consent order, unless precluded by law.

II. CONSENT TO WAIVER OF PROCEDURAL RIGHTS

WHEREAS, Respondents, through their execution of this Consent Order, voluntarily waive the following rights:

1.
To be afforded notice and an opportunity for a hearing within the meaning of Sections 36b-15(f) and 36b-27 [of the] 2010 Supplement, as amended, and Section 4-177(a) of the General Statutes of Connecticut;
2.
To present evidence and argument and to otherwise avail themselves of Sections 36b-15(f) and 36b-27 of the 2010 Supplement, as amended, and Section 4-177c(a) of the General Statutes of Connecticut;
3. To present their positions in a hearing in which they are represented by counsel;
4. To have a written record of the hearing made and a written decision issued by a hearing officer; and
5. To seek judicial review of, or otherwise challenge or contest the matters described herein, including the validity of this Consent Order;

NOW THEREFORE, the Commissioner hereby enters this Consent Order.

III. JURISDICTION/CONSENT

Respondents admit the jurisdiction of the Commissioner, neither admit nor deny the Findings of Fact and Conclusions of Law contained in this Consent Order, and consent to the entry of this Consent Order by the Commissioner.

IV. FINDINGS OF FACT

1. CSCO is a registered broker-dealer with a current address of 211 Main St., San Francisco, California 94105.
2. CSIM is a federally registered investment adviser with a current address of 211 Main Street, San Francisco, California 94105.
3. Schwab Investments is a open-end management investment company organized as a Massachusetts business trust and is registered under the Investment Company Act (“ICA”).  Schwab Funds are managed by CSIM.
4. The Fund is a bond mutual fund that was created in October of 1999 and offered as one of the mutual funds of Schwab Funds.  CSCO was responsible for sales and marketing of the Fund and CSIM managed the Fund’s investments.
5. Connecticut investors purchased shares of the Fund.  Some Connecticut investors that purchased shares of the Fund made complaints to the Division and CSCO about the Fund alleging, among things, inaccuracies about the risk, volatility and suitability of the investment and the marketing of the fund.
6. In the course of selling and marketing the Fund, CSCO failed to reasonably supervise its agents and failed to maintain and enforce written procedures that are reasonably designed to achieve compliance with the provisions of the Act.
7. Additionally, CSIM also failed to act in accordance with the provisions of the Act in the course of managing the Fund’s investments.

CSCO Improperly Marketed the Fund to Investors

8.
In advertisements for the fund, CSCO described the Fund, as a cash alternative investment, and compared the fund to money market funds, saying it had a “slightly higher risk” than a money market fund.  Schwab’s registered representatives similarly informed customers that YieldPlus was an alternative to money market funds and certificates of deposit.  However, CSCO did not sufficiently differentiate the risk characteristics of a money market investment versus an investment in the fund.
9. Some Connecticut investors were told by their CSCO registered representatives that the monies that they invested in the Fund “were a good alternative to cash”.  For example, a CSCO representative stated that “volatility is very, very low because the bonds in the fund are short-term the average maturity is only about six months.”  Some CSCO representatives also contacted Connecticut investors when they had large money market balances or when they had CD’s that were maturing and made comparisons between these investments.  Certain CSCO representatives recommended that Connecticut investors purchase shares of the Fund.  In doing so, they assured the Connecticut investors that the Fund was a safe, conservative, low risk investment that would provide a higher yield than its competitors with minimum risk, like a money market fund.
10.
A money market fund is commonly defined as follows:
A money market fund is a type of mutual fund that is required by law to invest in low-risk securities. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Money market funds typically invest in government securities, certificates of deposit, commercial paper of companies, or other highly liquid and low-risk securities.
11. In its marketing materials, CSCO compared the fund to money market funds.  For example, in a September 2006 mailing to customers, CSCO claims that the fund:
[O]ffers higher potential returns than money market funds with only marginally higher risk.
12. Additionally CSCO stated in a January 2006 marketing brochure:
If you’re comfortable accepting a slightly higher amount of risk in exchange for a return that’s generally better than other cash -equivalent investments, consider this ultra-short terms bond fund.
13.
CSCO also stated in an August 2006 webpage that “The Schwab YieldPlus fund . . . can be a smarter alternative to investing in money market [funds]”.
14. CSCO marketed the Fund as an ultra-short bond fund.  An ultra-short bond fund is commonly defined as a mutual fund that generally invests in fixed income securities with extremely short maturities, or time periods in which those securities become due for payment.  In 2000, the Fund’s prospectus was revised to remove the maturity limitations of the Fund.  Despite this change in the prospectus, CSCO continued to market and sell the Fund as an ultra-short bond fund even though the Fund invested heavily in longer maturity securities in a manner inconsistent with that of an ultra-short bond fund.
15. While ultra-short bond funds are permitted to invest in a wide variety of instruments including asset and mortgage-backed securities, the fund invested heavily in residential non-agency mortgage backed securities.  Residential mortgage-backed securities generally are not short term securities.
16. The Fund’s prospectus was revised in November of 2000 to remove the maturity limitations of the Fund:
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.
Duration is a measure of a bond’s interest rate risk.  Specifically, duration measures a bond’s sensitivity to a one percent change in market interest rates.  Duration does not, however, measure other types of risks that are associated with fixed income securities.
17. In short, CSCO should have known that an investment in the Fund carried higher potential risk than an investment in a money market fund.
18. Due to CSCO’s improper marketing of the Fund as an alternative to money market funds and/or a low risk bond fund, many individuals invested in the fund and experienced losses in the Fund.
19. CSCO improperly used as a benchmark the Lehman Brothers US Treasury Short 9 - 12 Month Index.  The benchmark held treasury securities with average maturities of 9 - 12 months.  The Fund held securities with longer periods. Further the benchmark held securities that were on average more liquid. CSCO inadequately disclosed these differences.  The Fund was less liquid and was a higher risk investment than its benchmark.

