In recent years the NASD has fined and censored a considerable number of firms for improperly recommending the purchase of Class B shares of mutual funds. The NASD has disciplined and suspended many brokers and advisers for the same reason.
Frequently, Class A shares of mutual funds are more cost effective than Class B shares. This is especially the case when the amount of the customer’s investment is in the millions. Unscrupulous and negligent brokers often fail to inform the investor on issues pertaining to breakpoint, expense ratio, commissions, and the contingent deferred sales charge. Improperly, and by virtue of fraud, the broker will place an investor’s assets in Class B shares of mutual fund, when the investor should have been in class A. The consequences can be devastating for the investor, who may end up losing his or her retirement savings.
CLASS B SHARES
The advantage of Class B shares over A shares is that B-shares typically do not charge a front-end sales charge.
Although Class B shares do not impose a front-end load, they do impose asset-based sales charges that are higher than those associated with Class A shares.
Class B shares impose a Contingent Deferred Sales Charge (CDSC)
when an investor sells the shares before the end of a designated period. The CDSC occurs on a declining basis, based on the length of time the shares are owned, and typically are eliminated after six to eight years.
The NASD, in a June 2003 Investor Alert, provided the following sample CDSC schedule:
Sample CDSC Schedule (Class B Shares)
Years Since Purchase…….Sales Charge (CDSC)
NASD Investor Alert, “Class B Mutual Fund Shares: Do They Make the Grade?” (June 25, 2003).
Selling Class B shares during the period in which the CDSC applies can significantly diminish the overall return, especially when coupled with the higher annual expenses charged on Class B shares. At the end of an investor’s CDSC period, the Class B shares convert to Class A shares. Conversion to Class A shares lower the annual expenses to the Class A rate. In the meantime, the investor is locked in the investment for an extended period of time.
Due to the CDSC, the investor may find himself locked up for a number of years and forced unnecessarily to pay an annual percentage. The investor could have forgone paying the extra cost, and remove the trading restriction, by investing in A shares, but the broker probably never explained this to the investor.
In view of all relevant considerations,Class B shares are subject to higher annual expenses than Class A shares
. See Department of Enforcement v. Raghavan Sathianathan
, NASD Disciplinary Proceeding No. C9B030076, at p. 11 (November 30, 2004) (“The expense ratios charged to Class B shareholders are higher than the expense ratios charged to Class A shareholders.”).
SMALL VERSUS LARGE INVESTMENTS
For large investments Class A shares are superior to Class B shares. Brokers should not recommend Class B or C shares to investors who seek to purchase in large amounts and who would incur significantly lower sales charges for Class A share purchases due to the availability of breakpoints, rights of accumulation, or letters of intent.
For small investments, Class B shares are considered more advantageous than Class A shares, because small investments in Class A shares do not qualify for any breakpoints and incur the highest initial sales charge rate.
BROKERS RECEIVE HIGHER COMMISSIONS FROM CLASS B SHARES
“[T]here is a substantial difference in the amount of commission credit a registered representative receives for selling Class B versus Class A shares of the same fund.” Department of Enforcement v. Raghavan Sathianathan
, NASD Disciplinary Proceeding No. C9B030076, at p. 11 (November 30, 2004). “This occurs because a representative receives a declining rate of commission credits at breakpoints for the sale of Class A shares, but the same percentage commission credit for the sale of all Class B shares, regardless of dollar amount.” All too often the broker will fail to disclose his incentive for investing in Class B shares of mutual funds, namely that he receives a significantly higher commission.
SUITABILITY AND CLASS B RECOMMENDATIONS
THE SUITABILITY RULE
: NASD Rule 2310 requires that a registered representative, when recommending investments, determine that such investments are suitable based on the customer’s financial profile and investment objectives. “A violation of NASD’s suitability rule is also a violation of Conduct Rule 2110 which requires members to observe high standards of commercial honor and just and equitable principles of trade.” Department of Enforcement v. Wendell D. Belden, NASD Complaint No. C05010012, at p.7 (August 13, 2002).
The NASD has repeatedly maintained that an unsuitable recommendation for the purchase of B shares constitutes a violation of NASD Conduct Rules 2110 and 2310. Department of Enforcement v. Wendell D. Belden, NASD Complaint No. C05010012, at p.7 (August 13, 2002). Department of Enforcement v. Raghavan Sathianathan, NASD Disciplinary Proceeding No. C9B030076 (November 30, 2004).
