NSCP. The Ultimate Multiple Choice Test for Brokers: the ABC s of Mutual Fund Share Classes. By Patricia C. Foster

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1 J U L Y / A U G U S T S p e c i a l E d i t i o n NSCP CURRENTS A Publication of the NATIONAL SOCIETY OF COMPLIANCE PROFESSIONALS The Ultimate Multiple Choice Test for Brokers: the ABC s of Mutual Fund Share Classes By Patricia C. Foster The multi-class structure made its debut in 1988 when the SEC granted the initial multi-class exemptive order to Merrill Lynch. 1 Competitors found the concept appealing and quickly filed applications for orders that would permit them to offer multiple classes of stock representing interests in a single portfolio. After dedicating considerable resources to processing these applications over a period of five years, the SEC recognized the need for a uniform exemptive rule and, in late 1993, proposed for comment Rule 18f-3 under the 1940 Act. 2 The adoption of Rule 18f-3 in 1995, along with contemporaneous amendments to certain other rules and forms, permitted open-end investment companies to issue multiple classes of shares upon the adoption of a plan in accordance with the rule (18f-3 Plan) and compliance with other requirements. 3 The new rule provided investors with more choices and, in addition, provided financial intermediaries with new ways to structure their compensation in connection with the sale of mutual funds. 4 This article is a consideration of the conflicts of interest and other sales practice issues that have arisen as a result of the dazzling array of choices now available to retail investors and how regulators are addressing these issues Patricia C. Foster, Esq. PLLC. Ms. Foster is an attorney in private practice in Pittsford, New York. More Choices, More Complexity and Less Transparency Prior to the 1980s, choices for mutual fund investors were limited to load or no load funds. Financial intermediaries selling load funds, which featured a front-end sales charge, received of a portion of that sales charge as compensation. The allocation of that sales charge between the principal underwriter and the selling broker was readily apparent to the investor, and the investor generally understood that the amount of the sales charge depended upon the amount invested and would be deducted at the time of the investment. Two subsequent developments had a major impact on the evolution of compensation practices in connection with retail sales of mutual funds, the adoption of Rule 12b-1 under the 1940 Act in , which permitted mutual funds to bear expenses in connection with the distribution of fund shares, and the adoption of Rule 18f-3 6 fifteen years later. The adoption of these rules increased the complexity of compensation arrangements because each of the three most common retail share classes (Class A, Class B and Class C) customarily featured a separate 12b-1 Plan. The type and amount of compensation to be received by the broker was less transparent to the retail investor in connection with Class B and Class C shares. 7 Although Form N-1A, the registration form for mutual funds, requires certain disclosure relating to the specific features of and the expenses associated with each share class, it has become clear that retail investors could benefit from a better understanding of their choices. Understanding the Economics of the Share Classes As the industry moved into the more complex pricing structure, many funds, upon the adoption of an 18f-3 Plan, redesignated their existing share classes as Class A and added both Class B and Class C shares. The following paragraphs describe the typical attributes of these share classes 8. Class A shares typically feature a front-end sales charge (deducted at the time of purchase) that declines as a percentage of the offering price as the size of the investment increases and breakpoints are achieved. In many cases the front-end sales charge is eliminated altogether for investments of $1 million or more, subject to certain requirements. 9 These breakpoint discounts, which are specific to each fund, illustrate the importance of trade size, as well as other factors 10, in a share class suitability analysis. Class B shares are generally sold subject to a back-end or contingent deferred sales charge (CDSC) that declines according to a schedule and is eliminated altogether once a specified holding period has been satisfied. If Class B shares are redeemed prior to the elimination of the CDSC, the CDSC (Continued on page 2) 2006 National Society of Compliance Professionals, Inc.

