Client
ALERT
August 2003
Recent Regulatory Activities with Respect to Class B Shares of Mutual Funds
By Gerald J. Fields & Richard C. Schoenstein
As we recently reported, there is
currently widespread regulatory and
congressional attention to broad
reforms in the mutual fund industry.1
Over the past few months, the regulators have focused on the suitability
of Class B shares of mutual funds
(“B-shares”) through a series of
disciplinary actions, administrative
proceedings, investigations and public
statements. Investors are not charged
a front-end sales charge on B-share
purchases, but instead pay a
Contingent Deferred Sales Charge
(“CDSC”) upon the sale of the shares,
a charge that declines over time until it
is eliminated. This is in contrast to
A-shares, which charge a front-end
sales charge (which is typically lowered
by “breakpoints” as the amount
invested increases) and no CDSC, and
C-shares, which typically charge a
modest CDSC in the first year, but not
thereafter. In addition, B-shares and
C-shares generally have higher annual
expense charges – typically in the form
of 12b-1 fees – for a period of years
(B-shares) or for the life of the
investment (C-shares).
Recent Regulatory Action
Involving Class B-Share
Suitability
On July 10, 2003, the Securities and
Exchange Commission (the
“Commission”) announced a settlement with Prudential Securities over
alleged mutual fund sale practice
violations involving sales by a former
Prudential registered representative of
B-shares.2 The Commission found
that the representative failed to disclose to a number of investors that
their purchases, which exceeded
$100,000, would have qualified for a
breakpoint discount had they been
made in A-shares, thereby effectively
increasing the commission on the
sales. The Commission also found
that while Prudential had proper
policies in place prohibiting this type
of sales practice, it had inadequate
systems to effectively monitor and
enforce those policies. Prudential was
censured, ordered to disgorge $82,000,
and fined $300,000.
On July 15, 2003, the Commission
brought administrative charges against
IFG Network Securities Inc., its
former president and several of its
former brokers, alleging that the
brokers violated the antifraud provisions of the 1933 and 1934 Securities
Acts, by omitting material facts in the
sales of B-shares to 29 customers. IFG
and the president were also charged
with failure to supervise.3
The Commission is also investigating
Morgan Stanley for its mutual fund
sales practices, an investigation that
appears to involve the firm’s B-share
sales practices.4 Finally, In re Flanagan, a
highly significant case involving
B-share suitability and securities fraud,
is currently on appeal before the
Commission.5
Lately, the National Association of
Securities Dealers (“NASD”) has also
been highly active in this area. In June
2003, the NASD censured and fined a
brokerage firm, suspended its
chairman, and directed that restitution
be paid to certain customers for
recommending the purchase of large
volumes of B-shares.6 This action was
the latest in a string of NASD
enforcement actions regarding the
unsuitability of large B-share
purchases.7 Regulators consider such
purchases violative of, among other
things, NASD Conduct Rule IM-28301, which discourages sales of mutual
fund shares in amounts just below
breakpoints in order to share in the
higher applicable sales charges as
contrary to just and equitable
principles of trade.8
In April 2003, a registered representative was fined and suspended for two
years for recommending the sale of
B-shares instead of A-shares.9 The
NASD determined that costs incurred
in the transaction exceeded the savings
that could be realized from lower
12b-1 fees on the A-shares purchases.
It therefore found such a
recommendation was unsuitable when
appropriate alternatives were available
at lower cost. It appears, therefore,
that regulators are requiring that
representatives calculate the costs
associated with multi-class share
purchases with increased precision.
Increased Investor Awareness of
B-Share Suitability
In addition to elevated levels of regulatory and legislative focus, investor
awareness of the B-share suitability
has also been heightened with the June
2003 release of an NASD Investor
Paul, Hastings, Janofsky & Walker
LLP
Alert entitled “Class B Mutual Fund
Shares: Do They Make the Grade?”
(the “Investor Alert”) – the third in a
recent series of investor alerts addressing the complications of multi-class
mutual fund investing.10 The Investor
Alert purports to explain the benefits
and disadvantages of various classes of
mutual fund shares, and discourages
investors from purchasing B-shares by
focusing on the unavailability of
breakpoint discounts and the higher
annual fees (including 12b-1 fees)
associated with B-share purchases. It
also draws investors’ attention to the
perceived problem by including a
summary of a recent disciplinary
action pursued by the NASD involving
allegedly unsuitable sales of B-shares.
