Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-cand-3_08-cv-01733/USCOURTS-cand-3_08-cv-01733-16/pdf.json

Nature of Suit Code: 850
Nature of Suit: Securities, Commodities, Exchange
Cause of Action: 15:78m(a) Securities Exchange Act

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United States District Court

For the Northern District of California

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IN THE UNITED STATES DISTRICT COURT

FOR THE NORTHERN DISTRICT OF CALIFORNIA

IN RE: 

CHARLES SCHWAB CORPORATION

SECURITIES LITIGATION.

This Document Relates

To All Cases.

 /

No. C 08-01510 WHA

ORDER RE 1940 ACT

SUMMARY JUDGMENT

MOTIONS

When a mutual fund attracts investors based on a diversification policy expressly

limiting investments in uninsured mortgage-backed securities or any other industry to

25 percent or less of the fund, this order holds that a shareholder vote is required before the

fund may reverse field and concentrate more than 25 percent in uninsured mortgage-backed

securities or in any other industry. That is, once they have gathered in the investments, the fund

managers and promoters must honor the stated concentration policy and may exceed the limit

only after a shareholder vote. This is required by Section 13(a) of the Investment Company Act

of 1940, 15 U.S.C. 80a–13(a). 

* * *

The 1940 Act was aimed at regulating “investment companies,” commonly referred to

today as “mutual funds.” One of the abuses that provoked the Act was a practice of attracting

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investors based on an announced investment policy and then, after having investors’ money in

hand, radically changing the investment policy. As the Senate Report stated: 

A major problem in the case of management companies is created

by the absence of any legal requirement for adherence to any

announced investment policies or purposes. Such policies have

often been radically changed without the knowledge or prior

consent of stockholders. 

Sen. Rep. No. 1775, 76th Cong., 3d Sess. at 7 (1940). 

The House Report was in accord. See House Rep. No. 2639, 76th Cong., 3d Sess. at 9

(1940). A congressional finding in the Act’s preamble stated that the national public interest and

the interests of investors were adversely affected when investment companies were reorganized,

become inactive or “change[d] the character of their business.” 

To remedy this abuse, Section 8(b) required that the registration statements set forth

“the policy of the registrant in respect of” a list of activities, one of which was “concentrating

investments in a particular industry or group of industries” as well as, separately, any matter

deemed by the registrant to be a “fundamental policy.” To prevent unilateral alteration of the

concentration policy or, for that matter, any fundamental policy, Section 13(a) further stated: 

No registered investment company shall, unless authorized by a

vote of a majority of its outstanding voting securities — 

* * *

(3) deviate from its policy with respect of concentration of

investments in any particular industry or group of

industries as recited in its registration statement, or deviate

from any fundamental policy recited in its registration

statement . . . . 

In sum, the 1940 Act established that once a mutual fund registered a policy in respect of

concentration of investments in an industry, it could deviate from that policy only by a majority

vote of the shareholders. 

* * *

Turning to the facts at hand, the fund in question is the Schwab YieldPlus Fund. 

From at least November 2001 until February 2006, it had an announced diversification strategy. 

In 2001, it amended its registration statement to state that it would treat mortgage-backed

securities issued by private lenders and not federally guaranteed as a stand-alone industry. 

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By defining uninsured mortgage-backed securities to be a stand-alone industry, the fund was

enabled to invest a full quarter of the fund in such securities in addition to investments in

whatever other industries might have comprehended such securities before the change. 

While this may have enlarged the manager’s freedom of movement at the time, it also introduced

a limitation if and when the 25-percent mark was ever reached for uninsured mortgage-backed

securities. This limitation remained in place for five years. For example, the fund’s statement

of additional information, set forth the limitation as follows (with passages of interest in italics): 

The following descriptions of investment securities, risks and

limitations supplement those set forth in the prospectus and may be

changed without shareholder approval unless otherwise noted. 

* * *

Concentration means that substantial amounts of assets are

invested in a particular industry or group of industries. 

Concentration increases investment exposure. Based on the

characteristics of mortgage-backed securities, each fund has

identified mortgage-backed securities issued by private lenders

and not guaranteed by U.S. government agencies or

instrumentalities as a separate industry for purposes of a fund’s

concentration policy. For purposes of a fund’s concentration

policy, the fund will determine the industry classification of

asset-backed securities based upon the investment adviser’s

evaluation of the risks associated with an investment in the

underlying assets. For example, asset-backed securities whose

underlying assets share similar economic characteristics because,

of example, they are funded (or supported) primarily from a single

or similar source or revenue stream will be classified in the same

industry sector. In contrast, asset-backed securities whose

underlying assets represent a diverse mix of industries, business

sectors and/or revenue streams will be classified into distinct

industries based on their underlying credit and liquidity structures. 