CSIM Concentrated the Fund in Non-Agency
Mortgage Backed Securities Without a Shareholder Vote

20. CSIM concentrated the Fund’s assets in non-agency mortgage-backed securities (“MBS”).  This concentration violated the Fund’s policy in regard to the concentration of investments in the Fund.  These violations ultimately gave rise to the substantial drop in the Fund’s NAV once the financial crisis of 2007-08 affected the value of those securities.
21. In regard to its concentration policy, CSCO and/or CSIM:
a. Initially defined non-agency mortgage backed securities as a single industry; and
b. Subsequently changed that definition on September 1, 2006, to define mortgage backed securities as not part of any single industry.
22. CSIM laid out the guidelines regarding the concentration of investments in the Fund’s Statement of Additional Information (“SAI”).  The Fund’s SAI for November 15, 2004, which the Fund’s prospectus incorporates by reference, states that:
The Schwab YieldPlus fund . . . may not . . . concentrate investments in a particular industry or group of industries, as concentration is defined under the 1940 Act, or the rules and regulations thereunder, as such statute, rules and regulations may be amended from time to time.
23. This same SAI defines concentration as “investing 25% or more of an investment company’s net assets in an industry or group of industries . . . .”
24. In regard to what constitutes an industry, the SAI made it clear that non-agency mortgage backed securities were to be considered a single industry.  The November 15, 2004, SAI stated:
Based on the characteristics of mortgage backed securities, each fund has identified mortgaged-backed securities issued by private lenders and not guaranteed by U.S. government agencies or instrumentalities as a separate industry for the purposes of a fund’s concentration policy.
25. In other words, the CSIM informed investors that it would not invest more than 25% of the Fund’s assets in non-agency mortgage backed securities.
26. This policy remained in effect until September 1, 2006, when the CSIM amended its November 15, 2005, SAI in order to re-define non-agency mortgage backed securities as investments that do not belong to any one industry:
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 lenders are not a part of any industry for purposes of the funds’ concentration policy.
27. This revision to the Fund’s SAI meant that the Fund was able to invest more than 25% of its total assets in privately-issued mortgage backed securities.  By mid-2007, approximately 50% of the fund’s assets were in non-agency MBS.
28. CSIM changed the Fund’s concentration policy for non-agency mortgage backed securities without approval from existing shareholders of the Fund.  On March 30, 2010, the District Court Judge found that Respondents’ unilateral change of the Funds policy regarding the Fund’s concentration in non-agency mortgage-backed securities was in violation of federal securities laws.
29. In 2006, CSIM modified the Fund’s registration statement to allow the fund to invest more than 25% of its assets in non-agency MBS. Prior to this change, the fund was not permitted to exceed this 25% threshold.  As a result, the fund invested more of its assets in securities with longer maturities, making the fund more vulnerable to significant changes in market conditions such as the credit crisis that began in the summer of 2007.
30.
Despite the increased risk involved in investing in the Fund, CSCO failed to change its marketing materials to reflect the increased risk.  Rather, they continued marketing the Fund as they had prior to the change in the Fund’s MBS classification policy.

