[ by Howard Haykin ] The SEC charged investment management company OppenheimerFunds Inc. and its sales and distribution arm with making misleading statements about 2 of its mutual funds that struggled during the credit crisis in late 2008. SEC Findings and Allegations. Oppenheimer used derivative instruments known as total return swaps (TRS contracts) to add substantial commercial mortgage-backed securities (CMBS) exposure in a high-yield bond fund called the Oppenheimer Champion Income Fund and the Oppenheimer Core Bond Fund, an intermediate-term, investment-grade fund. The 2008 prospectus for the Champion fund didn’t adequately disclose the fund’s practice of assuming substantial leverage in using derivative instruments. It was only when declines in the CMBS market had triggered large cash liabilities on the TRS contracts in both funds and forced Oppenheimer to reduce CMBS exposure, that Oppenheimer disseminated misleading statements about the funds’ losses and their recovery prospects.

"These Oppenheimer funds had to sell bonds at the worst possible time to raise cash for TRS contract payments and cut their CMBS exposure to limit future losses. Yet, the message that Oppenheimer conveyed to investors was that the funds were maintaining their positions and the losses were recoverable." -- Julie Lutz, Associate Director of SEC Denver Regional Office.

Substantial Exposure to CMBS's and Creation of Large Amount of Leverage. In the SEC Order instituting settled admin proceedings against OppenheimerFunds and OppenheimerFunds Distributor Inc., the TRS contracts allowed the two funds to gain substantial exposure to commercial mortgages without purchasing actual bonds.  But they also created large amounts of leverage in the funds.  Beginning in mid-September 2008, steep CMBS market declines drove down the NAVs of both funds.  These losses forced Oppenheimer to raise cash for month-end TRS contract payments by selling securities into an increasingly illiquid market. According to the SEC’s order, the funds’ portfolio managers had begun executing a plan in mid-November to reduce CMBS exposure - on instruction from senior management.  Unfortunately, before they could get that strategy in gear, the CMBS market collapse accelerated, creating staggering cash liabilities for the funds and driving their NAVs even lower. Misleading Statements. Oppenheimer allegedly advanced several misleading messages when responding to questions in the midst of these events.

• Oppenheimer communicated to financial advisers (whose clients were invested in the funds) and fund shareholders directly that the funds had only suffered paper losses and their holdings and strategies remained intact.

• Oppenheimer stressed that absent actual defaults, the funds would continue collecting payments on the funds’ bonds as they waited for markets to recover. These communications were materially misleading because...:

1. the funds were committed to substantially reducing their CMBS exposure, which dampened their prospects for recovering CMBS-induced losses.
2. the funds had been forced to sell significant portions of their bond holdings to raise cash for anticipated TRS contract payments, resulting in realized investment losses and lost future income from the bonds.

SEC Charges and Sanctions. The SEC found that OppenheimerFunds violated Section 34(b) of the Investment Company Act of 1940, Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 (Securities Act), and Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 promulgated thereunder. The order finds that OppenheimerFunds Distributor violated Sections 17(a)(2) and 17(a)(3) of the Securities Act. OppenheimerFunds agreed to pay nearly $36 million in penalties, disgorgement, and prejudgment interest - all of which will be held for the benefit of investors. SEC Staff Credits. Investigation by Coates Lear, Jeffrey Oraker, Hugh Beck, Patricia Foley, and Mary Brady in the Denver Regional Office.  Related examination of Oppenheimer by Francesco Spinella, Tracy O’Sullivan, Michael Hooper, Kathleen Raimondi, and Paula Weisz, and supervised by NY Regional Office branch chief Kenneth O’Connor and assistant director Dawn Blankenship. For further details, go to:  [SEC PR 12-110, 6/6/12] and [SEC Order Against Oppenheimer Funds].