March 9, 2015 / 3:31 PM / 5 years ago

UPDATE 1-Charles Schwab must face U.S. lawsuit over bond index fund

(New throughout, adds details from decision, comments, case citation, byline)

By Jonathan Stempel

March 9 (Reuters) - A U.S. appeals court on Monday revived a class-action lawsuit accusing Charles Schwab Corp of stuffing risky mortgage-backed securities into a bond index mutual fund, causing the fund to significantly lag its benchmark.

By a 2-1 vote, the 9th U.S. Circuit Court of Appeals reinstated breach of contract, breach of fiduciary duty and other claims by plaintiffs led by Northstar Financial Advisors Inc over alleged losses in the Schwab Total Bond Index fund.

Also known as a discount brokerage, Schwab is one of a handful of companies to face litigation over alleged surprise losses in fixed-income mutual funds during the housing and financial crises. Other companies that have been sued include Fidelity Investments and Morgan Keegan.

The plaintiffs said that by investing more than 25 percent of assets in non-agency mortgage securities and collateralized mortgage obligations, Schwab portfolio managers ignored the fund’s fundamental investment objectives of tracking the Lehman Brothers U.S. Aggregate Bond Index and avoiding big industry bets.

They said this caused the fund to lag its benchmark from Sept. 1, 2007 to Feb. 27, 2009, losing 4.80 percent while the index posted a positive total return of 7.85 percent.

Writing for the appeals court, Judge Edward Korman, who normally hears cases in Brooklyn, New York, said Schwab’s adoption of the fund’s fundamental policies were “sufficient to form a contract” between the shareholders and the fund itself.

Circuit Judge Carlos Bea dissented, saying Northstar lacked standing to sue because it did not own shares of the Schwab fund. Northstar pursued its case after being assigned the rights of an investor who had claims against Schwab.

The 9th Circuit took nearly 22 months to decide the case. It returned the case to U.S. District Judge Lucy Koh in San Jose, California, who dismissed Northstar’s lawsuit in August 2011.

Sarah Bulgatz, a spokeswoman for San Francisco-based Schwab, said: “We are reviewing the opinion and expect to continue to defend the allegations in court.”

Robert Finkel, a lawyer for the plaintiffs, said in a phone interview: “It was supposed to be an index fund, but for whatever reason Schwab deviated to buy some high-risk mortgage-backed securities. We’re grateful that two of the three judges saw this case the same way we did.”

The case is Northstar Financial Advisors Inc v. Schwab Investments et al, 9th U.S. Circuit Court of Appeals, No. 11-17187. (Reporting by Jonathan Stempel in New York; Editing by Meredith Mazzilli and David Gregorio)

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