V. CONCLUSIONS OF LAW

1. The Commissioner has jurisdiction over this matter pursuant to the Act.
2.
As more fully described in the Findings of Fact above, CSCO failed to supervise reasonably its registered agents.  Such conduct, if proven, would violate Section 36b-31-6f(b) of the Regulations and constitute a basis for administrative proceedings under Section 36b-15(a)(2)(K) of the Act; and initiating administrative proceedings under subsections (a) and (d) of Section 36b-27 of the Act.
3.
As more fully described in the Findings of Fact above, CSIM engaged in or materially aided in a course of conduct that could, if proven, support proceedings under subsections (a) and (d) of Section 36b-27 of the Act.
4. The Commissioner finds that this Consent Order and the following relief are appropriate, in the public interest, and consistent with the purposes fairly intended by the policies and provisions of the Act.

VI. CONSENT ORDER

On the basis of the Findings of Fact, Conclusions of Law, and Respondents’ consent to the entry of this Consent Order,

IT IS HEREBY ORDERED THAT:

1.
This Consent Order concludes the Investigation by the Department and any other action that the Department could commence under the Act on behalf of Connecticut as it relates to Respondents['] marketing and sale of the Fund.
2. This Consent Order is entered into solely for the purpose of resolving the above-referenced Investigation and is not intended to be used for any other purpose.
3. Respondents shall cease and desist from engaging in conduct constituting or which would constitute a violation of the Act or any regulation, rule or order adopted or issued under the Act, including but not limited to, failing to reasonably supervise its [sic] agents and failing to maintain and enforce written procedures that are reasonably designed to achieve compliance with applicable securities laws and regulations;
4. Within ten (10) days after the entry of this Consent Order by the Commissioner, Respondents shall remit to the Commissioner, by electronic funds transfer, the sum of Three Hundred Thousand Dollars ($300,000).
5.
Respondents shall compensate Connecticut investors that invested in the Fund between May 31, 2006 and March 17, 2008, (“Eligible Investors”) in an amount not to exceed $2,500,000.  Investors who sold after March 17, 2008 will be deemed to have sold as of March 17, 2008.  The first payment shall be paid no later than June 30, 2011.  The remainder, if any, will be made no later than 30 days after the final distribution made by the SEC Fair Fund.
6.

Respondents shall offer to Connecticut investors who file an arbitration claim after entry of this Consent Order the option to participate in an Expedited Arbitration if the Connecticut investor meets the following criteria:

a.   
Claims losses on holdings of the Fund purchased prior to November 15, 2006;
b.
Maintained those holdings at any time during the period of May 31, 2006 through the present; and
c. (i) Has not brought or does not currently maintain an arbitration or litigation claim against the Respondents in connection with YieldPlus; or (ii) has not entered into a settlement with any of the Respondents, or (iii) is not a member of the state or federal classes in the YieldPlus securities class action litigation No. 08-cv-01510 WHA (“Class Action Litigation”) with respect to the shares at issue in the Expedited Arbitration.  If the Connecticut investors hold some shares that are subject to the Class Action Litigation settlements, and some shares that are not, those shares that are subject to the class action will not be eligible for arbitration under this section.

7.
All Expedited Arbitrations held pursuant to paragraph 6 above shall be conducted by the American Arbitration Association under its Commercial Arbitration Rules and Securities Arbitration Supplementary Procedures, JAMS, under its Comprehensive Arbitration Rules and Procedures, or FINRA, and shall apply Connecticut law.  All arbitrators will be ‘public’ arbitrators not affiliated with the securities industry.  The arbitration proceedings shall be held in the State of Connecticut.  Schwab shall bear all costs associated with holding the arbitrations under this provision[.]
8. In any arbitration initiated pursuant to paragraph 6 above, the Respondents:
   
a. Shall not object to the jurisdiction of such proceedings;
b. Shall not make the objection that the Respondents were improperly named as parties in such proceedings;
c. Shall not assert any defense that such claims brought under this provision and which are eligible for arbitration in accord with paragraph 7 above, are otherwise addressed or precluded by this Order, any other regulatory settlement, or the Class Action Litigation; and
d. Shall not object to the entry of any regulatory Order or other regulatory settlement into evidence in such proceedings.
9.
In contemplation of this settlement, the Department has refrained from taking legal action, excluding this Consent Order, against Respondents with respect to Respondents’ failure to reasonably supervise its agents and failure to maintain and enforce written procedures that are reasonably designed to achieve compliance with applicable securities laws and regulations.
10. If payment is not made by Respondents, or if Respondents default in any of their obligations set forth in this Consent Order, the Department may vacate this Consent Order, at its sole discretion, upon ten (10) days notice to Respondents and without the opportunity for administrative hearing.
11. This Consent Order and any dispute related thereto shall be construed and enforced in accordance with, and governed by, the laws of Connecticut without regard to any choice of law principles.
12. Respondents enter into this Consent Order voluntarily and represent that no threats, offers, promises, or inducements of any kind have been made by the Department or any member, officer, employee, agent or representative of the Department to induce either Respondent to enter into this Consent Order.
13. This Consent Order shall be binding upon Respondents and their successors and assigns as well as to the successors and assigns of relevant affiliates with respect to all conduct subject to the provisions above and all future obligations, responsibilities, undertakings, commitments, limitations, restrictions, events and conditions.