According to NASD Notice to Members 95-80 (Sept. 1995)
, when determining whether a fund is suitable for an investor, a member should consider the fund’s expense ratio and sales charges as well as investment objectives.
EXAMPLES OF CASES:
In March 2005, NASD censured and fined Citigroup Global Markets, Inc., American Express Financial Advisors and Chase Investment Services a total of $21.25 million for suitability and supervisory violations relating to the sale of mutual funds. See NASD News Release, March 23, 2005.
See NASD News Release, March 23, 2005.
- Individually, Citigroup was fined $6.25 million, while American Express was $13 million, and Chase was fined $2 million.
- In all three cases, the firms made recommendations and sales of Class B shares of mutual funds to their customers without considering or adequately disclosing, on a consistent basis, that an equal investment in Class A shares would generally have been more economically advantageous for their customers by providing a higher overall rate of return.
- In particular, NASD found that the firms did not consistently consider that large investments in Class A shares of mutual funds entitle customers to breakpoint discounts on sales charges.
- The firms also had inadequate supervisory and compliance policies and procedures relating to these mutual fund sales. In resolving these actions, the firms agreed to a remediation plan that included more than 275,000 transactions in Class B shares.
In December 2005, NASD fined Merrill Lynch, Pierce, Fenner & Smith, Wells Fargo Investments Linsco/Private Ledger Corporation a total of $19.4 million for suitability and supervisory violations relating to sales of Class B mutual fund shares. See NASD New Release, December 19, 2005.
“In recommending mutual funds with different share classes, brokers must understand, consider and disclose information about which particular share class would be most beneficial for the customer form an expense perspective. The failure by these firms to do this resulted in their customers purchasing Class B and C shares when they would have been better served with Class A shares. The firms have agreed to a remediation plan that will give affected customers the opportunity to convert their holdings to a more financially advantageous mutual fund share class.”
- NASD investigated transactions during an 18-month period, and found that the three firms recommended and sold Class B shares of mutual funds to their customers without considering or adequately disclosing on a consistent basis that an equal investment in Class A shares would generally have been more advantageous to those customers.
- NASD Executive Vice President and Head of Enforcement, Barry Goldsmith, commented:
See NASD New Release, December 19, 2005.
- Individually, Merrill Lynch was fined $14 million, while Wells Fargo was fined $3 million and Linsco was fined $2.4 million. The amount of the fines approximate the additional commissions the firms received by selling Class B shares rather than Class A mutual fund shares. In addition, each firm was required to implement a remediation plan to compensate affected customers.
In June 2003, NASD censured and fined McLaughlin, Piven, Vogel Securities, Inc. (MPV) and its’ Chairman a total of $100,000 for supervisory violations and unsuitable sales of Class B shares of mutual funds, and directed restitution of approximately $90,000 to customers. Additionally, NASD suspended MPV’s Chairman, James C. McLaughlin for a period of 30 business days in his capacity as a principal.
In April 2001, NASD censured and fined brokerage firm Stifel, Nicolaus & Company, and in the process suspended a broker and his supervisor, and directed that restitution be paid to its customers for, among other things, recommending that each of 15 customers purchase over $250,000 in Class B shares when it would have been more cost-effective for those customers to purchase Class A shares. See NASD New Release, September 10, 2002.
The NASD has also pursued individual brokers for such violations. In Department of Enforcement v. Wendell D. Belden, Complaint No. C05010012 (August 13, 2002)
, the broker was fined $40,000, suspended in all capacities for one year, and ordered to pay restitution of $55,567, plus interest, to the customer’s estate.
- The broker, Wendell D. Belden, sold $2.1 million in Class B shares in two mutual fund families to a customer. The amount invested in one fund family was enough to entitle the customer to obtain Class A shares with no front-end load. The amount invested in the second fund family would have entitled the customer to obtain the largest breakpoint discount on Class A shares.
- NASD’s National Adjudicatory Council held that a broker’s suitability obligation includes the requirement to minimize the sales charges paid for mutual fund shares, when consistent with the customer’s investment objectives.
- The broker’s recommendation was unsuitable because the customer’s purchase of Class B rather than Class A shares resulted in significantly higher costs.
Similarly, in July 2002, NASD charged New York broker, Todd M. Eberhard, with securities fraud involving, among other abuses, purchasing large volumes of Class B shares that kept his customers from taking advantage of the lower sales charges available through different classes of shares.