2 NSCP Currents July / August 2006 Special Edition will be assessed in accordance with the methodology established by the particular fund. 11 Because Class B shares are generally subject to higher ongoing expenses (as a result of the Rule 12b-1 Plan adopted by the class) than Class A shares, Class B shares may convert to Class A shares automatically if held beyond the point in time at which the CDSC is eliminated. 12 Upon conversion, the lower expenses associated with Class A shares will apply. The conversion feature illustrates the importance of the holding period as a factor in a share class suitability analysis. Class C shares are generally sold subject to a CDSC that typically expires after 12 months. Like Class B shares, Class C shares are generally subject to higher ongoing expenses than Class A shares. However, unlike Class B shares, Class C shares do not incorporate the conversion feature which results in a lower expense structure subsequent to the expiration of the CDSC. The higher ongoing expenses associated with Class C shares and the absence of a conversion feature illustrate the importance of the holding period as a factor in a share class suitability analysis. Financial Calculators. The multiple class structure permits investors to consider a variety of pricing options in connection with mutual fund purchases. Numerous financial calculators have been developed in order to assist investors in understanding the economics of their share class choices. 13 Loaded with class-specific data for the share classes offered by various funds, many of these interactive software tools assist the user in determining which mutual fund share class might be best in various trade-specific scenarios. The calculators are intended to complement the selection process by permitting the user to make hypothetical investments and then compare the results for the various share classes. However, the inherent limitations of the calculators underscore the importance to investors of reading a current prospectus for the mutual fund under consideration and working with a knowledgeable financial professional. For example, most calculators do not illustrate certain industry practices that permit certain classes of investors to purchase Class A shares without a front-end load under specified circumstances (e.g., in accordance with scheduled variations from the sales load as permitted by Rule 22d-1 under the 1940 Act). These special arrangements will typically be described in the prospectus or Statement of Additional Information. The Morningstar White Paper. On May 17, 2006, Morningstar, Inc. published a White Paper entitled Mutual Fund Share Class Limits and Share Class Suitability. Citing concerns expressed by regulators that investors are being overcharged by brokers who have directed clients to Class B and Class C shares rather than Class A shares under circumstances where breakpoints associated the Class A shares could have been realized, the White Paper indicates that new bright line share class limits have informally emerged such that Class B and Class C shares typically may not be sold to investors who have at least $50,000 or $250,000 to invest. 14 The Morningstar study examines the extent to which investors may be protected by share class limits, and how financial advisors who seek to fulfill their fiduciary and suitability obligations to their clients can determine which share class is suitable given the client s investment horizon and wealth. The White Paper states that, although bright line share class limits are helpful generalizations that protect investors in many situations, there are many exceptions in which share class limits can harm investors. Four specific findings emerged from the Morningstar study: For investors who don t know their time horizon and can achieve a breakpoint, Class A shares are generally the best choice. However, for small investors with an unknown time horizon who are unlikely to reach a breakpoint, Class B shares may be a better choice. While Class B shares don t always come out on top, they are clearly better than Class A shares in the short term and Class C shares in the long term, and they rarely under-perform the best choice by much. For investors who are extremely 2 confident that their time horizon will be three years or less, Class C shares are almost always the best choice, regardless of the breakpoints available through an investment in Class A shares. For investors who believe their time horizon to be between four-to-seven years, the choice of share class is rarely clear-cut and depends upon the breakpoint achievable and the unique structural nuances of the fund being considered. For investors who believe their time horizon to be eight or more years, Class A shares are usually the best choice, although Class B shares are frequently the best choice for investors with $50,000 or less to invest. 15 The New Dimensions of Suitability and the Need for Adequate Systems The introduction of the multiple class structure has resulted in not only more choices for investors, but also new dimensions in the suitability obligations of financial intermediaries. The White Paper acknowledges that bright line share class limits are best viewed as a starting point for share class suitability and points to three factors that must be considered when evaluating the appropriate share class for an investor the specific share class structure of the fund under consideration, the investor s investment amount and the investor s time horizon. 16 Noting that there is little standardization among share classes from fund to fund, the White Paper states that financial advisors must take a multiplicity of other factors into account. Mutual fund sales practice issues have received a great deal of regulatory scrutiny in recent years. Much of that scrutiny has centered on conflicts of interest which may have motivated a broker to recommend one class of shares rather than another. In particular, regulators have expressed concern that Class B shares or Class C Shares, which have higher ongoing expenses than Class A shares, were recommended when Class A shares would arguably have been more appropriate. Regulators have also brought into focus certain systemic weaknesses by broker-dealers effecting mutual fund transactions. These weaknesses relate

