Source: https://www.scribd.com/document/46681391/SEC-Complaint-Against-Schwab-Executives
Timestamp: 2016-12-04 21:12:19
Document Index: 704119343

Matched Legal Cases: ['§ 80', '§ 80', '§ 77', '§ 78', '§ 80', '§ 80', '§ 77', '§ 78', '§ 80', '§ 80', '§80', '§ 80', '§ 80', '§ 80', '§80', '§ 80', '§78', '§ 240', '§ 78', '§ 240', '§78', '§ 240', '§ 78', '§ 240', '§ 78', '§ 77', '§ 77', '§ 80', '§ 80', '§ 80', '§ 275', '§ 80', '§ 275', '§80', '§80', '§ 80', '§80', '§80', '§80', '§ 80', '§ 80', '§ 80', '§ 80', '§ 77', '§ 78', '§ 240', '§ 80', '§ 80', '§ 275', '§ 80', '§ 77', '§ 78', '§ 240', '§ 80', '§ 275', '§ 80', '§ 77', '§ 78', '§ 80', '§ 80']

David 1. Gottesman (Trial Counsel) (Illinois Bar No. 6182719) (gottesmand@sec.gov) Frederick L. Block Antonia Chion Robert A. Cohen Melissa R. Hodgman David S. Mendel Attorneys for Plaintiff SECURITIES AND EXCHANGE COMMISSION 100 F Street, N.E. Washington, DC 20549-4030 Telephone: (202) 551-4470 (Gottesman) Facsimile: (202) 772-9245 (Gottesman) UNITED STATES DISTRICT COURT NORTHERN DISTRICT OF CALIFORNIA SAN FRANCISCO DIVISION SECURITIES AND EXCHANGE COMMISSION, Plaintiff, vs. KIMON P. DAIFOTIS and RANDALL MERK, Defendants. Case No. COMPLAINT DEMAND FOR JURY TRIAL Plaintiff Securities and Exchange Commission (the "Commission") alleges: SUMMARY OF THE ACTION 1. Between 2005 and mid-2008, defendants Kimon Daifotis ("Daifotis") and Randall Merk ("Merk") were senior officials of Charles Schwab Investment Management, Inc. ("CSIM"), and employees or officers of Charles Schwab & Co., Inc. ("CS&Co."), both of which provided investment advisory and other services to Schwab Investments. Daifotis and Merk engaged in fraudulent and deceptive conduct in violation of the antifraud provisions of COMPLAINT -1­
the federal securities laws, and also violated and aided and abetted violations of various other provisions of the securities laws involving shareholder voting rights, disclosure and reporting requirements. 2. Defendants' unlawful conduct primarily relates to the Schwab YieldPlus Fund ("YieldPlus" or the "Fund"), the former flagship fixed-income mutual fund advised by CSIM and CS&Co. At its peak in 2007, YieldPlus had $13.5 billion in assets and 200,000 accounts, and was the largest ultra-short bond fund in its category. A. Fraudulent Offer and Sale of YieldPlus 3. By 2006, Merk, acting knowingly or recklessly, substantially participated in directing a campaign to offer, sell, and market YieldPlus to the investing public as a cash alternative or cash equivalent investment, with only "slightly" or "marginally" more risk than cash products, such as certificates of deposit ("CDs") or money market funds. 4. Merk and Daifotis knowingly or recklessly made or substantially participated in making misrepresentations and omissions of material fact about YieldPlus, such as its supposedly being comparable to cash investments or money market funds. 5. The descriptions of YieldPlus were materially false and misleading because, for example, YieldPlus was substantially riskier than cash products such as CDs and money market funds, but defendants failed to disclose the material facts regarding such risks. B. Unlawful Deviations From Fund Concentration Policy 6. Daifotis, as lead portfolio manager, along with CSIM and CS&Co., as the Fund's advisers, directed the investments of the Fund. Daifotis approved the Fund's investment in assets that violated the Fund's "concentration policy." The Fund's long­
standing concentration policy provided that the Fund would not invest more than 25 percent of assets in non-agency, mortgage-backed securities ("MBS"), i.e., MBS issued by private COMPLAINT -2­
entities and not backed by federal agencies or government-sponsored enterprises. Pursuant to Section 13(a) of the Investment Company Act [15 U.S.c. § 80a-13(a)], YieldPlus could not deviate from that policy without first obtaining authorization by a vote of the majority of YieldPlus's outstanding shareholders. 7. Through the knowing or reckless actions of Daifotis, the Fund deviated from its concentration policy by at least early 2006, and violated the Investment Company Act, by investing more than 25 percent of its assets in non-agency MBS without shareholder approval. 8. As a trustee, Merk voted to change the treatment of non-agency MBS and to allow the Fund's investment advisers to concentrate the Fund's assets in those investments, even though the concentration was a deviation from the Fund's concentration policy and was not authorized by a shareholder vote. 9. Daifotis knew, or was reckless in not knowing, that reports and other filings with the Commission effectively masked the Fund's violation of its concentration policy. Although Daifotis reviewed and was able to edit various of such filings, he failed to make those materials adequately or appropriately disclose the deviation. 10. Daifotis also substantially assisted other funds, including but not limited to the Schwab Total Bond Market Fund ("Total Bond Fund"), in violating the Investment Company Act [15 U.S.c. § 80a-13(a)] by deviating from their concentration policy without shareholder approval. 11. Daifotis and Merk knew, or were reckless in not knowing, that they had submitted, or caused to be submitted, false and misleading reports and certifications to the Commission that failed to properly, fully, and accurately disclose the material fact that the funds described above had deviated from their concentration policy without shareholder approval. COMPLAINT -3­
1 2 3 '4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 C. False and Misleading Statements and Other Fraudulent Conduct During the Fund's Decline 12. In the summer of2007, YieldPlus's net asset value ("NAY") began to decline as its assets lost value. Many investors expected YieldPlus's NAY to fluctuate only minimally, at least in part because of the way the Fund had been marketed. A significant number of investors redeemed their investments when the NAY fell by more than a few pennies. Because YieldPlus did not have cash holdings, the redemptions forced YieldPlus's portfolio managers to sell assets in a depressed market to raise cash. 13. In a series of communications, including written materials and conference calls between at least August 2007 through at least March 2008, defendants knowingly or recklessly made a series of materially false and misleading statements and omissions of material fact about YieldPlus, and knowingly provided substantial assistance to others' misrepresentations, in an effort to dissuade YieldPlus investors from redeeming their investments. For example, in August 2007, Daifotis assured independent investment advisers and Schwab's registered representatives who were to communicate with Schwab's investors that "we've got very, very, very slight negative flows" from the Fund, or that the Fund had "minimal" outflows, when he knew that the Fund actually was suffering massive outflows. D. Redemptions By Other Schwab-Related Funds 14. During the effort to discourage most investors from redeeming their YieldPlus investments, Merk approved a series of redemptions of YieldPlus investments by a group of other Schwab-related mutual funds. Merk did so even though he knew material, nonpublic information about YieldPlus and knew that a portfolio manager involved in the redemptions had material, nonpub1ic information about the Fund. COMPLAINT -4­
E. Impact 15. During an eight-month period from 2007 to 2008, YieldPlus's NAV dropped 28 percent and its assets plummeted from $13.5 billion to $1.8 billion. To date, YieldPlus's NAV has declined by 50 percent and its assets are below $200 million. As a result of defendants' false and misleading statements and other misconduct, YieldPlus's investors lost hundreds of millions of dollars. 16. Unless enjoined, defendants are likely to engage in future violations of the securities laws. Accordingly, as to each defendant, the Commission seeks an injunction against future violations of the particular securities laws identified in the prayer for relief, disgorgement of ill-gotten gains with prejudgment interest, and civil money penalties. JURISDICTION AND VENUE 17. This Court has jurisdiction over this action under Sections 20(b), 20(d) and 22(a) of the Securities Act of 1933 ("Securities Act") [15 U.S.c. §§ 77t(b), 77t(d) and 77v(a)]; Sections 21(d), 21(e) and 27 of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.c. §§ 78u(d) and (e), and 78aa]; Sections 42(d), 42(e) and 44 of the Investment Company Act of 1940 ("Investment Company Act") [15 U.S.c. §§ 80a-41(d), (e) and 80a­
43]; and Sections 209(d), 209(e) and 214 of the Investment Advisers Act of 1940 ("Advisers Act") [15 U.S.c. §§ 80b-9(d), (e) and 80b-14]. Defendants have made use, directly or indirectly, of the means or instrumentalities of interstate commerce, of the means or instruments of transportation or communication in interstate commerce, of the mails, or of the facilities of a national securities exchange, in connection with the transactions, acts, practices, and courses of business alleged in this Complaint. 18. Venue is appropriate in this Court under Section 22(a) of the Securities Act [15 U.S.c. § 77v(a)]; Section 27 of the Exchange Act [15 U.S.c. § 78aa], Section 44 of the COMPLAINT -5­
Investment Company Act [15 U.S.c. § 80a-43]; and Section 214 of the Advisers Act of [15 U.S.C. § 80b-14], because certain of the acts or transactions constituting the violations alleged herein occurred in this judicial district. INTRADISTRICT ASSIGNMENT 19. Assignment to the San Francisco Division is appropriate pursuant to Civil Local Rule 3-2(d) because a substantial part of the events or omissions that give rise to the Commission's claims occurred in San Francisco County and one or more related class actions are pending in the San Francisco Division. DEFENDANTS 20. Kimon Daifotis, 51, resides in Corte Madera, California. Daifotis was employed by CS&Co. and was a Senior Vice-President and ChiefInvestment Officer - Fixed­
income at CSIM until his position was eliminated in July 2008. At all relevant times until his position was eliminated, Daifotis was lead portfolio manager for YieldPlus, the Total Bond Fund, and the Schwab Short-Term Bond Fund ("Short-Term Bond Fund"). Daifotis was actively involved in the day-to-day operations of YieldPlus, the Total Bond Fund, and the Short-Term Bond Fund. Among other things, Daifotis was responsible for directing the funds' investments and was actively involved in the offer, sale, and marketing of YieldPlus. From at least July 2007 until his departure, Daifotis reported to Randall Merk. At all relevant times, Daifotis has had Series 3, 7 and 63 licenses. Daifotis continues to serve as a paid consultant to Schwab-related entities. 21. Randall Merk, 56, resides in Menlo Park, California. Merk is and at all relevant times was an Executive Vice President at Charles Schwab Corporation and was an Executive Vice President at CS&Co. From July 2007 until December 2010, Merk served as President ofCSIM, and, at all relevant times until 2007, was a trustee of YieldPlus and the COMPLAINT -6­
other funds identified herein. At all relevant times, Merk has had a Series 24 license. Merk was actively involved in the offer, sale, and marketing of YieldPlus. RELEVANT ENTITIES 22. Charles Schwab Investment Management, Inc. ("CSIM") is a San Francisco-based, wholly-owned subsidiary of the Charles Schwab Corporation. CSIM was incorporated in Delaware in October 1989 and has been a registered investment adviser since January 25, 1990. CSIM manages the assets of registered and unregistered investment companies, including YieldPlus, the Total Bond Fund, the Short-Term Bond Fund, and other Schwab Funds. CSIM is the primary investment adviser of those funds. 23. Charles Schwab & Co., Inc. ("CS&Co.") is a wholly-owned subsidiary of Schwab Holdings, Inc., which is a wholly-owned subsidiary of the Charles Schwab Corporation. CS&Co. was incorporated in California in 1971. CS&Co. is a registered broker-dealer, transfer agent, and investment adviser. CS&Co. provided advisory, shareholder, and distribution services to the funds described herein, and at all relevant times, served as the distributor and transfer agent for funds, including YieldPlus, the Total Bond Fund, the Short-Term Bond Fund, and other Schwab Funds. CS&Co. also provided personnel who performed advisory, marketing, legal, and compliance services to those funds. 24. Schwab Investments is a no-load, open-end management investment company organized as a Massachusetts business trust and is registered under the Investment Company Act as of October 26,1990. YieldPlus, the Total Bond Fund, and the Short-Term Bond Fund are series of mutual funds issued by Schwab Investments. COMPLAINT -7­
