OppenheimerFunds Inc. agreed to pay roughly $35 million to settles charges by the Securities and Exchange Commission (SEC) that it made misleading statements to investors in two mutual funds that rapidly lost value during the 2008 financial crisis.
The settlement consists of a $24 million penalty, disgorgement of about $9.8 million and prejudgment interest of about $1.5 million, all of which will be deposited into a fund for investors. As in most SEC settlements, Oppenheimer neither admitted nor denied the SEC’s findings.
OppenheimerFunds Censured
The investment management company and its sales and distribution unit, OppenheimerFunds Distributor Inc., also agreed be censured, and to cease and desist from committing or causing any future violations of federal securities laws, according to the SEC order instituting settlement proceedings entered June 6. Oppenheimer was given 10 days to pay.
About OppenheimerFunds Inc.
A Colorado corporation, OppenheimerFunds Inc. is registered with the SEC as an investment adviser. The company has operations in New York City and Centennial, Colo., and as of February, provided services to about 100 investment companies with roughly $177 billion in assets under management.
The sales and distribution unit is a wholly owned subsidiary of OppenheimerFunds incorporated in New York and registered with the SEC as a broker dealer. The subsidiary markets and distributes shares of mutual funds managed by its parent company, the order said. For a disciplinary history of OppenheimerFunds Distributor, see FINRA public disclosure records.
The SEC Investigation
The SEC’s investigation was conducted by its Denver and New York regional offices. They found that Oppenheimer significantly increased the exposure of its Oppenheimer Champion Income Fund and its Oppenheimer Core Bond Fund to commercial mortgage-backed securities (CMBS) through the use of derivative instruments known as total return swaps (TRS). The Champion fund was a high-yield bond fund, and the Core Bond fund was an intermediate-term, investment-grade fund.
The prospectus issued for the Champion fund in 2008 did not properly disclose the fund’s use of derivative instruments, the order said. These derivatives left both funds highly leveraged, and when the CMBS market went into decline, the funds incurred large cash liabilities on the TRS contracts, forcing Oppenheimer to reduce CMBS exposure. Oppenheimer then disseminated misleading statements about the funds’ losses and prospects for recovery.
Julie Lutz, associate director of the SEC’s Denver Regional Office, explained in a statement that, because they had to raise cash for TRS payments and cut their CMBS exposure to avoid more losses, the two Oppenheimer funds sold bonds at the worst possible time. Yet, Oppenheimer told investors that the funds were maintaining their positions and the losses were recoverable.
Through TRS contracts, the two funds had increased their CMBS exposure without actually purchasing the bonds, but this strategy resulted in huge amounts of leverage, the order said.
When the CMBS market began to plunge in September 2008, it drove down the net asset values of both funds. Oppenheimer was left with few options. To raise cash for TRS contract payments due at the end of the month, the company started selling securities into a market growing more illiquid by the day, the order said.
Per instructions from senior management, the funds’ portfolio managers started reducing CMBS exposure in November 2008, the order said. A short while later the collapse of CMBS market picked up speed, driving the net asset values of the funds even lower and leaving the funds saddled with enormous cash liabilities.
Because of the market slide, it became increasingly difficult for the funds to sell securities to raise the cash they needed to pay off the TRS contracts, the order said. In fact, Oppenheimer made a $150 million cash infusion into the Champion fund on Nov. 21, 2008. Both funds continued to reduce their exposure to CMBS in an effort to avoid more losses.
During this time, Oppenheimer gave several misleading answers to questions from investors. For example, Oppenheimer told fund shareholders, as well as financial advisers whose customers were investors in the funds, that they had suffered only paper losses. Oppenheimer told them their holdings and strategies were intact, the order said.
Even while Oppenheimer was reducing the funds’ exposure to CMBS, the company told the shareholders and financial advisers that, outside of actual defaults, the funds would continue collecting payments on their bonds as they waited for the markets to recover. These communications were materially misleading, the order said. Given Oppenheimer’s committed strategy of reducing CMBS exposure, the prospects for recovering CMBS-induced losses were dim.
Furthermore, the funds were forced to sell off chunks of their bond holdings to raise cash for payments on TRS contracts. This resulted in actual investment losses as well as a loss of future income, the order said.
According to the SEC investigators, the Champion fund’s 2008 prospectus was materially misleading because it described the fund’s main investments in high-yield bonds, but it did not adequately disclose that the fund’s investment strategy resulted in substantial leverage on top of the high-yield bonds.
The prospectus disclosed that the fund used swaps and other derivatives as a means of managing risk and increasing income, but it did not adequately disclose that the fund used derivatives so extensively that its aggregate exposure could surpass the total value of its portfolio. This meant that its investment returns could turn out to depend mostly on the performance of bonds that it did not own, the order said.
The materially misleading statements by OppenheimerFunds violated Section 34(b) of the Investment Company Act of 1940, Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, Section 206(4) of the Investment Advisers Act of 1940. The order also found that the broker-dealer subsidiary violated Sections 17(a)(2) and 17(a)(3) of the Securities Act.
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