SECURITIES EXCHANGE ACT OF 1934
Release No. 50360 / September 14, 2004
INVESTMENT COMPANY ACT OF 1940
Release No. 26595 / September 14, 2004
ADMINISTRATIVE PROCEEDING
File No. 3-11648
In the Matter of CHARLES SCHWAB & CO., INC. Respondent. |
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ORDER INSTITUTING PUBLIC ADMINISTRATIVE AND CEASE-AND-DESIST PROCEEDINGS PURSUANT TO SECTIONS 15(b) AND 21B OF THE SECURITIES EXCHANGE ACT OF 1934 AND SECTIONS 9(b) AND 9(f) OF THE INVESTMENT COMPANY ACT OF 1940, MAKING FINDINGS, IMPOSING REMEDIAL SANCTIONS AND ISSUING A CEASE-AND-DESIST ORDER AS TO CHARLES SCHWAB & CO., INC. |
I.
The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative and cease-and-desist proceedings be, and hereby are, instituted pursuant to Sections 15(b) and 21B of the Securities Exchange Act of 1934 ("Exchange Act") and Sections 9(b) and 9(f) of the Investment Company Act of 1940 ("Investment Company Act") as to Charles Schwab & Co., Inc. ("Schwab" or "Respondent").
II.
In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purposes of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over Respondent and the subject matter of these proceedings, Respondent consents to the entry of this Order Instituting Public Administrative and Cease-and-Desist Proceedings Pursuant to Sections 15(b) and 21B of the Securities Exchange Act of 1934 and Sections 9(b) and 9(f) of the Investment Company Act of 1940, Making Findings, Imposing Remedial Sanctions and Issuing a Cease-and-Desist Order as to Charles Schwab & Co., Inc., as set forth below.
III.
On the basis of this Order and Respondent's Offer, the Commission finds that:
Nature of Proceedings
1. From at least January 2001 through October 2003, the brokerage firm Charles Schwab & Co., Inc. ("Schwab") engaged in a practice that enabled certain mutual fund shareholders to place mutual fund orders after the time as of which the funds calculated their net asset values ("NAV") for that day. Specifically, Schwab allowed clients of investment advisers to place substitute mutual fund orders after 4:00 p.m. Eastern Time ("ET"), the time as of which those funds calculated their NAV. The order substitutions were permitted when one of these client's original pre-4:00 p.m. ET mutual fund orders was rejected by Schwab's computer system because it could not be processed as submitted. On hundreds of occasions during this period, Schwab received the substitute orders after 4:00 p.m. ET, yet treated the substitute orders as though they had been received at the time of the original (rejected) orders. This practice violated Rule 22c-1(a) under the Investment Company Act of 1940 ("Investment Company Act") and Schwab's own internal policy requiring any orders Schwab received after 4:00 p.m. ET to get the next day's fund price.
2. These substitute orders were not made pursuant to any improper agreements between Schwab personnel and the investment adviser or the investment adviser's clients. However, Schwab's acceptance of substitute orders after 4:00 p.m. ET created a potential risk that investment advisers and their clients could capitalize on post-market close information by trading after hours based on stale prices. By failing to properly price these securities trades, Schwab violated Rule 22c-1(a) under the Investment Company Act.
Respondent
3. Charles Schwab & Co., Inc. is a broker-dealer headquartered in San Francisco, California. Schwab has been registered with the Commission pursuant to Section 15 of the Securities Exchange Act of 1934 ("Exchange Act") since June 13, 1971.
Facts
The 4:00 p.m. ET Mutual Fund Trading Cut-Off
4. Schwab sponsors the Schwab Mutual Fund Marketplace and the Schwab Mutual Fund OneSource programs ("the Programs"), which enable customers to purchase and redeem shares of participating mutual funds through Schwab. Pursuant to agreements with the participating funds, Schwab receives orders to buy and redeem fund shares on behalf of its brokerage customers.
5. Rule 22c-1(a) under the Investment Company Act requires, among other things, persons and entities that are designated in a mutual fund issuer's prospectus as authorized to consummate transactions in that mutual fund (and certain other entities) to sell or redeem shares at a price based on the net asset value of the shares next computed after receipt of the order. In practice, the regulation generally means that orders received by a designated person or entity and the other types of entities specified in Rule 22c-1(a) prior to 4:00 p.m. ET shall be priced at that day's price, while orders received after 4:00 p.m. ET shall receive the following day's price. Rule 22c-1(a) seeks to prevent exploitation of post-market close information by some investors at the expense of other investors, and to promote fairness for all mutual fund investors.
6. By agreement with Schwab, each of the funds participating in the Programs was required to designate Schwab as a party that is authorized to accept orders to buy and redeem that fund's shares. In this regard, each fund's prospectus was required to disclose that the fund authorized one or more brokers (Schwab being one of them) to accept orders to redeem and purchase the fund's shares. Thus, to the extent that the participating funds complied with the agreement terms, Schwab was a party designated in the prospectus as authorized to consummate transactions in those funds' shares on behalf of the funds.
7. From at least 1998 to September 2003, Schwab's internal policy relating to cut-off times for mutual fund orders ("Cut-off Policy") explicitly provided:
Schwab will offer customers a 4:00pm Eastern Time (Market Close) mutual fund order entry cutoff. All mutual fund orders for funds with the 4:00pm Eastern Time customer cutoff that are received by 4:00pm Eastern Time will be executed at the current day's price. Orders for those same funds that are received by Schwab after 4:00pm Eastern Time will be executed at the next business day's price.