A fund will limit its investments in each identified industry to less

than 25% of its total assets. 

Pages later, the SAI set forth another list of “investment limitations” that were

changeable “only by a vote of a majority of a fund’s outstanding voting shares.” Without a

shareholder vote, the SAI stated that the fund would not: 

2) Concentrate investments in a particular industry or group of

industries, as concentration is defined under the 1940 Act, or the

rules or regulations thereunder, as such statute, rules and

regulations may be amended from time to time; and 

* * *

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Concentration. The SEC has presently defined concentration as

investing 25% or more of an investment company’s net assets in an

industry or group of industries, with certain exceptions. 

* * *

6) Purchase securities (other than securities issued or guaranteed

by the U.S. government, its agencies or instrumentalities) if, as a

result of such purchase, 25% or more of the value of its total assets

would be invested in any industry or group of industries. 

(SCH11332596 and SCH11332600). 

In other words, the fund’s stated concentration policy was to diversify, i.e., not to

concentrate more than 25 percent of the fund in uninsured mortgage-backed securities or in any

other industry. Such mortgage-backed securities were specifically called out as an industry

subject to the 25-percent limit. 

After five years, however, and after having attracted large sums, the fund managers

reversed field and repudiated the 25-percent limitation. This was stated in the SAI as of

September 1, 2006, as follows: 

Concentration means that substantial amounts of assets are

invested in a particular industry or group of industries. 

Concentration increases investment exposure. For purposes of a

fund’s concentration policy, the fund will determine the industry

classification of asset-backed securities based upon the investment

adviser’s evaluation of the risks associated with an investment in

the underlying assets. For example, asset-backed securities whose

underlying assets share similar economic characteristics because,

for example, they are funded (or supported) primarily from a single

or similar source or revenue stream will be classified in the same

industry sector. In contrast, asset-backed securities whose

underlying assets represent a diverse mix of industries, business

sectors and/or revenue streams will be classified into distinct

industries based on their underlying credit and liquidity structures. 

A fund will limit its investments in each identified industry to less

than 25% of its total assets. 

* * *

The funds have determined that mortgage-backed securities issued

by private lenders do not have risk characteristics that are

correlated to any industry and, therefore, the funds have

determined that mortgage-backed securities issued by private

lenders are not part of any industry for purposes of the funds’

concentration policies. This means that a fund may invest more

than 25% of its total assets in privately-issued mortgage-backed

securities, which may cause the fund to be more sensitive to

adverse economic, business or political developments that affect

privately-issued mortgage-backed securities. Such developments

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may include changes in interest rates, state or federal legislation

affecting residential mortgages and their issuers, and changes in

the overall economy. 

(SCHYP0002098). 

Note well that this action not only abrogated the 25-percent limitation on uninsured

mortgage-backed securities but even went so far as to say that such securities were not part of

“any industry,” thereby raising the 25-percent limit to 100 percent. Put differently, since such

securities were not part of “any industry,” the promoters were now claiming the authority to

invest everything in such securities, since to do so would not concentrate in “any industry.” 

This was a phenomenal turnabout. 

This was done unilaterally by the fund managers and without any shareholder vote. 

No notice was sent to investors of the reversal in policy. They had no occasion to consult the

registration statements, as amended, having already made their investment. 

In short, for five years the registered policy in respect of concentration committed to

invest no more than one fourth of the fund in uninsured mortgage-backed securities or in any

other industry. The strategy was to employ diversification to guard against a precipitous decline

in a single industry. Under the 1940 Act, this registered concentration policy could be reversed

only by a majority vote of the shareholders. To rule otherwise would allow the very abuse that

led to the 1940 Act. Therefore, Section 13 was violated by the unilateral repudiation of the

concentration limitation. 

* * *

It is true that the industry definition was set forth in the SAI under the banner of matters

that could be changed without shareholder vote “unless otherwise noted.” This does not mean

a shareholder vote was not required to exceed the limit. The most direct reason is that a fund

promoter cannot proclaim self-serving reservations of power denied to it by the 1940 Act. 

This is not a disclosure question. It is a governance question. As a matter of governance, the

1940 Act insisted that reversals in concentration policy be approved by those that actually own

the fund, not merely by the managers. 

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Even as a matter of disclosure, however, the SAI should not be stretched as far the

defense now proposes. The stated concentration policy was to diversify and to limit investment

in a single industry to one-quarter of the fund. This was expressly stated to require shareholder

approval to change. The industry definition appeared under a long list of things that could be

changed without shareholder vote “unless otherwise noted.” Later in the SAI, of course, the

concentration policy was “otherwise noted” as something requiring a shareholder vote to change. 

