Improper Marketing of YieldPlus Bond Fund

US FINRA recently ordered Charles Schwab & Company, Inc., to pay $18 million into a Fair Fund to be established by 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.

FINRA's investigation found that despite changes in YieldPlus' portfolio that caused the fund to be disproportionately affected by the turmoil in the mortgage-backed securities market, Schwab failed to change its marketing of the fund. In written materials and in conversations with customers, some Schwab representatives omitted or provided incomplete or inaccurate material information relating to the fund's characteristics, risk and diversification, and continued to represent YieldPlus as a relatively low-risk alternative to money market funds and other cash alternative investments that had minimal fluctuations in NAV.

Between Sep 2006, and Feb 2008, Schwab sold over $13.75 billion in shares of YieldPlus to customers, which accounted for approximately 98% of the amount Schwab customers invested in ultra short-term bond funds. During this time period, Schwab's solicited sales of YieldPlus totaled approximately $3.36 billion, approximately 40% of which were to customers 65 years of age or older.

In late August 2006, Schwab Investment's Board of Trustees approved a proposal from YieldPlus' fund manager to no longer classify non-agency mortgage-backed securities as an "industry" for purposes of the fund's concentration policies. This change purportedly allowed the fund manager to increase the amount of non-agency mortgage-backed securities in the portfolio to greater than 25% of the fund's assets. As a result, by February 2008, YieldPlus held over 50% of its assets in mortgage-backed securities, and about 40% in non-agency mortgage-backed securities.

Schwab was or should have been aware of the fund's significant exposure to mortgage-backed securities in light of the increasingly unfavorable financial markets.  As YieldPlus' NAV declined in the latter part of 2007, Schwab acknowledged internally that YieldPlus was a higher-risk investment than it had been in the past. Internally, some Schwab employees even began referring to YieldPlus as "Yield Minus." Schwab nevertheless continued to describe to investors YieldPlus as being very low risk with minimal fluctuations in share price. Schwab also was aware that YieldPlus was being marketed improperly. The firm's product manager for YieldPlus advised others that the firm needed "to get away from saying YieldPlus is equivalent to a money market fund," but the firm failed to stop this practice.

Schwab's investment management unit was aware of the changes in the fund's portfolio and the significant increase in the percentage of the fund's mortgage-backed securities holdings, but it failed to appreciate the concomitant increase in the risk of the fund and price volatility. Meanwhile, Schwab's retail brokerage division did not change the way it marketed YieldPlus or the internal guidance it provided to its registered representatives. 

In its advertisements and sales literature, Schwab described YieldPlus as a cash alternative investment. Schwab initiated marketing campaigns during the second half of 2006 and continued into 2007, one of which was internally called the "Cash" campaign, which compared the performance of YieldPlus to a money market fund and promoted YieldPlus as an alternative to money market funds. In the campaigns, Schwab did not disclose that the higher returns resulted from the greater risk in the portfolio. Other advertisements emphasized the "minimal risk" and "high degree of price stability" in YieldPlus.

The increased concentration in mortgage-backed securities caused YieldPlus to be severely impacted by the decline in the mortgage-backed securities market that began in the summer of 2007. YieldPlus' NAV dropped significantly, falling from a high of $9.69 on 26 Feb 2007 to $8.79 on 29 Feb 2008, a decline of 9.3%.

Jack's comment: It is again a case about the conflict between product due diligence and product marketing. Investors should be educated to appreciate that bond, or bond fund, is not necessarily safe.

Analyst Fined for Disclosing Misleading Information

Last week UK FSA fined Christopher Gower £50,000 for making misleading and inaccurate disclosures to the market about Enterprise Inns plc (ETI) to clients via Bloomberg instant messenger, substantially impacting ETI share price.

Gower, a former senior research analyst employed by MF Global Securities Limited and MF Global UK Limited, attended a meeting with the CEO of Punch Taverns plc on 7 May 2008. In the course of the meeting they discussed an application made by ETI to Her Majesty’s Revenue and Customs (HMRC) for approval to convert to a REIT. This discussion concerned solely information which was in the public domain.