The Investor Alert suggests that
potential investors should use the
NASD’s “Mutual Fund Expense
Analyzer” (the “Expense Analyzer”) to
compare the costs associated with
different fund classes, particularly if
they are considering investing in
B-shares.11 The Expense Analyzer
prompts a potential investor to enter
information about funds from each
fund’s prospectus, and generates a
chart comparing the funds and their
expenses, as well as comparing the
information provided with industry
averages. Based on the information
entered, the Expense Analyzer
purports to calculate the following:
the fund value at the end of the
holding period entered by the
investor;
the profit gained or loss incurred
on the investment over the
holding period;
the total fees associated with the
purchase, including commissions,
annual fund operating expenses,
and other expenses incurred over
the holding period; and
the earnings lost over the holding
period on the amount not
invested due to sales charges,
whether front-end or CDSC, and
any other ongoing fund expenses.
The Expense Analyzer attempts to
ensure accuracy by, among other
things, reminding potential investors to
check for breakpoint discounts on any
initial investment over $25,000 and to
check for reductions in any CDSC
where applicable.
Nonetheless, the accuracy of the
Expense Analyzer is dependant in part
upon a series of facts that may not be
predictable at the outset of any
investment. First and foremost, the
Expense Analyzer presumes that an
investor knows, at the time of the
initial investment, both the total
amount that he or she plans to invest
in the fund, and how long he or she
will hold the investment. Given
changes in individual needs and market
conditions, this presumption may be
unreasonable. Indeed, taken one step
further, the NASD appears to be
suggesting that investors should
determine the holding period for their
mutual funds based on modest
differences in the costs of front-end
and back-end sales charges, rather than
upon such fundamental criteria as fund
performance and investor needs. Such
a change in investment focus may not
be beneficial to all mutual fund
consumers.
The Expense Analyzer also operates
on the assumption that the annual
return on a fund can and will stay
constant over the course of the investment. Indeed, the Expense Analyzer
has boxes to enter “Annual Rate of
Return” but does not specify the
period of time that should be
considered, instead telling investors
that they “may want to review a fund’s
average before and after tax returns,
for 1, 5 and 10 years … .” The NASD
itself has noted that using a fund’s past
performance as a future indicator
without the appropriate context can be
problematic.12 It is curious, therefore,
that the NASD now suggests using
previous annual returns when deciding
the appropriate mutual fund share
class to purchase.
Consistency in annual fees over the life
of the investment is yet another
built-in presumption of the Expense
Analyzer. This fails to take into
account the fact that annual fees can
be (and often are) modified by fund
companies. This prompting of
investor reliance on fees subject to
modification is particularly problematic
in light of the current regulatory and
legislative initiatives to reform mutual
fund management and improve mutual
fund fee transparency.13
Other problems may exist with the
manner in which the Expense
Analyzer actually performs its
calculations. For example, the
Expense Analyzer fails to consider
certain potential benefits associated
with investing in B-shares. Many
B-shares waive the CDSC in the event
of the investor’s death or disability.
Indeed, this benefit, coupled with the
advantage of having one’s entire
principal invested at the outset, is one
reason some investors choose Class B
shares. Similarly, the Investor Alert
ignores the fact that many investors
simply prefer not to pay up-front fees,
regardless of return comparisons years
later.14
Perhaps recognizing these deficiencies,
the NASD has linked a “disclaimer” to
the Expense Analyzer stating, in part,
that:
The results presented by this
calculator are hypothetical and
may not reflect the actual growth
of your own investments. NASD
and its affiliates are not
responsible for the consequences
of any decisions or actions taken
in reliance upon or as a result of
the information provided by these
tools. NASD is not responsible
for any human or mechanical
errors or omissions.
Potential for Private and Class
Action Suits
Increased investor concern is also
indicated by the filing of a handful of
class action suits against firms for
putting investors into large B-share
positions. The first of these cases, a
class action suit brought against Merrill
Lynch, was ultimately dismissed on
other grounds, but two additional
putative class actions against Morgan
Stanley and AIM are currently
underway.15 These suits are based on
the general premise that if one plans
on investing $50,000 or more, the
breakpoint discounts typically available
on A-shares and the potentially lower
CSDC on Class C shares make either
of those investment options preferable
to B-shares. In light of the recent
regulatory attention to B-shares, this
litigation trend is likely to continue in
the immediate future.