FACTUAL ALLEGATIONS A. False and Misleading Statements and Omissions, and Other Fraudulent Conduct In the Offer and Sale of YieldPlus 25. From at least 2005 through at least mid-2008, as discussed below, Daifotis and Merk made, substantially participated in making, or knowingly provided substantial assistance in the making of misrepresentations and omissions of material material fact with regard to the offer and sale of YieldPlus, including but not necessarily limited to those set forth in this Section A. 26. As shown below, in statements disseminated to the public, CSIM and CS&Co. described YieldPlus as a cash "alternative" or "equivalent" that generated a premium yield and was only minimally riskier than a money market fund, compared YieldPlus to insured CDs, and emphasized that YieldPlus's NAV was stable because, although it "may fluctuate minimally" and/or would fluctuate, it had fluctuated by only pennies in recent years. 27. Daifotis and Merk knew, or were reckless in not knowing, about these descriptions and they directly and substantially participated in the making of such statements to the public. Daifotis and Merk reviewed and approved the general approach of describing the Fund in this manner, and they reviewed and approved various specific advertisements containing these mistatements. Various of the false and misleading statements therein were directly attributed to Daifotis, as shown more fully below. 28. Daifotis and Merk knew, or were reckless in not knowing, that these communications were materially false and misleading because, in the various ways described below, YieldPlus was significantly riskier than money market funds, CDs, and other cash or cash-equivalent products, and its NAV had fluctuated significantly more than the three cents or pennies advertised. For example, at various times between 1999 (when the Fund was COMPLAINT -8­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 established) and 2003, the Fund's NAV sometimes fluctuated by six cents or more in just one day, by more than 15 cents in a month, and by 34 cents over a ten-month period. It was misleading and deceptive to characterize YieldPlus as a cash alternative or cash equivalent without fully disclosing the ways in which YieldPlus was fundamentally and substantially riskier than such products. 29. Daifotis and Merk also knew, or were reckless in not knowing, that these statements grew even more misleading over time because the Fund grew riskier as it concentrated in non-agency MBS. Daifotis directed the investments that caused this increased risk, and at least by late August 2006, Merk approved such investments. 1. YieldPlus Was Substantially Riskier Than Cash Products, Such as CDs and Money Market Funds 30. Daifotis and Merk knew, or were reckless in not knowing, that in the ways described below, YieldPlus materially differed from CDs and money market funds in ways which made the Fund fundamentally and significantly riskier than those and other cash or cash-equivalent products to which it was compared. 31. Lack ofInsurance. Investments in YieldPlus were not insured, as are CDs. 32. Maturity. From at least 2005 through at least mid-2008, the average maturity of YieldPlus's portfolio was significantly longer than the average maturities of money market funds. During the relevant period, under rules promulgated by the Commission under the Investment Company Act, a money market fund was required to have an average portfolio maturity of no more than 90 days and could not acquire any security with a remaining maturity of more than 397 days. In contrast, YieldPlus's average maturity was at least one­
and-one-halfto t:.wo years and, by one measure, reached four years in mid-2007, and a substantial portion of the Fund's assets were invested in securities with remaining stated COMPLAINT -9­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 maturities of more than 20 years. Ninety percent or more of YieldPlus's holdings could not have been held by a money market fund. 33. The Fund's concentration in non-agency MBS, beginning at least by 2006 (described more fully below), which Daifotis directed and Merk ultimately approved in late August 2006, caused the Fund's average maturity to increase. 34. In mid-2007, at the beginning of the period when the Fund's NAV declined dramatically, only 6 percent of YieldPlus's assets-$675 million of $11 billion in assets-
were scheduled to mature within the next six months. This was drastically different from a money market fund's average portfolio maturity of90 days. 35. The longer maturities of the securities owned by YieldPlus exposed the Fund to increased risk, including liquidity and default risk. Such liquidity risk contributed to the Fund's decline during the credit crisis of2007-2008. For example, when faced with redemptions, a money market fund largely is able to rely on frequently maturing securities to raise cash at par. In contrast, YieldPlus was forced to sell securities in a depressed market because its securities did not mature frequently. 36. Daifotis and Merk knew, or were reckless in not knowing, the facts above. Despite the Fund's longer average maturity, Merk, Daifotis, CSIM, and CS&Co. classified YieldPlus as an ultra-short bond fund because of its short "duration" (which is a measure of interest rate sensitivity, as explained more fully below). 37. Lower Credit Quality Bonds. As Daifotis and Merk knew, or were reckless in not knowing, YieldPlus also was significantly riskier than a money market fund because it invested in lower credit quality bonds. Pursuant to rules under the Investment Company Act, a money market fund may invest in a security only if the fund's board has determined that the security presents minimal credit risks. In contrast, YieldPlus did not make such COMPLAINT -10­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 determinations and was permitted to invest up to 25 percent of assets in below-investment­
grade bonds, and actually invested 15 to 25 percent of YieldPlus in bonds rated BBB (the lowest investment grade) or lower. 38. Lack of Risk Management. Daifotis and Merk knew or were reckless in not knowing that they did not adequately monitor and analyze the risks posed by YieldPlus's substantial investment in non-agency MBS and lower quality bonds. Just before YieldPlus's decline began in the summer of 2007, internal auditors warned CSIM and CS&Co. officials, including Daifotis and Merk, that YieldPlus's portfolio managers were not conducting sufficient portfolio-wide risk management and scenario-analysis testing regarding the possible performance ·ofYieldPlus's portfolio during adverse market events. The auditors warned that this risk was heightened for YieldPlus, due to its "concentration in mortgage securities and lower credit rated corporate bonds." 2. Defendants'Roles a. Merk 39. Two key departments responsible for YieldPlus reported to Merk. First, the Senior Vice President for Product Development who was in charge of the CS&Co. product development and management group responsible for YieldPlus reported to him. This group was largely responsible for creating and reviewing the statements about YieldPlus that are the subject of this Complaint. As Merk knew or was reckless in not knowing, the department relied on him as a fixed-income expert and relied upon him to ensure that that the overall public message - including characterizations of the Fund that are described herein - were accurate, complete, and not misleading. Second, the President of CSIM, who supervised the Fund's portfolio managers, also reported to Merk. Later, shortly before the Fund began its COMPLAINT -11­
decline, Merk assumed the position of CSIM President and Daifotis began to report directly to 2 him. 3 40. In 2006, senior Schwab executives were concerned that a competitor was 4 selling its cash products more successfully than Schwab. Schwab then established, in mid­
5 2006, the "Cash Counci1." The Cash Council was a committee of high-level executives who 6 met to coordinate, increase, and improve marketing of Schwab's cash products company­
7 wide. Merk was a member of the Cash Council. 8 41. Merk was very knowledgeable about fixed-income products and, as part of his 9 work on the Cash Council, in 2006, was asked to identify fixed-income products to highlight 10 on Schwab's website to draw attention to cash products at Schwab. 11 42. In May 2006, Merk identified Yie1dP1us as such a product. Merk directly and 12 substantially participated in the decision to include Yie1dP1us on the cash page of the Schwab 13 website. For e x a m p 1 e ~ in an email exchange on May 17 and 18, 2006, members of the Cash 14 Council twice requested that Merk identify appropriate products to include in the cash 15 campaign, specifically tasking him with identifying fixed-income products to highlight on the 16 cash page of the Schwab website. 17 43. In a response on May 18,2006, Merk endorsed the selection of YieldPlus as a 18 cash product for inclusion on the cash page, sometimes referred to as "cHome." Merk 19 personally informed the Cash Council that he and his team had identified Yie1dP1us for 20 inclusion in the "[i]ncreased cash promotion." Merk then received a summary of the 21 "[p]roposed cHome cash promotion" that was "[b]ased on the exchanges [above]," and 22 involved "text boxes to enable a cash emphasis," including one text box on the Schwab 23 website for CDs, another for Schwab's money market fund, and a third for YieldP1us. 24 44. From at least mid-2006, the Cash Council, including Merk, then directed an COMPLAINT -12­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 effort to highlight YieldPlus on portions of the Schwab website that discussed cash products, such as by adding links to take investors to pages with YieldPlus information. Merkdirectly and substantially participated in that effort to highlight YieldPlus. For example, in at least June and August 2006, Merk reviewed and agreed to the marketing plans and the proposed website changes that positioned YieldPlus with CDs and money market funds on the cash page of Schwab's website. 45. In causing YieldPlus to be placed and emphasized on the cash page of the website without substantial disclosures about the difference between YieldPlus and genuine "cash" investments, Merk knowingly or recklessly caused the misrepresentations or omissions of material fact about YieldPlus and the fact that it was significantly riskier than the other products listed, as described above. 46. The Cash Council, including Merk, also directed that sales materials emphasize claims that YieldPlus had a stable NAV. Merk directly and substantially participated in the marketing that resulted from the efforts of the Cash Council. In at least June and August 2006, as a member of the Cash Council and as a Trustee, Merk reviewed and agreed to the content of websites and communications that represented YieldPlus as being a cash-equivalent or cash-alternative investment. Examples are included in Section A.3. below. This was misleading because, especially when compared to cash products identified in the marketing materials, YieldPlus was more prone to substantial NAV fluctuations, as described above. 47. Merk knew, or was reckless in not knowing, that the statements about the Fund's stable NAV were misleading, in part because of the Fund's prior NAV fluctuation. In particular, from 1999 through 2003, the Fund's NAV fluctuated by $0.34, ranging from $10.03 to $9.69, with particular volatility in 2002 and 2003. The NAV also fluctuated COMPLAINT -13­
significantly within short periods, as described above. The Fund's fluctuations in NAV were material and significant, particularly because the Fund was characterized as a supposed "cash" product, was positioned with CDs and money market funds, which typically have no fluctuation in principal or NAV, respectively, and was characterized as having an NAV that had fluctuated in recent times by only a few cents. 48. The Cash Council, including Merk, also directed an effort in mid-2006 to re­
design the Fund's own web-page to highlight the yield that it generated and its supposed narrow NAV fluctuation as described below. Merk was aware of this effort and reviewed the revised web page. Merk knew, or was reckless in not knowing, that the marketing materials that he reviewed were materially false and misleading and contained material omissions, such as those concerning the risks associated with investing in the Fund. 49. Merk (along with Daifotis) directly and substantially participated in the issuance of a "cash/CDNieldPlus related press release" on August 1, 2006. Merk was the source of the idea to issue the August 1, 2006, press release, and Merk saw the draft and the final language of the press release, but did not correct the misrepresentations and omissions of material fact described below, despite his obligation to do so in light of his knowledge, positions, and responsibilities. 50. Specifically, consistent with the Cash Council's re-focused marketing approach for the Fund, the August l, 2006, press release misleadingly called the Fund a "cash alternative." Although the press release mentioned a recommended one-year holding period, it also stated that: "Unlike money market funds, ultra-short bond funds are subject to minimal price fluctuations." As Merk knew or was reckless in not knowing, this statement was misleading because it suggested that the Fund's price fluctuations would be limited to "minimal" changes. In stating that, in comparison to a money market fund, YieldPlus's NAV COMPLAINT -14­