The industry definition was placed in a paragraph entitled “Concentration.” It expressly

referenced the fund’s concentration policy. It even restated it. The industry definition would

have been understood by reasonable investors to be an integral part of the concentration policy

represented to be inviolate without shareholder approval. So the disclosure itself, read in the

way reasonable investors would have understood it, disclosed the opposite of what the promoter

now supposes. 

* * *

There is no merit in the notion that an investment policy not to concentrate is less

regulated (or not regulated at all) under the 1940 Act. Under Section 8(b)(1), the registration

statement must include “a recital of the policy of the registrant in respect of each of the

following types of activities . . . (E) concentrating investments in a particular industry or group

of industries . . . .” By this passage, therefore, the registrant must explain whatever its policy on

concentration will be, even if the strategy is to diversify and thus not to concentrate. In turn,

Section 13(a) requires a shareholder vote to deviate from a policy in respect of concentration

of investments in any particular industry or group of industries . . . .” The Act uses the phrase

“in respect of.” This requires up-front disclosure of the extent to which the strategy would or

would not concentrate so that investors would understand the risks and rewards, diversification

usually being less risky but less rewarding than concentration. 

To rule otherwise would reintroduce one of the pernicious abuses that specifically led to

the 1940 Act, namely funds that drew in savings based on supposed diversification policies only

to be squandered in a single industry that collapsed. The Commission study that served as the

Act’s foundation catalogued these abuses. For example, General Investment Company, which

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was formed to invest in diverse public utilities instead invested nearly all of its assets in a

subway in Buenos Aires, which the investment company later sold for a loss of nearly ninety

percent. REPORT OF THE SECURITIES AND EXCHANGE COMMISSION ON INVESTMENT TRUSTS

AND INVESTMENT COMPANIES, Pt. I, H.R. Doc. 279, 76th Cong., 1st Sess. at 497, 592–601

(1939). Similarly, Eastern Utilities Investing Corporation claimed that it would diversify its

investments among the securities “of a number” of public utilities, but in reality it placed nearly

all of its assets in a single company, with disastrous results. Id. at 624–28. Investors in the

United Founders Corporation Group, which promised international diversification of assets, lost

significant sums after the company concentrated in domestic securities just as the Untied States

market crashed in 1929. Id., Pt. III at 2224–30. 

Congress relied on this study when it created the Act, and the Supreme Court has referred

to it when interpreting the Act. United States v. NASD, 422 U.S. 694, 706 (1975) (The study

“as Congress has recognized, see 15 U.S.C. § 80a-1, forms the initial basis for any evaluation

of the Act”). See also 15 U.S.C. § 80a-1(a)–(b) (making findings and declarations “upon the

basis of facts disclosed by the record and reports of the Securities and Exchange Commission”). 

To the Senate Committee, the chief counsel of the Commission explained the phrase

“in respect of” in the proposed bill, which was soon thereafter enacted. He stated (emphasis

added): 

Mr. Schenker [Chief Counsel]. In the registration statement,

Senator, they are required to set forth what their investment policy

is going to be with regard to specific items. 

 If you will look on page 20, these are some of the things we

consider fundamental to investment policy. Starting with line 8: 

(1) a statement in respect of the policy of the registrant

in respect of — 

whether you are going to be diversified or nondiversified; do you

expect to issue senior securities; do you expect to engage in the

underwriting business; do you expect to have concentration of

investments in a particular industry or group of industries — like a

chemical fund or an aviation fund; do you expect to deal in real

estate and commodities, or either of them, or loans to other

persons; what is your policy with respect to portfolio turnover; do

you expect to have a rapid or slow turnover, and so forth? In order

to give a little rubber, we say that the company should not be

hamstrung by those recitals but should have some freedom of

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 There is no caselaw on the issue and this order rests on the plain language of the Act and its

legislative history. The literature is in accord. 3 Tamar Frankel, “The Regulation of Money Managers,”

ch XVIII, § 2 at 15 (1980); Lemke, “Regulation of Investment Companies,” § 7.10[2] at 7-59 (2009); Ansberry,

“Investment Company Act of 1940,” 29 Geo. L.J. 614, 622 (1941); Jaretzki, “The Investment Company Act of

1940,” 26 Wash. U.L.Q. 303, 317 (1941); Note, “The Investment Company Act of 1940,” 50 Yale L.J. 440,

444–45 (1941); Note, “The Investment Company Act of 1940,” 41 Colum. L. Rev. 269, 285–86 (1941). 