NOW THEREFORE, the Commissioner enters the following:

1. The Findings of Fact, Conclusions of Law and Consent Order set forth above, be and are hereby entered;
2. Entry of this Consent Order by the Commissioner is without prejudice to the right of the Commissioner to take enforcement action against either Respondent based upon a violation of this Consent Order or the matters underlying its entry, if the Commissioner determines that compliance with the terms herein is not being observed or if any representations made by either Respondent and reflected herein are subsequently discovered to be untrue; and
3. This Consent Order shall become final when issued.

 
Issued at Hartford, Connecticut,      _______/s/_________
this 31st day of January 2011.      Howard F. Pitkin 
    Banking Commissioner 


CONSENT TO ENTRY OF ORDER

I, Joseph Martinetto, state on behalf of Charles Schwab & Co., Inc. that I have read the foregoing Consent Order; that I know and fully understand its contents; that I am authorized to execute this Consent Order on behalf of Charles Schwab & Co., Inc.; that Charles Schwab & Co., Inc., agrees freely and without threat or coercion of any kind to comply with the terms and conditions stated herein; and that Charles Schwab & Co., Inc., voluntarily consents to the issuance of this Consent Order, expressly waiving any right to a hearing on the matters described herein.  Charles Schwab & Co., Inc. further agrees that it shall not claim, assert, or apply for a tax deduction or tax credit with regard to any state, federal or local tax for any administrative monetary penalty that Charles Schwab & Co., Inc. shall pay pursuant to the foregoing Consent Order.     

 
  
           
By: ______/s/______________________
Name: Joseph Martinetto
Title: EVP and Chief Financial Officer
  Charles Schwab & Co., Inc.

 
California All-Purpose Acknowledgment

State of California

County of San Francisco

On 28 January 2011 before me, Mila S.Y. Ching, Notary Public, personally appeared Joseph Martinetto, who proved to me on the basis of satisfactory evidence to be the person whose name is subscribed to the within instrument and acknowledged to me that he executed the same in his authorized capacity, and that by his signature on the instrument the person, or the entity upon behalf of which the person acted, executed the instrument.

I certify under PENALTY OF PERJURY under the laws of the State of California that the foregoing paragraph is true and correct.

WITNESS my hand and official seal.


_____/s/_____________________________
Notary Public
My Comm. Expires Jun 10, 2013


CONSENT TO ENTRY OF ORDER

I, Marie Chandoha, state on behalf of Charles Schwab Investment Management, Inc. that I have read the foregoing Consent Order; that I know and fully understand its contents; that I am authorized to execute this Consent Order on behalf of Charles Schwab Investment Management, Inc.; that Charles Schwab Investment Management, Inc., agrees freely and without threat or coercion of any kind to comply with the terms and conditions stated herein; and that Charles Schwab Investment Management, Inc., voluntarily consents to the issuance of this Consent Order, expressly waiving any right to a hearing on the matters described herein.  Charles Schwab Investment Management, Inc. further agrees that it shall not claim, assert, or apply for a tax deduction or tax credit with regard to any state, federal or local tax for any administrative monetary penalty that Charles Schwab Investment Management, Inc. shall pay pursuant to the foregoing Consent Order.     

 
  
           
By: __________/s/__________________________
Name: Marie Chandoha
Title: Chief Investment Officer
  Charles Schwab Investment Management, Inc.

 
California All-Purpose Acknowledgment

State of California

County of San Francisco

On 28 January 2011 before me, Mila S.Y. Ching, Notary Public, personally appeared Marie Chandoha, who proved to me on the basis of satisfactory evidence to be the person whose name is subscribed to the within instrument and acknowledged to me that she executed the same in her authorized capacity, and that by her signature on the instrument the person, or the entity upon behalf of which the person acted, executed the instrument.

I certify under PENALTY OF PERJURY under the laws of the State of California that the foregoing paragraph is true and correct.

WITNESS my hand and official seal.


_____/s/_____________________________
Notary Public
My Comm. Expires Jun 10, 2013
  

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