would have "minimal" fluctuations, the press release substantially understated the riskiness of the fund and its prior fluctuations, and thus was misleading and omitted material facts. 51. At the August 29, 2006, meeting of the Fund's board of trustees, which Merk attended as a trustee, Merk and the other trustees received documents and presentations concerning the plans to market YieldPlus to retail investors as a cash alternative. As a trustee, Merk was responsible for reviewing the materials and determining, based on his own knowledge and expertise, whether the marketing was truthful and appropriate. This marketing was to take the form of direct mail, email, and statements on the Schwab website. 52. For example, among the board materials that Merk received was a document entitled "Board Marketing Update, Schwab Funds" that was the subject of a presentation at the August 29, 2006, meeting and included summaries of the current and future marketing of YieldPlus. The materials discussed the growth of the YieldPlus Fund and provided a "Marketing Summary" for the second quarter. Among other things, the Marketing Summary listed four planned advertisements. One of those communications was for YieldPlus and read: "Are you sitting on cash? Do you need additional income? Here's a smart solution. The Schwab YieldPlus Fund™.'' The presentation also included the marketing plans for YieldPlus for the third and fourth quarter of2006, including marketing YieldPlus as a cash alternative. 53. These marketing plans were carried out through, for example, the publication of the sales and marketing materials described in Section A.3. below, which were materially false and misleading in the ways described below. 54. YieldPlus experienced exceptional growth in the year following the Cash Council's effort to highlight YieldPlus as a cash alternative with a stable NAV. From mid­
2006 to mid-2007, YieldPlus assets grew from under $7.5 billion to over $13 billion. COMPLAINT -15­
55. Also included in the materials given to Merk and the other trustees at the August 29,2006 meeting was a piece published by Dow Jones on July 19,2006, based in part upon an interview with Daifotis. The piece was circulated to Merk and others and was characterized as, "Dow Jones feature story on YieldPlus." The Dow Jones piece stated, "[t]he Schwab YieldPlus Fund (SPYSX) is aimed at investors seeking better returns than on money market products, but without significantly more market volatility or risk." 56. Also at the August 29,2006, meeting of the board of trustees, Merk voted to change the Fund's concentration policy (unlawfully, as described below) to allow the Fund's portfolio managers to concentrate the Fund's investments in non-agency MBS. Most of the Fund's non-agency MBS investments were securities that a money market fund could not own because of the length oftheir maturities. As a result, the concentration in non-agency MBS made the Fund even less like a money market fund. As a fixed-income expert who participated in the decision to concentrate the Fund's investments in non-agency MBS, Merk knew or was reckless in not knowing that this was a material change that made the Fund even riskier than cash investments and less like the cash investments to which it was being compared. Merk knew or was reckless in not knowing that this change was not revealed in the sales and marketing materials described in Section A.3. below. 57. Merk was obliged to correct any misrepresentations or omissions of material fact in any marketing materials, including those described herein, because of: (1) his senior executive positions as Executive Vice President at Charles Schwab Corporation, Executive Vice President at CS&Co., and trustee of YieldPlus; (2) his responsibilities as an executive overseeing other executives at CSIM; (3) the fact that he knew or was reckless in not knowing that he was relied upon within CSIM, CS&Co., and the Cash Council as a fixed-income expert; and (4) the fact that he knew or was reckless in not knowing that he was relied upon COMPLAINT -16­
by those within CSIM and CS&Co. who prepared offer, sales, and marketing materials for the Fund to make sure that the overall offer, sale, and marketing message for the Fund, as well as any descriptions of the overall characteristics of the Fund, and its comparison to cash products as described herein, were accurate, complete, and not misleading. 58. In addition to the foregoing, because ofMerk's experience managing fixed-
income products, Merk was in a unique position to correct the misleading statements in the YieldPlus sales materials, the website, and press releases that he reviewed or of which he was aware, as described above, and to make sure that they contained sufficient disclosures about the riskiness of the Fund, its significant NAV fluctuations, and the differences between the Fund and cash investments. 59. Merk knew, or was reckless in not knowing, that, among other things, CSIM and CS&Co. were issuing sales and marketing materials, displaying a website, and issuing press releases, including those described above and in Section A.3. below, that included materially false and misleading statements and omissions of material fact and would mislead investors regarding the riskiness of the Fund. Yet Merk failed to correct the misleading statements or to make sure that those materials included sufficient disclosures to make them not misleading. 60. As shown above, Merk directly and substantially participated in the preparation of misrepresentations and omissions of material fact about YieldPlus that were disseminated to the public. 61. Merk's actions and failures to act as described herein had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme to mislead the public about YieldPlus. COMPLAINT -17­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 b. Daifotis 62. Daifotis was actively involvedin the day-to-day operations of YieldPlus. 63. Because of Daifotis's knowledge of the Fund, which he helped develop; his day-to-day involvement in, knowledge of and responsibility for the Fund's portfolio, management, and characteristics; and his expertise in fixed-income products (including money market funds), Daifotis was relied on by marketing, compliance and other personnel within CS&Co. and CSIM to substantially participate in determining whether statements in marketing and sales materials, and in other materials describing the Fund's characteristics and performance, were accurate and complete, and Daifotis knew or was reckless in not knowing that he was relied upon in that regard. For example, Daifotis was relied upon to make sure that marketing materials and communications were consistent with the facts concerning the Fund's portfolio, management, and characteristics. 64. In the normal course of business, Daifotis regularly received, reviewed, and contributed to sales and marketing materials regarding YieldPlus and made suggestions and edits to some of them, many of which contained misrepresentations and omissions of material fact, as discussed below. 65. As shown in Section A.3. below, a number of sales and marketing materials disseminated to the public from at least 2005 through at least March 2008 contained . statements regarding the nature of YieldPlus that quoted Daifotis or that were directly attributed to Daifotis, some of which included his picture. Daifotis was aware of, or was reckless in not knowing, the content of these statements and that they included materially false and misleading statements and omissions of material fact in, for example, characterizing the Fund as a cash alternative or cash equivalent without disclosing the fundamental and significant differences and risks associated with the Fund. Although Daifotis was in a COMPLAINT -18­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 position to change the content of those materials, he failed to make them accurate, complete, and not misleading. 66. Daifotis (along with Merk) directly and substantially participated in the issuance of the August 1, 2006 "cashlCD/YieldPlus related press release." He participated in the discussions about and drafting of the press release, which, as discussed above, was misleading in calling the Fund a "cash alternative" and stating that it was "subject to minimal price fluctuations," without disclosing the material facts involving the substantially greater riskiness and price fluctuations associated with the Fund. 67. Daifotis saw one or more drafts and the final language of the August 1,2006 Press Release. Daifotis knew or was reckless in not knowing that it was misleading and omitted material facts, in the ways described above, but he did not correct the false and misleading statements and omissions, despite his obligation to do so in light of his knowledge, positions, and responsibilities. 68. In an August 2007 conference call with registered investment advisers, Daifotis admitted that marketing YieldPlus as a money market alternative was misleading but he falsely denied marketing YieldPlus in that manner. He stated: "[W]e do not and have never said this should be marketed as a money market fund alternative. So if anybody ever positioned it that way with [registered representatives], that is certainly not the right way to position this fund." Daifotis knew or was reckless in not knowing that YieldPlus had been marketed as a cash or money market alternative - and indeed as a "cash equivalent" - and that his denial was false and misleading. 69. By no later than the summer of 2007, CSIM, CS&Co. and Daifotis knew that investors were using YieldPlus as an alternative investment to money market funds and CDs. Nonetheless, Daifotis continued to compare YieldPlus to money market funds, as did CSIM COMPLAINT -19­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 and CS&Co. Examples include, but are not limited to, Daifotis's comparing YieldPlus to money market funds in August 2007 conference calls primarily with CS&Co. registered representatives and independent advisers, CS&Co. 's and CSIM's including such comparisons in sales materials placed on Schwab.com (including the YieldPlus landing page), the Schwab Mutual Fund Center, and the cash hub of the Schwab Marketplace webpage, and their continuing to market the Fund on the cash page of the public website, as discussed above. Daifotis knew or was reckless in not knowing of these statements and that they were materially misleading and failed to disclose that YieldPlus was significantly riskier than the cash products to which it was being compared, for the reasons discussed above. 70. Daifotis was obliged to make sure that such materials were accurate, complete, and did not contain any misrepresentations or omissions of material fact because of: (1) his senior executive position as Senior Vice-President and ChiefInvestment Officer - Fixed­
income at CSIM; (2) his position as lead portfolio manager for YieldPlus; (3) his active involvement in the day-to-day operations of YieldPlus, including its offer, marketing, and sale; and (4) his knowledge that others within CS&Co. and CSIM relied on him as described above. 71. Daifotis knew, or was reckless in not knowing, that sales materials, the website, press releases, and other communications with investors that he made, reviewed, or of which he was aware, including those described above and in Section A.3. below, included materially false and misleading statements and omissions of material fact and would mislead investors regarding characteristics such as the riskiness of the Fund and other material facts described above, yet he failed to correct the misleading statements or to make sure that those materials included sufficient disclosures to make them not misleading. 72. By reason of the foregoing, and the matters alleged in Section A.3. below, COMPLAINT -20­