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action. However, the statement of policy will indicate to all

persons what general type the company is going to be. As the

company enumerates these policies in its registration statement, it

will not be able to change them without a majority vote. 

Hearings on S. 3580 before a Subcommittee of the Senate Committee on Banking and Currency,

Pt.4, 76th Cong., 3d Sess., at 1115–16 (1940). 

It was abundantly clear in 1940 that the Act required the registration statement to state

whether the fund was going to be diversified or nondiversified — either way.1 

* * *

It is true that the Commission’s Form N-1A in 2006 divided the information required for

a prospectus into two broad parts, those required for the prospectus and those required for the

SAI, the former being deemed “essential” information and the latter being “useful” information. 

Item 4 of the former was to describe the “Investment Objectives, Principal Investment Strategies,

and Related Risks,” including “any policy to concentrate on securities of issuers in a particular

industry or group of industries (i.e., investing more than 25% of a Fund’s net assets in a

particular industry or group of industries).” Item 4 also required disclosure in the main

prospectus of “any other policy specified in Item 12(c)(1) that is a principal investment strategy

of the Fund.” Item 12 pertained to the SAI. Item 12 required disclosure of the risks of

“concentrating investments in a particular industry or group of industries” as well as “Any other

policy that the Fund deems fundamental or that may not be changed without shareholder

approval, including, if applicable, the Fund’s investment objectives.” The SAI was also required

to state “whether shareholder approval [was] necessary to change any policy” set forth in

Item 12(c)(1). 

Although Form N-1A distinguished between “essential” information versus “useful”

information in comparing the main prospectus with the SAI, the instructions for the form

contemplated that fundamental strategies would be set forth in the SAI, including those requiring

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 Schwab itself was not misled by this instruction in the form and disclosed its diversification policy. 

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a shareholder vote. Some of those were then to be re-duplicated under item 4 via its

cross-reference to item 12 (pertaining to SAI’s). 

The most that can be said is that the instructions called out strategies “to concentrate” and

omitted to call out (anywhere) strategies “not to concentrate.” This minor circumstance cannot

override the clear intent and language of the 1940 Act. And, the amicus brief of the Commission

on this very motion is decidedly against any such distinction. Perhaps the Commission should

consider whether to revise its form but this order will follow the 1940 Act. Whatever policy may

be adopted — to diversify or to concentrate — deviations are permitted only by approval of

a majority of shareholders.2

 

* * *

It is true that the 1940 Act did not define “industry or group of industries.” Nor has the

Commission done so except to the limited guidance it once gave by referring to standard

industry classifications in its now-withdrawn Guide 19. This order agrees, as said by the

defense, that a promoter is free to define an industry in any reasonable way when it establishes a

fund and assumes for the sake of argument that the promoter may unilaterally, even after the

fund is up and running, clarify in a reasonable way a definitional line that may otherwise be

vague. But once the promoter has drawn a clear line and thereafter gathers in the savings of

investors, the promoter must adhere to the stated limitation unless and until changed by a

stockholder vote. 

Here, the promoter drew a clear line and expressly stated it would not invest more than

one-fourth of the fund in uninsured mortgage-backed securities and defined those instruments

as a stand-alone industry. That was clear. Having done so, the shareholders in the fund were

entitled to count on that limitation unless and until changed by a vote of the shareholders. 

Yes, it is true that in 2001 the promoters — without shareholder vote — decided to treat

uninsured mortgage-backed securities as a stand-alone industry and placed that definition in the

amended registration statement. That this was done without a shareholder vote, however, does

not mean that the 2006 reversal could likewise be done without a shareholder vote. It must be

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said that the 2001 change would have required a vote had it been done to exceed the 25-percent

limitation on what was already an identifiable industry by simply “defining” part of that industry

to be a stand-alone industry. In that way, half of the entire fund could be split between the

“new” industry and the rest of the “old” industry. However that might have been, and even

assuming that the 2001 change merely clarified an otherwise vague line, the fact is that the 2001

change drew a clear line around uninsured mortgage-backed securities. Based thereon, the

promoters attracted many millions into the fund. Five years passed with the limit in place. In

2006, the reversal was not a mere clarification of an otherwise blurred line. It was an entire

repudiation of a clear-cut definition that had become a fixture of the fund on which shareholders

were entitled to depend for the safety of their savings. A vote was required. 

* * *

To the foregoing extent, plaintiffs’ motion for summary judgment is GRANTED and

defendant’s motion is DENIED.

IT IS SO ORDERED.

Dated: March 30, 2010. 

WILLIAM ALSUP

UNITED STATES DISTRICT JUDGE

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