* * *
In the midst of pending legislation and
proposed mutual fund reform, the
NASD continues to investigate purportedly unsuitable B-share purchases.
Additionally, since the latest Investor
Alert and the accompanying Expense
Analyzer may be expanding public
awareness of the issues raised by
B-share investing, the pending class
actions may be only the beginning.
Firms are therefore cautioned to
ensure their compliance with the
relevant NASD and SEC notices and
rules, including the documentation of
those purchases made as part of a
bona fide asset allocation plan.16
dÉê~äÇgKcáÉäÇë is a member and oáÅÜ~êÇ
`KpÅÜçÉåëíÉáå is Of Counsel in the New
York Litigation Department of Paul
Hastings, Janofsky & Walker L.L.P.
aÉÄçê~Üp~äòÄÉêÖ, a Law Clerk in the
Department, provided substantial assistance
in research and drafting this Client Alert.
If you have any questions regarding the issues
discussed in this Alert, please contact any one
of the following attorneys:
dÉê~äÇgKcáÉäÇë
(212) 318-6290
geraldfields@paulhastings.com
oáÅÜ~êÇ`KpÅÜçÉåëíÉáå (212) 318-6273
richardschoenstein@paulhastings.com
gìäáÉ^ääÉÅí~
(415) 856-7006
julieallecta@paulhastings.com
oçÄÉêí_çêÉëí~
(212) 318-6272
robertboresta@paulhastings.com
oçÄÉêíbK`~êäëçå
(213) 683-6299
robertcarlson@paulhastings.com
tÉåÇÉääjKc~êá~
(202) 508-9574
wendellfaria@paulhastings.com
jáÅÜ~Éädä~òÉê
(213) 683-6207
michaelglazer@paulhastings.com
a~îáÇ^KeÉ~êíÜ
(415) 856-7007
davidhearth@paulhastings.com
jáíÅÜÉääbKkáÅÜíÉê
(415) 856-7009
mitchellnichter@paulhastings.com
jáÅÜ~ÉäoKoçëÉää~
(212) 318-6800
mikerosella@paulhastings.com
jáÅÜ~ÉäiKwìééçåÉ (212) 318-6906
michaelzuppone@paulhastings.com
1
Our prior Client Alerts related to this topic were Increased Regulatory Focus on Mutual Fund Purchases, Transaction Fees and Breakpoints
(March 2003) and Legislative Update: Congressman Baker Introduces the Mutual Funds Integrity and Fee Transparency Act of 2003 (June 2003).
These are available under the “Current Thinking” section of the Paul Hastings website at http://www.paulhastings.com.
2
See In re Prudential Securities, Incorporated, Exchange Act Release No. 48149 (July 10, 2003), at
http://www.sec.gov/litigation/admin/34-48149.htm; SEC Alleges Violations of Mutual Fund Sales Practice Requirements, Sanctions
Prudential Securities, Incorporated (July 10, 2003), at http://www.sec.gov/news/press/2003-82.htm.
3
Securities Law Daily (BNA), 2003 SEC LEXIS 1653 (July 17, 2003).
4
See Jonathan Stempel, Morgan Stanley: SEC Probing Fund Sales, REUTERS (July 11, 2003), at
http://www.reuters.com/newsArticle.jhtml?type=topNews&storyID=3077185.
5 The appeal was heard by the Commission on July 10, 2003. See Staff Argues Fraud Was Committed In Sales of Class B Mutual Fund
Shares, Staff Argues Fraud Was Committed In Sales of Class B Mutual Fund Sales, Securities Law Daily (BNA) (July 14, 2003), at
http://pubs.bna.com/ip/BNA/sld.nsf/.
6
See NASD Brings Enforcement Action For Class B Mutual Fund Share Sales Abuses And Issues Investor Alert on Class B Shares (June 25,
2003), at http://www.nasdr.com/news/pr2003/release_03_027.html.