Daifotis directly and substantially participated in the preparation of misrepresentations and omissions of material fact about YieldPlus that were disseminated to the public. 73. Daifotis's actions and failures to act as described herein had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme to mislead the public about YieldPlus. 3. Misrepresentations and Omissions In Sales and Marketing Materials For YieldPlus 74. The following are examples of false and misleading written and electronic communications to which the foregoing paragraphs refer. Daifotis and Merk knew about these communications or were reckleSS in not knowing about them. In particular, CS&Co., with the assistance of CSIM, issued the following on behalf of Schwab Investments (italics and bold added): (a) From at least late 2006, following the Cash Council's directives, Schwab's Cash Investments and Strategies page on its public website, which was reached by selecting the "Cash" tab, included sweep accounts, CDs, a money market fund and YieldPlus as investment options and read: (i) "Want to make your cash work hard? This section highlights the different options Schwab offers to get more out of your cash." (ii) The webpage then offered a description of each product, including: "Schwab YieldPlus Fund ® If you're comfortable accepting a slightly higher amount ofrisk in exchange for a return that is generally better than the other cash equivalent investments, consider this ultra-short bond fund. This fund consisting of hundreds of bonds that offer enhanced diversification is best suited for those with investment horizons of one year or COMPLAINT -21­
more. Note that the Schwab YieldPlus Fund's net asset value will fluctuate." (b) A brochure mailed to Schwab investors in or about Spring 2006 with the heading, "STASH YOUR CASH-ULTRA-SHORT BOND FUNDS" and in which YieldPlus is the only ultra-short bond fund mentioned read: (i) "In the current uncertain interest rate and investing environment, cash has become an increasingly attractive defensive holding for many investors. Kimon Daifotis, chief investment officer and fixed-income portfolio manager of Charles Schwab Investment Management, says investors can receive better returns by using ultra-short bond funds as an alternative to traditional cash holdings, like money market funds and CDs, though with a slightly increased risk to principal." (c) A brochure mailed to Schwab clients in or about September 2006, entitled "Schwab YieldPlus Fund read: Your cash could be in a much more rewarding position" stated: (i) "If you're looking for a smart alternative for your cash, investing in the Schwab YieldPlus Fund ® could be your answer." (ii) "YieldPlus can be a great choice for clients with a 12-month or longer investment horizon. With historically strong performance, it offers higher potential returns than money market funds with only marginally more· risk." (iii) "YieldPlus is an actively managed mutual fund consisting primarily of ultrashort duration bonds that mature frequently to limit interest rate exposure. Its net asset value (NAV) has fluctuated by no more than $0.03 (between $9.65 and $9.68) over the last year ending 06/30/2006, giving it the COMPLAINT -22­
performance potential and relative stability necessary in today's market." (d) In June 2006, the YieldPlus page on Schwab's public website read: (i) "Schwab YieldPlus Fund. Discover a smart alternative for long-term cash holdings." (ii) "Looking for a way to earn better yields on your long-term cash without taking on significantly higher risk? The Schwab YieldPlus Fund ™ seeks to benefit from the current rising-rate environment and can be a smarter alternative to investing in money market and long-term bond funds." (iii) "The fund offers: Increased yieldpotential-Ultrashort bond funds like YieldPlus Fund have historically provided higher sustained yield verSus money market funds, as their short duration helps minimize exposure to falling bond prices as rate rise. Even though the share price mayfluctuate minimally, these funds offer lower risk than longer-term bonds funds and only marginally higher risk than money market funds." (e) In or about September 2006, an email was sent to investors from Charles Schwab with the subject line "Put your cash in a stronger position with YieldPlus." The body ofthe text included the following claims: (i) "Higher income potential, minimal risk." (ii) "It offers higher potential returns than many money market funds, with only marginally higher risk." (iii) "YieldPlus primarily consists of ultra-short duration bonds that mature frequently to limit interest rate risk exposure. Its net asset value (NAV) has fluctuated by no more than $0.03 (between $9.65 and $9.68) over the past year ending 6/30/2006, giving it the performance potential and relative COMPLAINT -23­
stability necessary in today's market." (iv) "What are the advantages of the Schwab YieldPlus Fund? High Yield. . .. Strong Ratings. . .. Minimal Risk." (f) In or about September 2005, an advertisement ran with a picture of Daifotis and a quote attributed to him reading: "'With consistent exceptional performance, The Schwab YieldPlus Fund ™ is a smart cash alternative for your clients in the current rising-rate market, providing enhanced yield potential over money market funds. '" (g) A September 2005, advertisement included apicture iJfDaifotis and the claim: "It's an ultrashort bond fund, not a money market fund. It seeks to provide higher yield with slightly higher risk than a money market fund, but maintains minimal fluctuation in share price and lower risk than a longer-term bond fund." (h) A brochure mailed to investors in or about January 2006, entitled "Smart cash strategies. Easy ways to keep your cash working." stated: "Understanding the different roles that cash plays in your portfolio can help you make smart decisions about the type of investment that is best suited for your cash. Use this chart to review some of your choices." The chart listed YieldPlus with money market funds and CDs as a type of investment cash, and included as suggested uses for such cash: emergency reserves, upcoming tax bills, planned vacations, down payments, future purchases and portfolio diversification. Next to these uses was a brief explanation of each product. YieldPlus was described as follows: (i) "Ifyou're comfortable with accepting a slightly higher amount of risk in exchange for a return that's generally better than other cash-equivalent investments, consider this ultra-short bond fund. The net asset value of the COMPLAINT -24­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Schwab YieldPlus Fund will fluctuate." (i) From at least 2005 through at least March 2008, CSIM and CS&Co. listed the Lehman Brothers U.S. Treasury 9-12 Month Index as the benchmark for measurement ofYieldPlus's The benchmark was listed on fact sheets for the YieldPlus Fund on Schwab's public website, Schwab.com. This was misleading because it suggested that the Fund invested regularly and substantially in bonds issued by the U.S. Treasury, and that YieldPlus's performance and risk profile would be similar to that of Treasury bonds, neither of which were true. Daifotis participated in selecting the benchmark, and he and Merk knew, or were reckless in not knowing, that use of a 9-12 month Treasury benchmark for the Fund would be misleading for the reasons described above. 75. The sales and marketing materials described in the preceding paragraph were misleading and contained misrepresentations or omissions of material fact in at least the following respects: (a) identifying YieldPlus as a cash-alternative and cash-equivalent investment and asserting that YieldPlus was only slightly or marginally riskier than other cash or cash-like products, such as CDs or money market funds, was false and misleading because YieldPlus in fact was substantially riskier than those products, and the greater risks were not fully or accurately disclosed; (b) asserting that YieldPlus offered enhanced diversification was false and misleading because it deviated from its own concentration policy and its investments were heavily concentrated in residential mortgage-backed securities and financial institutions, which was not adequately disclosed; (c) asserting that YieldPlus consisted primarily of ultrashort duration bonds that matured frequently was false and misleading because it held a large percentage of investments with longer actual maturities, especially in comparison to investments held by money market funds, which was not disclosed; and (d) asserting that COMPLAINT -25­
YieldPlus's NAV fluctuated only minimally was false and misleading, and asserting that it fluctuated by only $0.03 in the year ending June 30, 2006 was at best misleading because it had fluctuated much more during other recent periods and was subject to the risk of much greater fluctuation, which was not adequately disclosed. 76. The foregoing sales and marketing materials were reviewed and/or prepared by CS&Co. 's product development and management group. The personnel who prepared such materials, along with others within Schwab who reviewed such materials, relied upon Daifotis and Merk, as described above. 77. At or about the time periods of the sales and marketing materials identified above, Daifotis and Merk knew or were reckless in not knowing that CS&Co. and CSIM were disseminating either those particular marketing and advertising materials or materials containing the substance thereof, and that materials were materially false and misleading in the ways· described above. 78. Because of their senior-executive positions and their responsibilities, their knowledge of the Fund and fixed-income products generally, and the fact they knew or were reckless in not knowing that they were relied upon within CSIM and CS&Co. as described above, Daifotis and Merk were obligated to see to it that CSIM and CS&Co. did not make false and misleading statements and omissions about YieldPlus such as those described above. Daifotis and Merk nevertheless, as described above, made or substantially participated in making various of these statements, and knew or were reckless in not knowing that CSIM and CS&Co. were making these statements, but failed to prevent such materials from being disseminated or stop them even after they knew, or were reckless in not knowing, that such misleading statements or omissions of material fact were being disseminated to the public. COMPLAINT -26­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 4. Misleading Statements and Omissions Regarding YieldPlus's Weighted Average Maturity 79. With regard to mutual funds such as YieldPlus, facts pertaining to the tenn of investments held by the Fund, i.e., the time until maturity of the investments, are material facts. 80. Investors can use weighted average maturity ("WAM") -ameasurement of the average length of time until the underlying bonds in a portfolio mature-to evaluate the riskiness of a product. Among similar funds, those with longer WAMs generally involve more risk. 81. For eighteen months, from February 2006 to September 2007, CSIM and CS&Co., with Daifotis's substantial participation, misstated YieldPlus's WAM in communications designed for investors, including but not limited to marketing materials on the public website (as explained more fully below) and one Commission filing, a Fonn N­
CSR Annual Report dated August 31,2007. 82. In early 2006, the YieldPlus Fund's WAM tripled to over one to two years in length because of a change in the calculation method used by Schwab Investment's new fund accountant. Investors complained about the increase, some even telling CSIM and CS&Co. that they might invest in CDs instead of YieldPlus as a result of the longer WAM. 83. Because of the response of investors and representatives to the longer WAM, between at least November 2005 and February 2006, Daifotis suggested to others at CSIM and CS&Co. that "duration" be included instead of or in addition to WAM. 84. "Duration" is a ratio that measures interest-rate sensitivity affected by hedging techniques, but is not a measure of maturity or any other unit of time. 85. Despite owning many long-maturity bonds, YieldPlus was classified as an COMPLAINT -27­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 ultra-short fund because of its low duration. To keep YieldPlus's duration low, YieldPlus "shorted" Treasury futures. By selling Treasury futures short (which means selling the futures contracts without owning them, and profiting if the value of the securities declines), CSIM and CS&Co. hedged the interest rate risk of the securities in YieldPlus's portfolio. This may have reduced YieldPlus's exposure to interest rate risk, but it did not mitigate the liquidity risk and other risks posed by the bonds held by YieldPlus, especially those with longer maturities. 86. The numerals reflecting YieldPlus's duration (which generally ranged from 0.4 to 0.6) were significantly lower than the numerals reflecting the Fund's WAM (i.e., 1.2 to over 4.2 by some calculations). 87. Based on Daifotis's suggestion in or about January 2006, CSIM and CS&Co. then began listing YieldPlus' s "duration" in place of its WAM in various sales materials, such as tables on its public website listing Schwab funds and their attributes. Daifotis also discussed with CS&Co. and CSIM officials how to make that change. 88. CSIM and CS&Co. replaced WAM with duration only for YieldPlus, not for any other fund. In some communications, CSIM and CS&Co. noted the replacement with a footnote indicating that duration, not WAM, was listed, while in other communications, CSIM and CS&Co. failed even to disclose that they had made such a substitution. 89. From at least February 2006 through September 2007, CSIM and CS&Co. listed a duration figure of 0.5 in place ofWAM, without any notation of the replacement, on Schwab's external website available to the public, Schwab.com. The duration figure was included in tables of multiple Schwab investments, allowing comparisons of the products and quick review of their attributes (including WAM and performance data). The tables listed the investment products by categories and included columns for yield or performance data as well COMPLAINT -28­
