By Gerald J. Fields and Richard C. Schoenstein
While late trading and market timing have dominated the headlines in recent mutual fund industry reports, the Securities and Exchange Commission ("SEC") and the National Association of Securities Dealers ("NASD") continue to pursue the failure by firms to provide breakpoint discounts on Class A share purchases, coming forth with a host of new activities designed to compensate investors who may have been deprived of breakpoint opportunities. Additionally, these regulators are continuing their efforts to seek out and sanction unsuitable Class B share recommendations. This Alert is a brief summary of the regulatory action and developments since our last Alert on these issue in early August of 2003.1
Breakpoint Discounts for A-Share Purchases
The NASD first officially announced that investors as a whole had not uniformly received appropriate breakpoint discounts on their purchases on Class A shares in a March 2003 joint report issued by the SEC, NASD, and New York Stock Exchange.2 This report was followed by another from the Joint NASD/Industry Task Force on Breakpoints in July 2003, which concluded that the difficulty in delivering breakpoints was an "unintended consequence" of both increased opportunities for breakpoint discounts and greater variation in the manner in which mutual fund transactions are processed.3
On August 25, 2003 the NASD issued Notice 03-47 to members in which it reiterated that members must "make refunds to customers expeditiously where they were aware that customers did not receive the sales load discount to which they were entitled."4 The NASD further stated it expected members would "make refunds to any customers who come forward and assert that they did not receive all applicable breakpoint discounts" and would not place the burden of demonstrating breakpoint entitlement on the investor. The Notice also offered guidelines for accomplishing these refunds, including an interest rate of at least 2.5%. Towards this end, the NASD created another calculator – this time purportedly designed to assist member firms in providing investors with refunds, although it may just as easily assist investors who take it upon themselves to ascertain the refund to which they believed they are entitled.5
On November 3, 2003 the NASD and SEC jointly announced that they are "directing nearly 450 securities firms to notify customers who purchased Class A mutual fund shares since Jan. 1, 1999, that they may be due refunds as a result of the firms’ failure to provide breakpoint discounts."6 Additionally, the NASD announced it was directing almost 175 of those firms with poor records of providing breakpoint discounts to complete a comprehensive review of transactions since the beginning of 2001 for possible missed discount opportunities …" In general, these findings are to be supplied to the regulators by the end of March, 2004. By contrast, those brokerage firms that had overcharges totaling less than $1,000 over a two-year period are not generally being required to take any remedial action.7
In conjunction with the release, the NASD also issued Investor Alert advising investors that they may be eligible for a refund of a portion of the front-end sales charge they paid when purchasing A-shares.8 The Alert included information about the potential refund, how it would be paid and applicable interest rates, as well as information about letters of intent and rights of accumulation. Finally, the NASD concluded its recent flurry by remarking in its release that "[a] number of those firms may be subject to enforcement actions by NASD and the SEC" – actions that will "certainly" be brought "this year."9 The SEC is similarly poised to issue Wells notices to "a significant number of brokerage firms" that do not appear to have provided investors with the appropriate discount.10
Unsuitability of B-Share Purchases
Meanwhile, regulators have not abandoned their pursuit of allegedly unsuitable recommendations of Class B share purchases. On August 12, 2003, the NASD announced additional enforcement actions "as part of its ongoing focus on the sale of Class B mutual fund shares."11 Four of these actions were immediately settled, each time involving a finding that the broker violated the NASD Rule 2310 (the suitability rule) "by recommending their customers purchase … B-share mutual funds instead of A shares" when "[t]he purchase of A shares would have eliminated or reduced front-end sales charges through breakpoint discounts available at various dollar amounts; resulted in lower ongoing expenses than those available through B shares; and would have avoided the contingent deferred sales charges associated with B shares." Fines imposed on those brokers who settled ranged from $2,5000 to $60,000, and suspensions ranged from to 10 days to 9 months. In its release about the actions, the NASD stressed "[i]t is critical that a broker consider the costs of A shares versus B shares for the customer, and not the profit for the broker."
Regulatory action on the B-share front has not halted since the onset of the late trading and market timing investigations of the past two months.
