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Schwab's Strike to Fend Off SEC Mortgage-Backed Suit Makes Solid Argument


Charles Schwab filed arguments in federal court in San Francisco to try to preclude the Securities and Exchange Commission from suing it over its YieldPlus fund. Once one of the biggest short-term bond funds in the world, with $13.5 billion at its peak in 2007, YieldPlus lost 35%, before dividends, in 2008 due to high exposure to mortgage-backed securities, which comprised nearly 50% of its portfolio. Today, a mere shell of its former self, it stands at $184 million.

In a Wells notice, the SEC accused of Schwab of marketing the fund as being as safe as a money market fund and of withholding information about the fund's risk from retail investors ahead of a rush of redemptions by Schwab proprietary mutual funds.

But now the two sides are now essentially arguing over the meaning of the word "industry," under Section 13(a) of the '40 Act. Schwab argues that the SEC's semantics over adhering to a cap of 25% on "industry" investments refers to industry, as in manufacturing, automobiles or steel, not the MBS industry. SEC rules preclude a fund from investing more than 25% in any one industry without a shareholder vote.

"The fund was free to make its own determination about what is, and is not, industry," Schwab attorney Darryl Rains said in the court document. "It merely changed the way the word 'industry,' as under [the fund's investment] policy, is applied to a certain type of security."

"Whether certain types of mortgage-backed securities are an 'industry' is not, and never was, part of the fund's fundamental policy," added Schwab spokesman David Weiskopf.

Rains and Weiskopf should go even further because the crucial point here is that in 2006, Schwab amended the YieldPlus prospectus to say that MBS would no longer classify as an industry-and the SEC approved the change.

For their part, SEC lawyers argued in the court filing, "Schwab declared that billions of dollars of fund assets invested in mortgage-backed securities were not part of any 'industry' and then invested nearly 50% of the fund's assets in mortgage-backed securities despite what it had previously recited in its registration statement. Shareholder approval was required." If this was true, then why did the SEC approve the change to the prospectus?

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