as the WAM for each product. But the website did not disclose that YieldPlus' s duration had replaced WAM figures. . 90. Because duration figures had replaced WAM figures for YieldPlus but that change was not disclosed, the website and tables deceptively appeared to still be listing WAM figures for the Fund. The mere fact that CSIM and CS&Co. were listing a duration figure instead ofWAM for YieldPlus was a material fact. Their failure to disclose that fact, and to explain the differences between "duration" and WAM, caused these communications with investors to be deceptive and misleading. 91. Because the numerals reflecting duration (i.e., 0.4 to 0.6) were significantly lower than the numerals that would have reflected WAM (i.e., 1.2 to 4.2 years), this made the materials appear to indicate that YieldPlus held investments with maturities of a few months to six months, when in fact the maturities were at least three times that. 92. Further, CSIM and CS&Co. also listed a duration figure of 0.5 in place of WAM, without any notation of the replacement, in a Commission filing, a Form N-CSR Annual Report dated August 31, 2007, and filed with the Commission on November 2,2007. 93. CSIM and CS&Co. also listed a duration figure of 0.5 in place ofWAM, without any notation of the replacement in Schwab's publicly distributed magazine, entitled "On Investing, " including at least the issued dated March 21, 2007. 94. Also for the period of at least February 2006 to at least September 2007, on the Schwab Mutual Fund Center website, CSIM and CS&Co. replaced WAM with duration in tables listing data for Schwab products. Again, they made the replacement only for YieldPlus, not other products. Although they included a footnote noting the change, they failed to make the change obvious or to explain its import. 95. Thus, even when CSIM and CS&Co. included a footnote indicating that COMPLAINT -29­
duration was listed for YieldPlus instead ofWAM, their failure to explain the difference 2 between the two measures was materially misleading. 3 96. The difference between duration and WAM greatly confused many investors 4'· and even CS&Co. representatives, who erroneously believed that YieldPlus's short duration 5 meant that it held only short-maturity bonds. 6 97. The duration number that CSIM and CS&Co. listed was false and misleading 7 in another way because the figure itself was false. Although YieldPlus's duration fluctuated, 8 CSIM and CS&Co. hard-coded the number "0.5" into tables and documents discussed above. 9 This misleadingly suggested to investors that YieldPlus's duration (or WAM, when the 10 footnote was omitted) was absolutely constant, implying a stability that did not exist. 11 98. Having been a lead decision-maker in deciding to replace WAM with duration, 12 Daifotis knew or was reckless in not knowing that that the materials described above, 13 including the Schwab.com website, the November 2,2007 Form N-CSR, and the issues of the 14 On Investing publication listed duration figures in place of WAM but did not disclose that 15 change. Indeed, the November 2,2007 Form N-CSR even bore Daifotis's picture, thus 16 attributing the contents to him. 17 99. Daifotis also knew or was reckless in not knowing that replacement of a 0.5 18 WAM with duration figures without disclosing the change and fully explaining the duration 19 figures in the above-described materials was false and misleading because, as discussed 20 above, the Fund's WAM was substantially longer than that. 21 100. Daifotis knew or was reckless in not.knowing that CSIM and CS&Co. listed a 22 hard-coded duration figure of 0.5 on the Schwab Mutual Fund Center website, without 23 explaining the nature of duration or how it differed from WAM figures, as described above, 24 and that it was misleading to fail to fully explain those things and to list a hard-coded figure COMPLAINT -30­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 that actually fluctuated. 101. Daifotis failed to correct the misrepresentations or omissions regarding the listing of duration figures, as described above, despite his obligation to do so as a result of his senior executive position, his involvement in causing the change to be made, his responsibilities and the fact that, as he knew or was reckless in not knowing, he was relied upon within CSIM and CS&Co. to make sure that information about the Fund that was disseminated to the public was accurate, complete, and not misleading. 102. As a result of the foregoing, CS&Co. employees, including, but not limited to registered representatives and regional bond specialists, communicated incorrect information to investors. For example, during one telephone call, on or about July 24,2007, a CS&Co. representative told a Schwab customer that the Fund invested in bonds with maturities of 180 days or less. This was false because many of the Fund's holdings had maturities much longer than 180 days. B. Unlawful Deviation From Concentration Policy I. Background 103. Section 8 of the Investment Company Act [15 U.S.C. §80a-8] requires that a fund's registration statement contain a recital of certain investment policies, including its policy regarding concentration of investments in particular industries, fundamental investment policies or any investment policy that is only changeable if authorized by a shareholder vote. Section 13(a)(3) of the Investment Company Act [15 U.S.c. § 80a-13(a)(3)] states that a fund may not "deviate from" these investment policies unless authorized by a shareholder vote. 104. To comply with Section 8, Schwab Investments recited a single concentration policy for its taxable bond funds, including YieldPlus, the Total Bond Fund, and the Short-
Term Bond Fund, in a registration statement shared by all of the funds. The registration COMPLAINT -31­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 statement was filed with the Commission when the funds were created, which was 1999 for YieldPlus, 1997 for the Total Bond Fund, and 1991 for the Short-Term Bond Fund, and updated registration statements were filed at least annually. They were available to the public. 105. All registration statements filed for the above-mentioned funds from each of their inceptions stated that the funds would not concentrate more than 25 percent of their assets in any industry. 106. For five years prior to August 2006, the registration statements also stated that, "for the purpose of its concentration policy," each fund would treat non-agency MBS as an industry. As a result, the bond funds, including YieldPlus, the Total Bond Fund, and the Short-Term Bond Fund, could not invest more than 25 percent of portfolio assets in non-
agency MBS. 107. The concentration policy and treatment of non-agency MBS as an industry were material facts that impacted the riskiness, desirability and performance potential of the funds. 2. YieldPlus Invested More Than 25 Percent of Assets in Non-Agency MBS 108. Schwab Investments, in violation of Section 13(a)(3) of the Investment Company Act [15 U.S.c. § 80a-13(a)(3)], deviated from YieldPlus's concentration policy by at least early 2006 when it invested more than 25 percent of its assets in non-agency MBS. Contemporaneous documents, including quarterly review power point presentations for YieldPlus dated March 31, 2006, and June 30, 2006, created by Fund portfolio managers, and that Daifotis reviewed or was reckless ifhe did not review, reflected the deviation in charts summarizing the Fund's holdings, which conflicted with holding percentages reported in COMPLAINT -32­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 documents that Schwab Investments filed with the Commission. 109. By at least March 2006, Daifotis directed YieldPlus's investments that caused it to deviate from its concentration policy and violate Section 13(a)(3) of the Investment Company Act [15 U.S.c. § 80a-13(a)(3)), and he knew or was reckless in not knowing that this was the result of his actions. 110. Moreover, YieldPlus deviated from its concentration policy partly because Daifotis and the portfolio managers that he supervised failed to classify some securities as non-agency MBS for purposes of YieldPlus's concentration policy. For example, from at least 2005 through mid-2008, Daifotis and the portfolio managers he supervised excluded two entire categories of securities, commercial MBS and subprime MBS, when calculating the percentage of assets invested in non-agency MBS, even though those categories should have been included as non-agency MBS. If these categories ofMBS were included in the calculation of non-agency MBS, YieldPlus's total non-agency MBS holdings significantly exceeded 25 percent by early 2006, as Daifotis knew or was reckless in not knowing. 111. In addition, some securities were moved among classifications in filings with the Commission, thus masking the improper concentration, as Daifotis knew or was reckless in not knowing. Consistently classifying the securities as MBS would have disclosed that YieldPlus had exceeded its concentration limit. 112. As a result of the foregoing, CSIM and CS&Co. filed reports with the Commission that substantially understated the actual percentage of YieldPlus's total non-
agency MBS holdings, making those reports materially false and misleading because they falsely made it appear that non-agency MBS did not make up more than 25 percent of YieldPlus's holdings. 113. In particular, from at least late 2005 through mid-2008, the annual registration COMPLAINT -33­
statement amendments filed each November on Form N-1A and supplemented as necessary, the annual and semi-annual Certified Shareholder Reports filed on Form N-CSR as of February 28 and August 31 of each year, and the annual and semi-annual Quarterly Schedule of Portfolio Holdings filed on Form N-Q as of May 31 and November 31 of each year, were false and misleading in indicating that YieldPlus's non-agency MBS holdings did not exceed 25 percent, when in fact YieldPlus's non-agency MBS holdings substantially exceeded 25 percent. 114. During the time period that the above-referenced reports were being filed with the Commission, Daifotis knew or was reckless in not knowing that YieldPlus investments that he directed, the improper classification of assets that he and his portfolio managers directed, and the improper shifting of classification of assets, as described above, were causing such false reports to be filed with the Commission. Daifotis thereby substantially participated in the creation of the false reports described above. 115. From at least March 2006, CSIM, CS&Co. and Daifotis knew, or were reckless in not knowing, that YieldPlus had deviated from its recited concentration policy without shareholder approval. CSIM, CS&Co., and Daifotis knew or were reckless in not knowing, that YieldPlus's filings with the Commission, including but not necessarily limited to those discussed above, contained material misstatements and omissions about YieldPlus' s concentration in non-agency MBS. 3. Schwab Investments' Invalid Change of the Concentration Policy Without Shareholder Approval 116. After exceeding the 25 percent limit, the board oftrustees of Schwab Investments, including Merk, voted in August 2006 to stop treating non-agency MBS as an industry and allow the funds to invest more than 25 percent of assets in non-agency MBS for COMPLAINT -34­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 funds including YieldPlus, the Total Bond Fund and the Short Term Bond Fund. 117. By at least August 2006, Daifotis and another CSIM portfolio manager recommended the change and Daifotis presented the recommendation to the board. Daifotis did not inform the board that, as Daifotis knew or was reckless in not knowing, YieldPlus already had deviated from the concentration policy. 118. The board voted in August 2006 to approve the change, but did not seek shareholder approval to allow the funds to invest over 25 percent of their assets in non-agency MBS as required by Section 13(a) of the Investment Company Act. 119. This vote was improper and invalid because, under Section 13(a) of the Investment Company Act [15 U.S.c. §80a-13(a)], any such change in concentration policy had to be approved by a shareholder vote. 120. YieldPlus's investment in non-agency MBS ballooned after the purported change, approaching 50 percent within a year. 121. By at least November 2006, the Total Bond Fund and the Short Term Bond Fund, which were governed by the same prospectus, also exceeded 25 percent of assets invested in non-agency MBS in violation of the concentration policy. 4. Failure to Properly Disclose the Change of Concentration Policy 122. Not only was Section 13(a) of the Investment Company Act violated as set forth above, defendants also signed or substantially participated in the submission of one or more false documents to the Commission regarding the deviation from the concentration policy, including but not necessarily limited to those set forth below. 123. As a trustee, Merk, among others, authorized his signature on and the filing of one or more documents that contained material misstatements or omissions concerning the concentration policy, including filings on Form 485B on November 15, 2006. The filing was COMPLAINT -35­