Following the meeting, Gower sent a Bloomberg instant message to 14 clients of MF Global, a Bloomberg reporter and MF Global equity salesmen in the following terms:

"*** HOT OFF PRESS*** Just had meeting with CEO of PUNCH TAVERNS. They have heard from HM Revenue & Customs that it is highly likely Enterprise Inns has been granted REIT status and ETI are due to announce this on 13th May at interims. Expect ETI to bounce (was up 10% on previous HMRC news) BUT then fall back as mkt realises it will take time to implement.... MORE on my meeting to follow.... Chris"

This instant message did not accurately reflect the conversation Gower had had. It gave the impression of containing inside information although, in fact, Gower had no such information. The message was misleading and inaccurate. It was rapidly circulated widely in the market and contributed to a substantial increase in the volume of ETI shares traded.

Gower gave no apparent consideration to the consequences to the market of his message. His conduct was careless and fell below proper standards of conduct in the circumstances.

Jack's comment: Pretending to be an insider would not commit an offence of insider dealing, but market abuse.

Promotion of Unauthorized Investment Fund

Investment fund promoter, Ms Kwok Sau Ping, was convicted last week at the Eastern Magistrates Court of issuing documents in relation to a collective investment scheme without the authorization of SFC and not disclosing interests in listed securities on time. Kwok was fined a total of $12,000 and ordered her to pay SFC investigation costs of $ 80,000.

The Court found that on 13 and 20 October 2007, Kwok held a series of public presentations to promote a collective investment scheme called Reliance China Hong Kong Opportunity Fund. Kwok conducted the presentations using Powerpoint slides, which were not authorized by SFC. A total of 120 investors subscribed to the Fund.

Kwok, who controlled the Fund, was deemed to be interested in the Fund's investments which included an indirect interest in 60 million shares of Hong Kong-listed Bel Global Resources Holdings Limited, and she failed to disclose it within three business days.


Jack's comment: Some people may think that only displaying but not distributing Powerpoint slides about an unauthorized investment product would not constitute a breach of SFO. I don't think so, because the document is still "issued" (the term "issue" is broadly defined under S.102 of SFO) as an invitation to the public for inducing investment.

Expert Immunity

Today I read this interesting article published by a law firm about "expert immunity":



Keeping up with the Jones case – will expert immunity survive?

If you have ever acted, currently act, or contemplate acting as an expert for litigants, then you ought to be aware of an interesting case before the English Supreme Court. The pending decision could abolish the long-standing doctrine that provides experts with immunity from suit for almost all work done in relation to litigation proceedings (expert immunity). This extends to oral evidence given at trial and preliminary steps undertaken in connection with giving evidence, such as the creation of expert reports.

The subject case on appeal from the English High Court is Jones v Kaney [2010] EWHC 61 (QB). Justice Blake of the English High Court summarily struck out a negligence claim against an expert witness on the basis that he was bound by the leading English case on point, Stanton v Callaghan (Stanton). Stanton upheld the absolute immunity from suit conferred on witnesses (including experts) with respect to testimony in court or work otherwise intimately related to court proceedings.

Since the Court of Appeal would also be bound by Stanton, Blake J granted the claimant, Mr Jones, a 'leapfrog' certificate for the Supreme Court to decide whether or not to allow an appeal, under s.12(1) of the Administration of Justice Act. The Supreme Court has granted permission, and the appeal will be heard on 11 and 12 January 2011.

Although it seems likely that the ordinary 'witness immunity' will be left unaltered, it is not inconceivable that expert immunity could be removed, particularly in view of:

• attacks on the public policy underpinning the doctrine of expert immunity;
• the fact that these days many experts derive income or indeed make a full-time career acting as an expert witness; and
• the judgment of Lord Hoffman in Arthur JS Hall & Co v Simons (Hall v Simons) which overruled the long standing principle that advocates, whether solicitors or barristers, were immune from suit for things done or omitted in the course of conducting a case in court.

It remains to be seen whether the Supreme Court will take the opportunity on this appeal to revisit the case law and the public policy considerations behind the immunity. If, however, expert immunity is abolished, experts who derive fees advising litigants should pay careful attention. The decision could well reverberate across all common law jurisdictions.