NEW YORK Charles Schwab Corp (SCHW.N) violated federal law when it failed to get approval from shareholders of its YieldPlus SWYSX.O mutual fund before putting roughly half the fund's assets into uninsured mortgage-backed securities, a federal judge ruled.
Tuesday's ruling by U.S. District Judge William Alsup in San Francisco is a victory for YieldPlus investors, who are seeking to recover $970 million of damages resulting from the fund's exposure to the collapsing housing and credit markets.
Alsup said Schwab's decision to concentrate the fund's assets marked "an entire repudiation" of prior limits on which shareholders in the fund "were entitled to depend for the safety of their savings. A vote was required."
After returning between 2.37 percent and 6.05 percent in every year from 2000 and 2006, the fund fell 1.04 percent in 2007, 35.37 percent in 2008 and 10.52 percent in 2009, data from Morningstar Inc (MORN.O) show. The fund information service characterized that slide as "monumental."
"We are going to have a damages trial, and we think damages will be easily proven," said Steve Berman, a partner at Hagens Berman LLP in Seattle representing three classes of investors seeking recovery from Schwab, in an interview.
YieldPlus is an "ultra-short" mutual fund, a type that many fund companies marketed as an alternative to cash, but without any guarantee against a loss of principal.
Its assets have fallen to $181 million from a 2007 peak above $13 billion, in part because of investor redemptions.
The U.S. Securities and Exchange Commission has separately threatened to sue San Francisco-based Schwab over the fund.
Schwab spokesman David Weiskopf said the brokerage and fund company disagrees with Alsup's ruling, but several claims and issues remain unresolved.
"We look forward to putting all the facts, evidence and expert testimony to the jury and presenting a strong case at trial," he said.
SCHWAB PREPARED FOR TRIAL
Investors alleged that Schwab invested nearly half of the fund's assets in the risky, uninsured mortgage securities without first seeking required permission from shareholders.
Schwab contended that it did not need shareholder approval for its 2006 decision to lift the fund's limit on owning the debt, which it said was not an "industry" subject to a 25 percent cap on industry investments.
But Alsup said that decision marked a "phenomenal turnabout" by Schwab, given its promise not to concentrate more than 25 percent of fund assets, as it ultimately did.
"Shareholders in the fund were entitled to count on that limitation unless and until changed by a vote of the shareholders," the judge wrote. He said Schwab's actions violated a 1940 federal law governing investment advisers.
Berman said Tuesday's ruling covers California investors seeking $170 million of damages. He said other investors are seeking $800 million, and allege that the fund's prospectus and registration materials were false and misleading.
A trial for these other investors is set to begin on May 10, Berman said. Further proceedings for the California investors have yet to be scheduled, he said.
Regions Financial Corp's (RF.N) Morgan Keegan unit and Fidelity Investments are among other companies to face a variety of litigation and arbitrations over alleged surprise losses in fixed-income mutual funds.
Schwab in October said the SEC had issued a "Wells notice" indicating that it might file civil charges over YieldPlus.
Earlier this month, the SEC said Schwab had no authority to concentrate the fund's assets as it did.
"What occurred in 2006 was no mere 'rejiggering,'" the SEC said in a March 19 court filing.
"In the Commission's view, shareholder approval must be obtained before taking such action," it added. "'Promptly and fully' disclosing the change to investors after the fact does not cure the failure to obtain such approval."
SEC spokesman John Heine said the Commission was pleased by Alsup's ruling. He declined to discuss the Wells notice.
Schwab shares were down 13 cents at $18.62 in afternoon trading on the New York Stock Exchange.
The case is In re: Charles Schwab Corp Securities Litigation, U.S. District Court, Northern District of California, No. 08-01510.
(Reporting by Jonathan Stempel; editing by John Wallace and Gerald E. McCormick)