misleading because it failed to properly and adequately disclose to the Commission or the public the material facts that Merk and the other trustees had voted to materially change the funds' concentration policies, and that the funds had not obtained the required shareholder approval for the change and had taken on the additional risk, and that YieldPlus already had deviated from the concentration policy. 124. Moreover, Merk knew, or was reckless in not knowing, that the Form 485B filing contained a false certification that the filing did not contain any material changes. Merk's signature appears on the same page as the certification that the document contained no material changes. Merk allowed his signature to be affixed to the document even though he knew that the trustees had voted to change the funds' concentration policy and knew, or was reckless in not knowing, that it was a material change and that, therefore, the certification in the Form 485B was false. 125. Daifotis reviewed the November 2006 Form 485B before it was filed and he was specifically asked to review and comment on the language concerning the change to the concentration policy and the related additional risk disclosure. Although Daifotis knew or was reckless in not knowing that the document was false and misleading for the reasons stated above, and that it was to be filed with the Commission, Daifotis failed to make the changes that would have been necessary to prevent the document from being false and misleading, such as disclosing that the Form 485B contained a material change to the funds' concentration policy, and that YieldPlus already had deviated from the policy. 126. In light ofMerk's and Daifotis's executive-level positions and responsibilities, as described above, and the fact that they knew or were reckless in not knowing that others within CSIM and CS&Co. who prepared such documents relied on them to make sure that statements that they reviewed or that they were asked or able to review were factually COMPLAINT -36­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 accurate, complete, and not misleading, Daifotis and Merk were obligated to see to it that the filings described above did not contain misrepresentations or omissions of material fact. C. Fraudulent Statements and Conduct Regarding YieldPlus During its Decline 1. The Decline 127. Due, in part, to the misrepresentations and omissions described above, such as the misleading comparisons of YieldPlus to cash investments, the false descriptions of YieldPlus as only marginally riskier than a money market fund, the false statements that its NAV was unlikely to fluctuate by more than a few pennies, the understatement of YieldPlus's WAM, and the failure to seek shareholder approval for YieldPlus' s concentration in non-
agency MBS, and YieldPlus's historical performance, many YieldPlus investors expected that YieldPlus would experience minimal NAV fluctuations. 128. When YieldPlus's NAV began to decline in the summer of2007, many investors redeemed their holdings. 129. Daifotis and Merk believed that they needed investor redemptions to diminish. For example, early in the crisis, a senior portfolio manager for YieldPlus sent an email to· Daifotis, Merk and others stating that, "we need flows to stabiliz[e]." Shortly after, Daifotis sent an email to Merk stating that, "[i]fthe Advisor community starts to bailout, who [sic] has been stable to this point, we will be in trouble." 130. In response, as detailed below, CSIM and CS&Co. held a series of conference calls, spoke with individual customers and advisers, issued written materials, and circulated internal talking points regarding the Fund's decline. 131. As described more fully below, Daifotis and Merk played key roles in this communication effort and knew or were reckless in not knowing that statements that they COMPLAINT -37­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 made, or statements for which they knowingly provided substantial assistance, contained misrepresentations and omissions of material fact. 132. Daifotis was the primary face ofCSIM and CS&Co.'s statements. He led conference calls discussing YieldPlus's status, personally made misrepresentations and omissions of material fact, received daily updates about YieldPlus's level of redemptions and cash status, and authored or reviewed most of the documents circulated to investors, advisers and CS&Co. representatives. 133. Merk authored, reviewed, and/or approved a number of the public statements and internal talking points that contained misrepresentations and omissions of material fact. He received daily updates concerning the Fund, monitored the Fund's performance and participated in crafting the public response. He also supervised Daifotis during the relevant period. 134. The defendants made, substantially participated in making, or knowingly provided substantial assistance in the making of misrepresentations or omissions of material fact during the period of the Fund's decline, including but not necessarily limited to those set forth in sections C.2. and C.3. below. 2. False Statements and Omissions About the Level of Redemptions 135. Prominent among the false statements early in the crisis were two false statements by Daifotis about YieldPlus's level of redemptions in two prescheduled conference calls on August 14 and 16, 2007, with large groups of registered representatives and independent investment advisers. The calls were intended to respond to investors' questions and concerns about YieldPlus. 136. From August 1 through 14, 2007, investors redeemed almost $1.2 billion in assets, or approximately 10 percent of Fund assets. Because YieldPlus had a negative cash COMPLAINT -38­
position as of July 31, 2007, it had to sell assets to meet the redemptions and prepare for more . redemptions. During that two-week period, YieldPlus sold over $2.1 billion in portfolio securities, representing 16 percent of assets. YieldPlus' s portfolio managers had never before sold a significant percentage of Fund assets. 137. Because redemptions were a growing concern, Daifotis monitored redemption levels multiple times per day in August 2007, and thus was well aware of the high level of redemptions. 138. Six days before the August 14,2007 conference call, Daifotis and Merk received the email from a portfolio manager stating that, "we need flows to stabiliz[e]." 139. Three days before the August 14,2007 conference call, Daifotis sent an email to Merk in which he said that, "[i]f the Advisor community starts to bailout, who has been stable to this point, we will be in trouble." 140. On August 12,2007, two days before the first conference call, Daifotis sent an email editing a set of questions and answers ("Q&A") to be posted on the Schwab. com website and thus available to the public. The edits removed redemption information from the Q&A and, in the email, Daifotis explained, "I don't want anyone to sense that we are having outflows." (emphasis added). 141. On August 14, 2007, Daifotis held a prescheduled conference call with a large number of independent registered investment advisers to discuss YieldPlus. During the call, an adviser asked Daifotis, "how expensive have your redemptions been since the decline?" During his answer, Daifotis responded that some advisers had purchased more shares, and that "we've got very, very, very slight negative flows over the course of the last week or two." (emphasis added). 142. Two days later, on August 16, 2007, Daifotis held a similar conference call COMPLAINT -39­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 with a large number of CS&Co. registered representatives. In that call, a representative asked "what are the net outflows ofthe Schwab Yield Plus fund to date?" During his answer, Daifotis stated, "[i]t's not that much.... So outflows have been minimal' (emphasis added). 143. Daifotis knew or was reckless in not knowing that his statements were materially false and misleading because YieldPlus was experiencing tremendous, unprecedented outflows, which required over $2 billion in asset sales in only two weeks, and therefore could not fairly be described as "very, very, very slight" or "minimal." 144. Daifotis's false statements were communicated to YieldPlus investors, and Daifotis knew or was reckless in not knowing that this would occur. For example, in the week after the conference calls, a CS&Co. representative told a YieldPlus investor during a telephone call: "And what we really have to be concerned about, is what have the outflows been on the fund. And surprisingly-and this-Kim Daifotis, who is the head of Schwab Investment Management said that he was very surprised, and he said the redemptions were negligible on the fund." 3. Other Fraudulent Statements and Conduct During the Decline 145. August 2007 Q&A on the Website. In early August 2007, CS&Co. published on the Schwab website a Q&A, which was available to the public, that listed Merk as the author. Merk reviewed and edited the document before it was published. Among other false and misleading statements and omissions, the Q&A stated that the "fund's short maturity structure has mitigated much of the price erosion that some other ultrashort bond funds have experienced." This remained on the Schwab website through at least March 2008. 146. When he made the statement described above, Merk knew or was reckless in not knowing that his statement was false and misleading because YieldPlus did not have a short maturity structure, especially compared to money market funds. Rather, as described COMPLAINT -40­
above, it held many long-term bonds with stated maturities of twenty years or more, and used interest rate hedging strategies to limit YieldPlus's duration. 147. Merk's statement also was false and misleading because YieldPlus was performing worse than most of its peers. For example, the day after the Q&A piece was posted, Merk received statistics showing that YieldPlus was ranked in the bottom 15 percent percentile of its peers. In light ofMerk's statement about YieldPlus's performance in relation to other funds, it was a material omission to not disclose the fact that the large majority of peer funds had performed better, and this made Merk's statement on that point materially misleading. Merk, however, did not remove his misleading statement from Schwab's website, and the false statement remained on the website through at least March 2008. 148. In addition to being on the Schwab website, the false statements were communicated to YieldPlus investors, as Merk knew or was reckless in not knowing would result from his having posted the statements. For example, on August 21,2007, a CS&Co. representative told a YieldPlus investor during a telephone call: "And if we take a look at the peer group of ultrashort term bond funds, this has actually performed much better than all the other ultrashort term bond funds, because it does have a very quality portfolio." 149. November 2007 Talking Points. In late November 2007, CS&Co. and CSIM circulated a set of internal talking points that were used by Schwab employees when discussing YieldPlus with investors. Before circulation, both Daifotis and Merk reviewed the talking points, which covered half of the one-page document, the rest of which mainly contained standard disclosure language and a chart entitled "Average Annualized Total Returns." Merk suggested an edit and then approved the talking points. The document stated that: • "The portfolio management team has confidence in the Fund's strategy given COMPLAINT -41­