Schwab Permitted Investment Advisers To Substitute Mutual Fund Orders After The 4:00 p.m. Cut-off
8. Despite Schwab's Cut-off Policy, Schwab permitted investment advisers who had originally submitted mutual fund orders prior to 4:00 p.m. ET to replace them with orders placed after 4:00 p.m. ET and still receive the current day's price.
9. The electronic order-processing systems used by investment advisers to submit trades automatically rejected orders that, for various reasons, could not be processed in the form originally submitted. Because the processing systems did not necessarily provide investment advisers with contemporaneous notice of the order rejections at the time the orders were submitted, personnel in Schwab's Services to Institutional Managers (or "SIM") unit would contact investment advisers to report any rejected orders. In some instances, SIM personnel were unable to or did not contact these customers until after 4:00 p.m. ET.
10. During the relevant period, SIM mutual fund order processing representatives permitted investment advisers to substitute a different mutual fund order after 4:00 p.m. ET, at that day's price when 1) the selected mutual fund was closed to new investors; (2) the investor had been banned from trading in the selected mutual fund; 3) the mutual fund required pre-approval of investors; or 4) the mutual fund was not registered in the investor's state of residence.
11. An internal investigation commenced by Schwab in the fall of 2003 identified several hundred instances over a nearly three-year period in which the SIM group accepted substitute orders from investment advisers after 4:00 p.m. ET that were processed at the current day's price.
12. The order substitutions were not the product of any formal or informal agreements between Schwab and its investment adviser customers, and Schwab and the Commission staff found no evidence of any scheme to exploit Schwab's order entry process or circumvent its controls. Schwab personnel did not receive any additional compensation in exchange for processing the substitute orders. Senior management at Schwab was not aware of the practice of allowing substitute trades after market close.
13. Nonetheless, Schwab's practice of allowing investment advisers and their clients to substitute mutual fund orders after 4:00 p.m. ET exposed Schwab's mutual fund customers and the participating mutual funds to potential abuse by investment advisers who could seek to profit from post-market close information.
Schwab Failed To Take Adequate Steps To Prevent Improper Pricing Of Mutual Fund Trades
14. Throughout the relevant period, supervisors in the SIM unit erroneously trained SIM traders that it was appropriate to permit the type of replacement trades discussed above.
15. Internal controls problems prevented senior Schwab management from learning about the order substitution practice. In April 2003, Schwab discovered that for a period of nearly two years, certain orders processed after 4:00 p.m. ET at same-day pricing had been inadvertently omitted from a report used to supervise trading cut-off procedures. Although Schwab resolved the technical malfunction, it did not discover the substitute orders at that time.
Identification And Correction Of The Erroneous Order Substitution Practice
16. In September 2003, the Commission's Office of Compliance Inspections and Examinations ("OCIE") - the Commission office responsible for monitoring the securities laws compliance of broker-dealers, investment advisers and investment companies - requested that Schwab (among other large broker-dealers) provide information relating to its mutual fund trading practices. In connection with its response to OCIE, Schwab initiated an investigation of its own mutual fund trading operations. During the course of Schwab's investigation, Schwab discovered and notified the Commission staff of the SIM unit's practice of permitting substitute orders.
17. Beginning in approximately October 2003, Schwab clarified its Cut-off Policy for mutual fund trades by specifying the instances in which a change made to an order would require that the transaction receive the next day's NAV.
18. In addition, Schwab has implemented a number of enhancements to its systems, policies and procedures, and internal controls relating to the processing of mutual fund orders. These enhancements include, among others, a restructuring and reorganization of the SIM mutual fund trading functions within its mutual fund operations division to augment oversight of order processing activity, increased reporting and documentation of mutual fund order processing activity, and supplemental training of Schwab representatives regarding mutual fund order processing policies and procedures.
Violations
19. As a result of the conduct described above, Schwab willfully violated Rule 22c 1(a) under the Investment Company Act.1 Rule 22c-1(a) requires certain persons and entities, including those designated in a fund issuer's prospectus as authorized to consummate transactions in such security, to sell and redeem fund shares at a price based on the current NAV next computed after receipt of an order to buy or redeem. Schwab's practice of permitting substitute orders received after 4:00 p.m. ET to be priced based on the current trading day's NAV violated this regulation.
IV.
In view of the foregoing, the Commission deems it is appropriate and in the public interest to impose the sanctions specified in Respondent Schwab's Offer. Accordingly, it is hereby ordered:
Pursuant to Section 9(f) of the Investment Company Act, that Respondent cease and desist from committing or causing any violations and any future violations of Rule 22c-1(a) under the Investment Company Act;
Pursuant to Section 15(b) of the Exchange Act, Respondent be, and hereby is censured;
Respondent shall, within 30 days of the entry of this Order, pay a civil money penalty in the amount of $350,000 to the United States Treasury. Such payment shall be: (A) made by United States postal money order, certified check, bank cashier's check or bank money order; (B) made payable to the Securities and Exchange Commission; (C) hand-delivered or mailed to the Office of Financial Management, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312; and (D) submitted under cover letter that identifies Schwab as a Respondent in these proceedings, the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to Helane L. Morrison, San Francisco District Office, Securities and Exchange Commission, 44 Montgomery Street, Suite 1100, San Francisco, CA 94104.
By the Commission.
Secretary
Endnotes