7
See, e.g. NASD Charges New York Broker Todd M. Eberhard with Numerous Sales and Reporting Violations (Oct. 18, 2002), at
http://www.nasdr.com/news/pr2002/release_02_055.html; In re Dep’t of Enforcement v. Belden, NASD Case No. C05010012,
(National Adjudicatory Council, Aug. 18, 2002), available at http://www.nasdr.com/pdf-txt/nac0802_01.txt; Dain Rauscher, Inc. &
Gary Franklin Hayden, NASD Case No. C04020002, Firms Fined, Individuals Sanctioned, NASD Disciplinary Actions (March 2002), at
http://www.nasdr.com/pdf-txt/0203dis.txt; NASD Regulation Censures and Fines Stifel, Nicolaus & Company, and Two Individuals for the
Unsuitable Sale of Class B Mutual Fund Shares (Apr. 18, 2001), at http://www.nasdr.com/news/pr2001/ne_section01_026.html.
8
However, purchases made as part of a bona fide asset allocation plan, designed to meet an investor’s diversification needs and
investment goals, may not be violative of this rule provided the registered representative discloses to the investor that he will not
qualify for breakpoint reductions that are otherwise available. Firms are therefore encouraged to update and maintain records of
those exceptional circumstances in which large positions in B-shares are considered desirable for their customers.
9
See Gregory Scott Kolb, NASD Case No. C3A030005, Individuals Barred or Sanctioned, NASD Disciplinary Actions (March 2003), at
http://www.nasdr.com/pdf-text/0304dis.txt.
10
See NASD Investor Alert: Class B Mutual Fund Shares: Do They Make the Grade? (Jun. 25, 2003), at
http://www.nasdr.com/alert_classb_funds.htm; see also NASD Investor Alert: Mutual Fund Breakpoints: A Break Worth Taking (Jan.
14, 2003), at http://www.nasdr.com/alert_breakpoint.htm; NASD Investor Alert: Understanding Mutual Fund Classes (updated
Jan. 24, 2003), at http://www.nasdr.com/alert_mfclasses.htm.
11
The Expense Analyzer, also available for Exchange Traded Funds, is accessible through the NASD’s website at
http://www.nasdr.com/FundCalc/expense_analyzers.asp (last visited July 14, 2003).
12
See NASD Notice to Members 00-21, NASD Regulation Reminds Members Of Their Responsibilities When Advertising Recent Mutual
Fund Performance (April 2000) (reminding members that extraordinary fund performance must be communicated to investors with
appropriate caution).
13
See Mutual Funds Integrity and Fee Transparency Act of 2003, H.R. 2420, 108th Cong. (2003).
14
Investor sensitivity to salient sales loads, as opposed to operating expenses and on-going fees, has been documented in 2002
Berkeley study. See Brad Barber, Terrance Odean, and Lu Zheng, OUT OF SIGHT, OUT OF MIND: THE EFFECT OF EXPENSES ON
MUTUAL FUND FLOWs, at http://faculty.haas.berkeley.edu/odean/papers/MutualFunds/Out%20of%20Sight%200112281.pdf.
15
The Supreme Court declined to review the decision in the Merrill Lynch suit, which was dismissed on the grounds that the state
law claims were preempted by the Securities Litigation Uniform Standards Act. See Behlen et al v. Merrill Lynch, 311 F.3d 1087 (11th
Cir. 2002), cert den’d 123 S.Ct. 2583 (June 16, 2003). See also Ruling Stands State Law Claims over Fund Classes Preempted by SLUSA, 35
BNA Securities Regulation & Law 25, 1034 (June 23, 2003). The suits against Morgan Stanley and AIM are both currently moving
towards trial. See Colin Dodds, Suit Accuses AIM of Improper B-Share Sales, IGNITES.COM (June 19, 2003).
16
The bona fide asset allocation exception to NASD Rule IM-2830 can often be implicated by purchases of B-shares. See Client
Alert: Increased Regulatory Focus on Mutual Fund Purchases, Transaction Fees and Breakpoints (March 2003), available under “Current
Thinking” section of the Paul Hastings website at http://www.paulhastings.com.
`äáÉåí^äÉêí is published solely for the interest of friends and clients of Paul, Hastings, Janofsky & Walker LLP and should in no way be
relied upon or construed as legal advice. For specific information on recent developments or particular factual situations, the opinion of
legal counsel should be sought. Paul, Hastings, Janofsky & Walker LLP is a limited liability partnership.