our outlook for the fixed-income markets." • "Despite the recent spike in bond market volatility, history suggests this is a temporary condition." • YieldPlus's umealized loss, which made up 75 percent of YieldPlus's losses, was a "paper loss." • "Since last summer, the Fund has maintained a higher than normal cash position, in an effort to capitalize on investment opportunities and to effectively manage potential redemption requests." • "The portfolio is highly diversified with approximately 400 securities across a wide range of sectors and industries." 150. The talking points contained a number of false and misleading statements and omissions of material fact, including but not necessarily limited to the following: (a) The statement that the portfolio management team had "confidence" in YieldPlus was, at best, misleading because it omitted the material fact that the portfolio management team's contemporaneous internal discussions stated the opposite. For example, in one email sent days before Merk approved the talking points, the portfolio manager assigned to give daily updates on the Fund reported to Daifotis, Merk, and other senior executives that raising cash "was like pulling teeth" and that "[l]iquidity is AWFUL ....period." In a second email sent that week, the same portfolio manager reported to Daifotis that "it[']s not better today and likely won't be for some time." In a third email that he sent shortly before the talking points were finalized, he reported to Daifotis, Merk, and others that "we are hostage to the market at this point and can't improve the NAV." The statement also was misleading COMPLAINT -42­
because it omitted material facts concerning the high level of redemptions and the fact that many of the Fund's best assets were being sold at depressed prices in order to meet redemptions. (b) The statements that YieldPlus's losses to date were "paper loss[es]" and were "unrealized" were at best misleading because they omitted the material fact that, by that time, YieldPlus had sold its safest, most liquid assets, which made the portfolio more vulnerable to further declines. YieldPlus had sold its safest assets because it needed to raise cash to meet redemptions and the safest assets were easiest to sell. (c) The statement that YieldPlus was raising cash "since last summer" to take advantage of buying opportunities was false, misleading, and omitted material facts. During August 2007, Merk had instructed the portfolio management team to focus on selling assets to raise cash, and to stop buying bonds. The false statement was repeated in a November 2007 document labeled a "Manager's Discussion," which stated that "[w]e continue to maintain higher-than-normal cash positions in an effort to capitalize on purchasing opportunities in the current market environment and to effectively manage the timing of any redemption requests." YieldPlus was not looking for "current" buying opportunities. (d) The statement that YieldPlus was "highly diversified" was misleading and omitted material facts. Combining YieldPlus's MBS and its ownership of corporate bonds issued by financial institutions, over 75 percent of YieldPlus's assets were tied to the real estate and financial sectors. 151. As Daifotis and Merk knew or were reckless in not knowing would occur, CS&Co. 's representatives repeated the substance of the talking points and other misleading COMPLAINT -43­
communications in at least November 2007 when communicating with investors about YieldPlus in telephone calls regarding concern over YieldPlus's performance and general reviews of portfolios that held YieldPlus. 152.· In light of their senior executive positions and responsibilities, and the fact that they knew or were reckless in not knowing that they were relied upon within CSIM and CS&Co. to convey accurate, complete, and not misleading information about the Fund, as described above, Daifotis and Merk were obligated to make sure that the November 2007 talking points - which they reviewed and Merk approved - were accurate, complete, and not misleading in the ways described above. Daifotis and Merk failed to carry out that obligation because they allowed the talking points to be issued without correcting the above-described misrepresentations and omissions. 153. November 15,2007 Email Regarding Sales at Distressed Prices. Also in November 2007, Daifotis and Merk knew or were reckless in not knowing that Fund representatives were misleading the public by understating the stress that YieldPlus was experiencing because, among other things, representatives were being told to inform investors that YieldPlus was not forced to sell assets at distressed prices to meet redemptions. One November 15, 2007, email, a copy of which was sent to Daifotis and Merk, was sent to CS&Co. representatives telling them that "[t]he portfolio managers have not been forced into selling securities at distressed prices to meet client redemptions." Daifotis and Merk knew or were reckless in not knowing that the substance of this would be communicated to the public. 154. As Daifotis and Merk knew or were reckless in not knowing, the statement in the November 15,2007 email was false, misleading, and omitted material facts. Only one day before that November 15,2007 email was sent, the YieldPlus portfolio manager assigned to preparing a daily update told Daifotis, Merk and others that "we are selling securities that are COMPLAINT -44­
'money-good' high quality assets at depressed prices." The same portfolio manager told Merk, two weeks prior, that "almost every sale in YP [YieldP1us] has been ofa good bond at depressed prices. We've had no choice but to sell or not provide daily liquidity to shareholders." 155. Even though Daifotis and Merk knew or were reckless in not knowing that the Fund was selling "good bond[s] at depressed prices," Daifotis and Merk did not correct the statement that they saw going to the representatives in November 2007 that the Fund was not being forced to sell securities at distressed prices to meet redemptions, and they failed to ensure that that the statement included the material facts mentioned above. In light of their senior executive positions and responsibilities, as described above, and the fact that they knew or were reckless in not knowing that that they were relied upon within CSIM and CS&Co. to convey accurate, complete, and not misleading information about the Fund, as described above, Daifotis and Merk were obligated to make sure that the November 15,2007 email was accurate, complete, and not misleading, but they failed to do so. 156. This misstatement was communicated to Schwab investors. For example, in March 2008, a Schwab representative told a YieldPlus investor in a telephone call that, "Schwab hasn't been a forced seller into the lower prices, just selling those that have dropped a lot in price. We haven't been forced to sell those to raise cash to meet redemptions, in that manner." 157. Omission of Facts Regarding Alt-A MBS Investments. Also misleading was frequent emphasis of YieldPlus's "minimal" subprime holdings, which constituted approximately 6 percent of Fund assets, but omitting to state that, although YieldPlus arguably had modest subprime holdings, approximately one-third of YieldPlus's assets were invested in Alt-A securities, another type of security backed by lower quality residential COMPLAINT -45­
mortgages that were suffering price declines, which were similar to subprime mortgages and which posed risks similar to those of subprime mortgages. 158. The early-August 2007 Q&A, discussed above, which identified Merk as the author, included a discussion of YieldPlus's subprime holdings without references to the related substantial Alt-A MBS investment. As Merk knew or was reckless in not knowing, because this communication stressed the "minimal" exposure to "subprime" holdings, the Q&A was misleading and deceptive because it omitted the material fact that the Fund had a large percentage of Alt-A MBS securities, which exposed the Fund to risks similar to those of subprime assets. 159. A November 2007 "Manager's Discussion" reviewed by Daifotis was issued to the public under his title, "Manager," and Merk also received a copy. Thus, Daifotis and Merk knew of or were reckless in not knowing the contents of the document. The Manager's discussion, which was made available to the public and posted on Schwab's external website, also emphasized the Fund's minimal subprime holdings, stating that they were approximately 5 percent of the Fund's holdings. This document also omitted the material fact that that the Fund had a large percentage of Alt-A MBS securities, which exposed the Fund to risks similar to those of subprime assets. It was misleading to state that the Fund held only 5 percent in subprime assets without also disclosing the Fund's large holdings of Alt-A MBS securities. 160. Daifotis and Merk knew or were reckless in not knowing the contents of the August and November documents described above, as well as other documents that contained similar material omissions regarding the Fund's Alt-A holdings. In light of their senior-level executive positions and responsibilities, as described above, and the fact that they knew or were reckless in not knowing that they were relied upon within CSIM and CS&Co. to ensure that such materials were accurate, complete, and not misleading, they were obligated to make COMPLAINT -46­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 sure that the documents cited above did not contain false or misleading statements or omissions, but they failed to do so. In particular, in connection with the documents' statements about the Fund's minimal subprime holdings, they should have made sure that the documents disclosed the Fund's substantial A1t-A holdings. D. Redemptions by Schwab-Related Funds 161. While Daifotis and Merk were telling investors that they had confidence in Yie1dP1us and to maintain a patient, long-term perspective on their investments, and while Merk and Daifotis knew that CSIM and CS&Co. were making those statements to investors, a number of Schwab-related Funds with material nonpub1ic information about the adverse condition of Yie1dP1us redeemed their investments in YieldPlus. 162. For example, Schwab's five target date and retirement funds ("Target Date Funds") redeemed investments in Yie1dP1us in March 2008, after its senior portfolio manager received material, nonpub1ic information about Yie1dP1us. The Target Date Funds' senior portfolio manager was the ChiefInvestment Officer for Equities ("CIa-Equities") at the time. 163. Both the CIa-Equities and Daifotis reported directly to Merk during Yie1dP1us's decline, and the CIa-Equities learned material nonpub1ic information about Yie1dP1us from Daifotis in regular meetings with Merk and his direct reports in at least February and March 2008. 164. During these meetings, Daifotis discussed Yie1dPlus, its NAV decline, high redemption levels, and plans to satisfy redemptions by selling assets. 165. While in possession of this information, the CIa-Equities approved the recommendation of another portfolio manager to redeem the Target Date Funds' investments in Yie1dP1us and personally arranged to expedite the redemptions. This material information was not disclosed to the public at that time. COMPLAINT -47­
166. The CIa-Equities informed Merk of his intention to redeem. 167. CSIM and CS&Co. served as investment advisers to YieldPlus and thus owed a fiduciary duty to YieldPlus, as did Merk because of his position as a trustee of YieldPlus and as a senior officer of CSIM and CS&Co. 168. Despite Merk's awareness of the foregoing, and his knowledge that the CIO-
Equities learned material, nonpublic information about YieldPlus during the meetings of the Merk reports, Merk approved the Target Date Funds' redemptions of investments in YieldPlus. 169. Merk failed to disclose to YieldPlus's board of trustees and to the investors in YieldPlus the material fact that the Target Date Funds were redeeming investments in YieldPlus after their senior portfolio manager had learned material nonpublic information about YieldPlus. 170. The material nonpublic information that was shared during the meetings with Merk and Merk's direct reports belonged to YieldPlus and should not have been shared with other investors - such as the CIO-Equities, who managed funds that invested in YieldPlus­
without the permission of YieldPlus's trustees. The trustees had not been informed of the disclosure of the Fund's information and had not approved such disclosure. 171. This unauthorized disclosure harmed YieldPlus because it contributed to the Target Date Funds' decision to redeem their YieldPlus investments. These redemptions harmed YieldPlus because they came at a time when YieldPlus was struggling to raise cash to meet redemptions by selling bonds in a declining market. 172. Through the actions of Merk, who was a senior officer of CSIM and CS&Co., in permitting the unauthorized disclosure of material nonpublic information and in approving the Target Date Fund's redemptions in YieldPlus when he possessed material nonpublic COMPLAINT -48­
