Appellate Court Says Charles Schwab & Co. Must Face Financial Advisory Firm’s Lawsuit Over Mortgage Debt Involving Bond Funds

A panel of U.S. Judges says that Charles Schwab & Co. (SCHW) must face a lawsuit brought by Northstar Financial Advisors Inc. The investment advisory firm claims that Schwab invested the assets of a bond-index fund in high-risk mortgage debt prior to the financial crisis. The plaintiff is proposing that this case be a class action securities claim, which could include investors who have owned the fund since 2007. In particular, notes Northstar Financial Advisors Inc., the Schwab Total Bond Market Fund (SWLBX) placed lots of risky debt into the fund, resulting in losses of tens of millions of dollars, as well as underperformance against its benchmark.

Reuters reports that the plaintiffs claim that because Schwab invested over 25% of assets in non-agency mortgage securities and collateralized mortgage obligations, the firm’s portfolio managers disregarded the fundamental investment objectives of the fund to track the Lehman Brothers U.S. Aggregate Bond Index and stay away from industry bets. Because of this, they argued, the fund lagged its benchmark from 9/1/07 to 2/27/09, suffering a 4.80% loss while the index posted a 7.85% positive total return.

Northstar Financial Advisors Inc. filed its securities case in 2008 but the complaint was mired in procedural matters until now. This latest appeal was argued in 2013 in front of three federal judges of the 9th U.S. Circuit Court of Appeals in San Francisco. Their decision, finally—albeit nearly two years later—reinstates the breach of fiduciary duty, breach of contract, and other claims.

Writing for the court, Judge Edward Korman said that Schwab fund’s fundamental policies were enough to create a contract between the fund and shareholders. One of the judges, Circuit Judge Carlos Bea, who was the single dissent, said that Northstar did not have standing to sue since it did not own Schwab fund shares. (Northstar sued after it was assigned the rights of an investor who did have claims against Schwab.)

The 9th circuit is now sending the case back to district court to Judge Lucy Koh. She is the one who dismissed the plaintiff’s case in 2011.

While the North Caldwell, N.J.-based advisory firm’s legal team expressed approval of the latest ruling, Schwab said it plans to keep mounting its defense. A spokesperson for the firm said that it would prove that the drop in the fund’s net asset value was because of the financial crisis and that the shareholders who held the fund during that time sustained few if any losses. After the peak of the economic crisis, mortgage-backed securities saw their value decline when a number of homeowners were unable to meet their loan obligations.

Schwab is one of a number of companies dealing with litigation over allegedly unexpected losses in fixed-income mutual funds during the financial and housing crises. Morgan Keegan and Fidelity Investments also have been sued.

Northstar Financial Advisors Inc v. Schwab Investments et al, 9th Circuit (Opinion) PDF

Charles Schwab must face U.S. lawsuit over bond index fund, Reuters, March 9, 2015

Schwab must face adviser’s lawsuit after all: appellate court, Investment News, March 9, 2015

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