The NASD is currently examining approximately 50 cases of potential B-share violations. As such, firms would be well advised to ensure that policies and procedures are in place and in use to provide investors with full disclosure about multi-class mutual fund fee structures, including the potential availability of breakpoint discounts on A-shares. Firms should also continue to document those exceptional circumstances which demonstrate a sizeable position in B-shares is suitable (e.g. as part of a bona fide asset allocation plan) for a particular customer.
In addition to regulatory attention, arbitrations involving funds are also hitting record levels. Significantly, "[t]he NASD expects to see more arbitration complaints involving B shares and fund sales practices next year" after regulators complete the above discussed investigations. In fact, "[c]laims related to such practices are already growing."12 Finally, it is quite possible that, in addition to continued regulatory actions, there will be a revival of congressional attention to H.R. 2420 and its accompanying debate about mutual fund fee transparency.13
Notes
1.
Our prior client alerts on this topic were Recent Regulatory Activities with Respect to Class B Shares of Mutual Funds (August 2003) and Increased Focus on Mutual Fund Purchases, Transaction Fees and Breakpoints (March 2003)2. The "Joint SEC/NASD/NYSE Report of Examinations of Broker-Dealers Regarding Discounts on Front-End Sales Charges on Mutual Funds" is available on the NASD’s website at http://www.nasdr.com/pdf-text/bp_joint_exam.pdf.
3. The "Report of the Joint NASD/Industry Task Force on Breakpoints" is available on the NASD’s website at http://www.nasdr.com/pdf-text/breakpoints_report.pdf.
4. NASD Notice to Members 03-47, Refunds to Customers Who Did Not Receive Appropriate Breakpoint Discounts in Connection with the Purchase of Class A Shares of Front-End Load Mutual Funds and the Capital Treatment of Refund Liability (Aug. 2003), available on the NASD website at http://www.nasdr.com/pdf-text/0347ntm.pdf.
5. The calculator is available on the NASD’s website at http://www.nasdr.com/breakpoint_calculator/default.asp. This calculator does seem better situated to provide accurate information than its "Expense Analyzer" – discussed at length in our August 2003 Client Alert, and still available on the NASD’s website at http://www.nasd.com/Investor/Tools/Calculators/FundCalc/expense_analyzers.asp.
6. See NASD Press Release, SEC and NASD Announce Actions as a Result of Findings of "Breakpoint" Overcharges on Mutual Fund Transactions (Nov. 3, 2003), at http://www.nasdr.com/news/pr2003/release_03_045.html.
7. See Judith Burns, "NASD Orders Brokers to Contact Fund Customers on Charges", Wall Street Journal (Nov. 6, 2003).
8. The Investor Alert, entitled "Mutual Fund Breakpoints: Are You Owed a Refund?" is available on the NASD’s website at http://www.nasd.com/Investor/Alerts/alert_breakpoint_refund.htm.
9. See Judith Burns, "NASD Plans to File Charges Against Two Dozen Fund Firms", Wall Street Journal (Nov. 3, 2003) (quoting Mary Schapiro, Vice Chairman and President of Regulatory Policy, NASD).
10. See id. (quoting Stephen Cutler, Director, Division of Enforcement , SEC).
11. See NASD Press Release, NASD Files Enforcement Actions Involving Unsuitable Sales of Mutual Funds (Aug. 12, 2003), at http://www.nasdr.com/news/pr2003/release_03_034.html.
12. See Ruth Simon, "Arbitrations Over Funds Hit Record Levels: Irate Investors Challenge Brokers On Sales Practices, High Costs; Going It Alone vs. Class Actions", Wall Street Journal (Oct. 29, 2003).
13. See Mutual Funds Integrity and Fee Transparency Act of 2003, H.R. 2420, 108th Cong. (2003); see also Legislative Update: Congressman Baker Introduces The Mutual Funds Integrity and Fee Transparency Act of 2003. The bill, which appeared to have stalled in Congress, was repeatedly discussed in testimony this week before the Senate and House regarding late trading and market timing, and many legislators again appear to be taking an active interest in mutual fund fee legislation.
Gerald J. Fields is a member and Richard C. Schoenstein is Of Counsel in the New York Litigation Department of Paul Hastings, Janofsky & Walker L.L.P. Deborah Salzberg, an Associate in the Department, provided substantial assistance in research and drafting this article.
For specific information on recent developments or particular factual situations, the opinion of legal counsel should be sought. Paul Hastings is a limited liability partnership.
