Randall Merk, a former executive for Charles Schwab & Co. Inc., has agreed to pay a civil penalty of $150,000 and be suspended for one-year to settle charges of fraud and misleading investors

On Nov. 21, the SEC announced that Merk signed a consent and a proposed final judgment against him without admitting or denying the allegations.

The unlawful conduct related mostly to the Schwab YieldPlus Fund, the former flagship fixed-income mutual fund advised by Charles Schwab & Co. Inc. and Charles Schwab Investment Management (CSIM). Merk was the president of CSIM, an executive vice president of the parent company, and a trustee of YieldPlus.

SEC’s Antonia Chion

Antonia Chion, associate director of the SEC’s Division of Enforcement, said in a statement that Schwab marketed YieldPlus as a cash alternative with only slightly more risk than a money market fund, when in reality, more than half the fund’s assets were invested in mortgage-backed securities at one point. Mortgage-backed securities, as well as other securities in which the fund invested, were of a much lower credit quality than the kinds of investments typically made by money market funds.

SEC’s Findings

The SEC found that YieldPlus assets were invested in these high-risk securities without the required shareholder approval. About 50 percent was invested in private-issuer mortgage-backed securities, despite the fact that this high concentration went against the policy stated in the fund’s SEC filings.

As a result, YieldPlus lost more than $10 billion during the credit crisis of 2007 and 2008. The fund’s assets fell from a peak of $13.5 billion in 2007 to $1.8 billion during an eight-month period due to redemptions and declining asset values, according to the information released by the SEC.

The Companies Settle With SEC

The companies settled with the SEC back in January shortly after the charges were brought, agreeing to pay a penalty of $118 million which the SEC has requested to be placed in a fund to reimburse investors. The SEC has requested that Merk’s penalty be added to that fund. Litigation is continuing against Kimon Daifotis, the lead portfolio manager of YieldPlus.

Charges against the companies included making misleading statements regarding YieldPlus and failing to supervise by establishing, maintaining and enforcing policies and procedures to prevent the misuse of material, nonpublic information.

Merk and Daifotis Charged

The two executives were charged in a different complaint that alleged they engaged in fraudulent and deceptive conduct in violation of federal securities laws when they were senior officials of CSIM between 2005 and mid-2008.

Merk and Daifotis were also charged with violating — and aiding and abetting violations of — securities laws involving shareholder voting rights, disclosure and reporting requirements.

According to the Complaint

By 2006, Merk was part of a campaign to market YieldPlus to the investing public as a “cash equivalent investment” only slightly more risky than familiar cash products like certificates of deposit or money market funds. The SEC charged that Merk either knowingly or recklessly participated in these offers and sales.

In addition, the complaint alleged that Merk knowingly or recklessly misrepresented material facts, or omitted material facts, about the nature of the YieldPlus investments. The descriptions were materially false and misleading because YieldPlus was much riskier than the products to which it had been compared.

YieldPlus also had a longstanding concentration policy, filed with the SEC, that indicated the fund would not invest more than 25 percent of its assets in non-agency, mortgage-backed securities. Non-agency refers to securities issued by private entities and not backed by any federal agencies or government-sponsored enterprises.

A deviation from a stated concentration policy violates Section 13(a) of the Investment Company Act if approval is not obtained from a majority of outstanding shareholders of a fund.

The complaint stated that YieldPlus deviated from its concentration policy by early 2006, through the knowing or reckless actions of Daifotis, who is still embroiled in litigation with the SEC. In his role of trustee of YieldPlus, Merk voted to allow the over-concentration.

Daifotis also submitted reports to the SEC that were not clear about what was transpiring at the fund. Both executives were charged with submitting false and misleading reports and certifications to the SEC. The reports did not fully and accurately disclose that YieldPlus and other funds had deviated from their concentration policy without shareholder approval, the complaint said.

When the net asset value of YieldPlus began to decline in the summer of 2007, many investors were surprised, in no small part because of the way the fund had been marketed, the complaint said. Quite a few of them redeemed their investments when the net asset value fell only slightly. These redemptions forced the fund’s portfolio managers to sell assets in a depressed market to raise cash.

From about August 2007 through at least March 2008, the complaint said that Merk and Daifotis knowingly or recklessly made a series of materially false and misleading statements in written materials and during conference calls about YieldPlus in an effort to keep investors from making a run on the fund.

For example, the complaint said that in August 2007, Daifotis assured independent investment advisers and Schwab’s brokers that the negative flows were slights and that outflows were minimal, though he knew that YieldPlus was actually hemorrhaging money.

At the time, YieldPlus had experienced more than $1.2 billion in redemptions during the two weeks prior, which caused the fund to sell more than $2.1 billion of its securities, the complaint said.

In addition, as part of the effort to discourage investors from redeeming their YieldPlus positions, Merk approved a series of redemptions of YieldPlus investments by a group of other Schwab-related mutual funds, the complaint said. He did so even though he knew material, nonpublic information about YieldPlus, and knew that a portfolio manager involved in the redemptions also had such material, nonpublic information.

When Merk agreed to settle with the SEC on Nov. 21, he signed a consent to an entry of final judgment permanently enjoining him from violating various sections of the Investment Company Act of 1940, including Section 34(b) which prohibits the making of untrue statements of material fact, or material omissions, in documents filed with the SEC.

Merk also agreed to pay the $150,000 civil penalty. If the federal court approves the proposed judgment, an administrative proceeding will suspend Merk for 12 months from associating with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization, and from participating in any penny stock offering, the complaint said.

Guiliano Law Firm

The practice of Nicholas J. Guiliano, Esq., and The Guiliano Law Firm, P.C., is limited to the representation of investors in claims for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost to unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.

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