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News January 17, 2011 Issue

A(nother) Cautionary Tale - Schwab Case A Lesson Learned

(Or Ė A fictional tale with non-fictional roots.)

Ah, the credit crisis. Another gift that just keeps giving.

Many folks "stubbed their toe" on the way down, not expecting the ultimate calamity that ensued. Some folks, however, invited disaster by glossing over errors, repeating errors, and committing new, worse errors. "Greed is good," as Gordon Gecko said, and anything goes.

The tale has been told before. State Street Bank got its comeuppance with mortgage-backed securities errors last February. This time, it is Charles Schwabís turn. All the same actors are here Ė misrepresentative disclosures, active denial of the situation at hand, and favored redemptions at the expense of others. New actors also make their debuts Ė the blown fundamental policy on concentration, the board of directors that voted to change the policy, and the under-the-radar SEC filing that disclosed the change, but in a way that would not attract the SECís attention. The villain Ė depending on how you look at things Ė is again mortgage-backed securities, once the darlings of yield and a must-have for just about every fixed-income portfolio. It was gold in the streets.

Here, fairy tale style, is the story.

The protagonist is the Little Fund That Could Ė Schwab Investmentís YieldPlus Fund. It was not a money market fund. It was an ultra short-term bond fund. It earned an interesting yield in the run-up to the fall of 2007.

Schwab "wizards" (the parent companyís "Cash Council") wanted the YieldPlus Fund to make it over the mountain from BondTown with its load of toys (that yield) for all the good little girl and boy investors in MoneyMarketFund Land.

It would be good for business, the wizards decreed, and they could share the wealth with all those conservative investors Ė uh, good girls and boys Ė down in MoneyMarketFund Land.

So the fundís adviser and distributor described the Fund as a "cash alternative" with "slightly higher risk" than a money market fund. They marketed the Fund with other cash products, creating web page links and content that moved the Fund closer to to the money end of the spectrum in Schwabís product lineup. New disclosures "characterized the Fund as a long-term cash alternative, even though it had been previously marketed with short-term and long-term bond funds," said the SECís order.

The Fundís literature noted that its net asset value had fluctuated by only pennies for a period of years. This was true.

I think I can, I think I can...

As early as 2004, however, the (then) NASD observed that the Fundís disclosures were a little less revealing than they should be. The Fundís distributor minimally tweaked the disclosures, and went merrily on its way for the next two years.

Then, a 2006 SEC examination noted that the Fundís disclosures still seemed out of balance. The SEC noted that the Fundís sales materials "could mislead investors because they compared the Fund to money market funds without describing the differences between these two investments." Once again, the distributor made some tweaks, but this time, to the wrong disclosures.

In response to the SECís concerns, the distributor added additional disclosure in the Fundís prospectus, but not in the Fundís advertisements or other sales communications (where the problem had been noted).

~ BO-RING! ~

Disclosure violations? Ė NEVER happen to us! (Right?)

Okay, itís time for the action sequences.

The Little Fund That Could got very good at making the trip over the mountain with all that yield. Too good, in fact. It began to overinvest in the mortgage-backed toy factory that was making it so popular with the kids. The Fund had named mortgage-backed securities as an asset class and had a fundamental policy not to invest more than 25 percent of its assets there. However, the sector was too irrisistible to pass up, and Fund investments passed the limits..

So what did the Fundís board do? Instead of going to the kids and asking for permission, like they should have, they simply "unmade" the asset class and poof! the problem went away. Now the Little Fund That Could could carry all the toys it could handle. And the boys and girls in MoneyMarketFund Land were none the wiser, but they were happy. The Little Fund That Could was happy, too.

Trouble at the toy factory.

"As the credit crisis unfolded and bond valuations declined in the summer of 2007, the Fundís NAV began to decline and many investors redeemed their holdings," said the SECís order.

But the Little Fund That Could was not a money market fund with liquidity. It was not even an ultra short-term bond fund any more. It was concentrated in tanking mortgage-backed securities and "had to sell assets in a depressed market to raise cash to meet redemptions."

The Fund made it over the mountain alright, but all of a sudden the "toys" had been looted and the brakes were gone. The boys and girls in MoneyMarketFund Land were not happy. They demanded their toys. The Fund had to sell some of its parts cheap to make repairs and keep those kids happy. The engineer Ė the Fundís lead portfolio manager and the adviserís chief investment officer for fixed-income Ė lied about the looting and the asset outflows from the Fund. "If the Advisor community starts to bail out, Öwe will be in trouble," he said.

Little did he know.

$2 billion is not "very, very, very slight" outflows.

Other engineers back at the train yard were getting the word about what was happening to the Little Fund That Could. They should not have, but internal controls about the use of material non-public information were weak, and you know, people talk.

On the basis of the information circulating in the yard, the Fundís engineer let some of the other engineers offload some more parts in the hopes of keeping what was happening quiet as long as possible.

For everyone outside the yard, however, the message was consistent. "[W]eíve got very, very, very slight negative [outward] flows," said the lead portfolio manager.

Once upon a time, the Little Fund That Could was a $13.5 billion dollar baby. And then it was worth $1.8 billion. Somebody has to pay.

"If the disclosures had fit, theyíd have to acquit." (Sorry, taking license with another story).

Not quite, and minding disclosure lines might be boring, but it would have kept Schwab and Fund executives out of a lot of hot water.

So you can see, gentle readers, the moral to this tale is basically, (well, we have to resort to Aristotle): "The least initial deviation from the truth is multiplied later a thousandfold."

We also like: "The most dangerous untruths are truths moderately distorted," penned by Georg Christoph Lichtenberg.

The bottom line, however, is a $188 million settlement by Schwab Ė almost $119 million to the SEC, and $69 million to FINRA.

The SECís case continues against the executives, but thatís another story...