information and was aware of the unauthorized disclosures of material nonpublic information, CSIM and CS&Co. breached the fiduciary duties that they owed to YieldPlus in their roles as the Fund's investment advisers, and they violated Section 206( 1) and (2) ofthe Investment Advisers Act Act [15 U.S.c. § 80b-6(l) and (2)]. FIRST CLAIM FOR RELIEF (Against Daifotis and Merk) Violations of Section 1O(b) of the Exchange Act [15 U.S.c. §78jeb)1 and Rule 10b-5 Thereunder [17 C.F.R. § 240.1 Ob-5] 173. The Commission realleges and incorporates by reference paragraphs 1 through 172 above. 174. Daifotis and Merk, directly or indirectly, in connection with the purchase or sale of securities, by the use of means or instrumentalities of interstate commerce, or the mails, with scienter: (a) employed devices, schemes, or artifices to defraud; (b) made untrue statements of material fa.cts or omitted to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or (c) engaged in acts, practices, or courses of business which operated or would operate as a fraud or deceit upon other persons, including purchasers and sellers of securities. 175. By reason of the foregoing, Daifotis and Merk violated Section 1O(b) of the Exchange Act [15 U.S.c. § 78j(b)] and Rule lOb-5 thereunder [17 C.F.R. § 240.l0b-5]. SECOND CLAIM FOR RELIEF (Against Daifotis and Merk) Aiding and Abetting Violations of Section 1O(b) of the Exchange Act [15 U.S.c. §78jeb)] and Rule lOb-5 Thereunder [17 C.F.R. § 240.l0b-5] 176. The Commission reallegesand incorporates by reference paragraphs 1 through 175 above. 177. CSIM and CS&Co., directly or indirectly, in connection with the purchase or COMPLAINT -49­
sale of securities, by the use of means or instrumentalities of interstate commerce, or the mails, with scienter: (a) employed devices, schemes, or artifices to defraud; (b) made untrue statements of material facts or omitted to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or (c) engaged in acts, practices, or courses of business which operated or would operate as a fraud or deceit upon other persons, including purchasers and sellers of securities. 178. By reason ofthe conduct described above, Daifotis and Merk knowingly provided substantial assistance to CSIM and CS&Co. in violation of Section 1O(b) of the Exchange Act (15 U.S.c. § 78j(b)] and Rule lOb-5 thereunder (17 C.F.R. § 240.10b-5], and thus aided and abetted such violations. 179. Accordingly, pursuant to Section 20(e) of the Exchange Act (15 U.S.c. § 78t(e)], Daifotis and Merk are liable for such violations. THIRD CLAIM FOR RELIEF (Against Daifotis and Merk) Violations of Section 17(a) of the Securities Act [15 U.S.C. § 77q(a)] 180. The Commission realleges and incorporates by reference Paragraphs 1 through 179 above. 181. Daifotis and Merk, directly or indirectly, in the offer or sale of securities, by use of the means or instruments of transportation or communication in interstate commerce or by use of the mails, (a) employed devices, schemes, or artifices to defraud; (b) obtained money or property by means of untrue statements of material fact or by omitting to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or (c) engaged in transactions, practices, or courses of business which operated or would operate as a fraud or deceit upon the purchasers. COMPLAINT -50­
182. By reason of the foregoing, Daifotis and Merk violated Section 17(a) of the Securities Act [15 U.S.C. § 77q(a)). FOURTH CLAIM FOR RELIEF (Against Merk) Aiding and Abetting Violations of Sections 206(1) and (2) of the Advisers Act [15 U.S.c. § 80b-6(1) and (2)] 183. The Commission realleges and incorporates by reference Paragraphs 1 through 182 above. 184. CSIM and CS&Co., while acting as investment advisers, directly or indirectly, by use of the mails or means or instrumentality of interstate commerce: (a) employed devices, schemes, or artifices to defraud a client or clients or prospective clients; and/or (b) engaged in transactions, practices or courses of business which operated as a fraud or deceit upon a client or clients or prospective clients. 185. By reason of the foregoing, and in particular, Merk's conduct as in Section D, above, CSIM and CS&Co. violated Sections 206(1) and 206(2) of the Advisers Act [15 U.S.C. § 80b-6(1) and (2)). 186. By reason of the conduct described above, Merk knowingly aided, abetted, counseled, commanded, induced, or procured said violation by CSIM and CS&Co. 187. Accordingly, pursuant to Section 209 of the Advisers Act [15 U.S.c. 80b-9], Merk is liable for such violations. FIFTH CLAIM FOR RELIEF (Against Daifotis and Merk) Aiding and Abetting Violations of Section 206(4) [15 U.S.c. § 80b-6(4)] of the Advisers Act and Rule 206(4)-8 [17 C.F.R. § 275.206(4)-8] Thereunder 188. The Commission realleges and incorporates by reference Paragraphs 1 through 187 above. COMPLAINT -51­
189. CSIM and CS&Co., while acting as investment advisers, directly or indirectly, by use of the mails or means or instrumentality of interstate commerce, engaged in acts, practices, or courses of business that were fraudulent, deceptive or manipulative. 190. CSIM and CS&Co., while acting as investment advisers to pooled investment vehicles: (a) made untrue statements of material facts or omitted to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, to investors or prospective investors in the pooled investment vehicle; or (b) engaged in acts, practices, or courses of business that were fraudulent, deceptive, or manipulative with respect to investors or prospective investors in the pooled i n v e s ~ e n t vehicle. CSIM and CS&Co. thereby violated Section 206(4) [15 U.S.c. § 80b-6(4)] of the Advisers Act and Rule 206(4)-8 [17 C.F.R. § 275.206(4)-8] thereunder. 191. By reason of the conduct described above, Daifotis and Merk knowingly aided, abetted, counseled, commanded, induced, or procured said violations by CSIM and CS&Co., and thus aided and abetted such violations. 192. Accordingly, pursuant to Section 209 of the Advisers Act [15 U.S.c. 80b-9], Daifotis and Merk are liable for such violations. SIXTH CLAIM FOR RELIEF (Against Daifotis and Merk) Violations of Section 34(b) of the Investment Company Act [15 V.S.C. §80a-33(b)] 193. The Commission realleges and incorporates by reference Paragraphs 1 through 192 above. 194. In registration statements, applications, reports, accounts, records, or other documents filed or transmitted pursuant to the Investment Company Act, Daifotis and Merk made untrue statements of material fact, and/or omitted facts necessary in order to prevent COMPLAINT -52­
statements made, in the light of the circumstances under which they were made, from being materially misleading. 195. By reason of the foregoing, Daifotis and Merk violated Section 34(b) of the Investment Company Act [15 U.S.c. §80a-33(b)]. SEVENTH CLAIM FOR RELIEF (Against Daifotis and Merk) Aiding and Abetting Violations of Section 34(b) ofthe Investment Company Act [15 U.S.C. §§ 80a-33(b)1 196. The Commission realleges and incorporates by reference Paragraphs 1 through 195 above. 197. Schwab Investments, CSIM and CS&Co. made untrue statements of material fact, and/or omitted facts necessary in order to prevent statements made, in the light of the circumstances under which they were made, from being materially misleading, in registration statements, applications, reports, accounts, records, or other documents filed or transmitted pursuant to the Investment Company Act. 198. Schwab Investments, CSIM and CS&Co. thereby violated Section 34(b) of the Investment Company Act [15 U.S.c. §80a-33(b)]. 199. Daifotis and Merk knowingly provided substantial assistance to Schwab Investments, CSIM and CS&Co., and thereby aided and abetted said violations of Section 34(b) of the Investment Company Act [15 U.S.c. §80a-33(b)]. 200. Accordingly, pursuant to Section 48(b) of the Investment Company Act [15 U.S.c. §80a-47(b), as amended pursuant to Section 929M of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), Public Law 111-203, 2010 HR 4173 (July 2010)], Daifotis and Merk are liable for such violations. COMPLAINT -53­
EIGHTH CLAIM FOR RELIEF (Against Daifotis) Aiding and Abetting Violations of Section 13Ca) of the Investment Company Act [15 U.S.c. §§ 80a-13(a)] 201. The Commission realleges and incorporates by reference Paragraphs 1 through 200 above. 202. Schwab Investments deviated from its policy in respect of concentration of investments in a particular industry or group of industries as recited in its registration statement, deviated from an investment policy which is changeable only if authorized by shareholder vote, and deviated from a policy recited in its registration statement pursuant to Section 8(b) of the Investment Company Act [15 U.S.c. § 80a-8(b)]. 203. By reason of the foregoing, Schwab Investments violated Section 13(a) of the Investment Company Act [15 U.S.c. § 80a-13(a)] 204. By reason of the foregoing, and, in particular, Daifotis's conduct as described in Section B, above, Daifotis knowingly provided substantial assistance to Schwab Investments and thereby aided and abetted Schwab Investments in its violations of Section 13(a) of the Investment Company Act [15 U.S.c. § 80a-13(a)]. 205. Accordingly, Daifotis is liable for such violations pursuant to Section 48(b) of the Investment Company Act [15 U.S.c. 80a-47(b)], as amended pursuant to Section 929M of the Dodd-Frank Act. COMPLAINT -54­
PRAYER FOR RELIEF WHEREFORE, the Commission respectfully requests that this Court: 1. Find that defendants Daifotis and Merk committed the violations alleged; II. Permanently enjoin Daifotis from directly or indirectly violating Section l7(a) of the Securities Act [15 U.S.c. § 77q(a)], Section lOeb) of the Exchange Act [15 U.S.c. §§ 78j(b)], and Rule 10b-5 thereunder [17 C.F.R. § 240.l0b-5], Section 34(b) of the Investment Company Act [15 U.S.c. § 80a-33(b)], Section 206(4) of the Advisers Act [15 U.S.c. §§ 80b­
6(4)], and Rule 206(4)-8 thereunder [17 C.F.R. § 275.206(4)-8], and from aiding and abetting violations of Section 13(a) of the Investment Company Act [15 U.S.c. §§ 80a-13(a) and 80a­
33(b)). ill. Permanently enjoin Merk from directly or indirectly violating Section 17(a) of the Securities Act [15 U.S.c. § 77q(a)], Section lOeb) of the Exchange Act [15 U.S.c. §§ 78j(b)], and Rule 10b-5 thereunder [17 C.F.R. § 240.lOb-5], Sections 206(1), (2) and (4) of the Advisers Act [15 U.S.c. §§ 80b-6(1), (2) and (4)], Rule 206(4)-8 thereunder [17 C.F.R. § 275.206(4)-8],and Section 34(b) of the Investment Company Act [15 U.S.c. § 80a-33(b)]; IV. Order Daifotis and Merk to pay civil penalties pursuant to Section 20(d) of the Securities Act [15 U.S.c. § 77t(d)], Section 21(d) of the Exchange Act [15 U.S.c. § 78u(d)], Section 209(e) of the Advisers Act [15 U.S.c. § 80b-9(e)] and Section 42(e) of the Investment Company Act [15 U.S.c. § 80a-41(e)]; COMPLAINT -55­
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 V. Order Daifotis and Merk to disgorge any ill-gotten gains, including prejudgment interest; VI. Retain jurisdiction of this action in accordance with the principles of equity and the Federal Rules of Civil Procedure in order to implement and carry out the terms of all orders and decrees that may be entered, or to entertain any suitable application or motion for additional relief within the jurisdiction of this Court; and COMPLAINT -56­
VII. Grant such other and further relief as this Court may determine to bejust and necessary. JURy DEMAND Plaintiff respectfully demands trial byjury on all issues in this case triable by a Jury. DATED: January J1. 2011 Respectfully Submitted, David J. Gott s FrederickL. B Antonia Chion Robert A. Cohen Melissa R. Hodgman David S. Mendel Attorneys for Plaintiff SECURITIES AND EXCHANGE COMMISSION 100 F Street, N.E. Washington, DC 20549-4030 Telephone: (202) 551-4470 (Gottesman) Facsimile: (202) 772-9245 (Gottesman) .0- 0" COMPLAINT More From This UserGAO Report on Auditor Independence, 2003Political Contributions Executive OrderOver Billing of Treasury by U.S. Law FirmsSEC Complaint Against Joseph Skowron1989 GAO Report on Mortgage Servicing AbusesReport on Deloitte Negligence in Kabul Bank FraudFDIC Suit Against WAMU ExecsComplaint Against Bristol-Myers SquibbFTC Annual Report on Consumer FraudExecutive Sentenced to 14 Years in Mortgage Fraud CaseSEC Complaint Against Bonnie Hoxie and Yonni SebbagGAO Report on Crop Insurance FraudDOJ statement on fighting healthcare fraudMedicare Fraud ReportIRS Report on the Tax GapCyrus Vance Speech on White Collar CrimeFTC Nestle SettlementConsumers Union Report on Pre-Paid Credit CardsFTC Complaint Against United States BenefitsFood Safety Whistle Blower ActReport on Corruption in Florida, 12.17Nursing Home Over Billing - HHS ReportAlabama Massey Statement of FactValcich Letter in CityTime Corruption Case
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