3 3 NSCP Currents July / August 2006 Special Edition to administrative matters in connection with the processing of trades and supervisory matters as well. A major concern has involved the apparent disregard by financial intermediaries of breakpoint schedules for Class A shares which would have resulted in an economic benefit to the investor. To address this concern, commencing in November of 2002, the SEC s Office of Compliance, Inspections and Examinations (OCIE), NASD and NYSE conducted a three-month examination sweep of 43 broker-dealers that sell mutual funds with a front-end sales charge. The purpose of the examinations was to determine whether investors were actually receiving the benefit of available discounts on those front-end sales charges. The regulators issued a joint report in March of 2003 which revealed that in some instances most of the firms examined did not provide customers with breakpoint discounts for which they appeared to have been eligible and that the most frequent causes for not providing a breakpoint discount were not linking a customer s ownership of different funds in the same mutual fund family, not linking shares owned in the same fund or fund family in all of a customer s accounts at the firm and similar administrative weaknesses in processing transactions. 17 Noting that most of the problems did not appear to be intentional, the Report stated that many firms can improve their compliance and supervisory systems and controls with respect to the disclosure of breakpoint opportunities and obtaining information from customers about related accounts. 18 In July of 2003, the Commission settled an enforcement action involving the failure of Prudential Securities Incorporated ( Prudential ) to supervise allegedly unsuitable sales of Class B shares by a registered representative. 19 The Commission found that the rep had consistently recommended Class B shares of certain proprietary mutual funds to customers, allegedly without disclosing the existence of breakpoints that would have made the fund s Class A shares a lower-cost, and, thus, more suitable investment. 20 The Commission also found that while Prudential had adopted policies and procedures in connection with the sale of mutual fund shares, the firm had allegedly failed to adopt a system sufficient for the purpose of determining whether the existing policies and procedures were followed above the branch office manager level. 21 Prudential agreed to disgorge $82,000 in commissions and to pay a civil penalty of $300,000 in connection with the settlement of these claims. Following a number of situations which indicated systemic problems, the Commission and the NASD responded with a number of important initiatives. In late 2003, the NASD directed nearly 450 securities firms to notify customers who had purchased Class A shares since January 1, 1999, that they might be entitled to refunds resulting from missed breakpoint discounts. 22 In early 2004, the Commission and the NASD announced enforcement and disciplinary proceedings against 15 firms that had allegedly failed to provide breakpoint discounts during 2001 and In connection with these proceedings, the Commission alleged that the failure to disclose the availability of breakpoint discounts violated the anti-fraud provisions of the federal securities laws, while the NASD alleged that firms failed to observe just and equitable principles of trade as required by NASD Conduct Rule In 2004, the Commission amended Form N-1A, the registration form for mutual funds, to require enhanced disclosure of breakpoint discounts on front-end sales loads. 24 Understanding the Economics of Broker Compensation It is important that investors understand the financial incentives that could motivate a financial intermediary to recommend one share class over another. The release published in connection with the adoption of Rule 18f-3 stated that the multiple class structure may increase investor choice, result in efficiencies in the distribution of fund shares, and allow fund sponsors to tailor products more closely to different investor markets. 25 The release also noted that investor understanding of sales and service charges in connection with these arrangements had been a source of concern to the Commission. 26 Noting the substantial opposition to the extensive disclosure requirements originally proposed, the Commission decided that rather than relying on prospectus disclosure, it would address these concerns through consumer education and the promotion of good sales practices. 27 Regulators have long recognized the importance to investors of understanding the compensation received by broker-dealers in connection with securities transactions for their accounts. Transactions in mutual fund shares are currently subject to the confirmation requirements of Rule 10b-10 under the Securities Exchange Act of 1934 (Exchange Act), which was adopted in 1977 under Section 10(b), the Exchange Act s general antifraud provision. 28 Subject to certain exceptions, Rule 10b-10(a) requires disclosure of, among other things, the amount of any remuneration received or to be received by the broker from a customer in connection with the transaction. However, Rule 10b-10(f) provides the Commission with authority to exempt any broker-dealer from the requirements of Rule 10(b)-10(a) with regard to specific transactions or specific classes of transactions for which the broker or dealer will provide alternative procedures. In 1979, pursuant to the exemptive authority provided by Rule 10b-10(f), the Commission granted relief to the Investment Company Institute (ICI) which, on behalf of the mutual fund industry had sought no action assurances in connection with the use of trade confirmations for mutual fund transactions that would omit information relating to compensation received by the broker-dealer, provided that the prospectus for the mutual fund contained disclosure of sales charges, breakpoints and maximum dealer discounts. 29 In its letter granting the relief requested, the staff of the SEC relied upon the release adopting Rule 10b-10 which had explicitly acknowledged that, if information about the source and amount of third-party compensation was disclosed in a final (Continued on page 3)

4 NSCP Currents July / August 2006 Special Edition prospectus, then the confirmation for the transaction did not have to repeat the information ( ICI Letter ). 30 It is important to note that the ICI Letter was issued prior to the adoption of Rule 12b-1 and the adoption of Rule 18f-3, two developments which not only provided investors with more choices, but also introduced a new level of complexity. By the time that the multiple class structure was introduced in 1988, the use of the simpler trade confirmation had become commonplace in the industry. It appears that many broker-dealers selling mutual fund shares have continued to rely on the ICI Letter to satisfy the disclosure requirements of Rule 10b- 10. In such cases, the investor must rely on disclosures in the mutual fund prospectus and Statement of Additional Information for specific information concerning the compensation to be received by the broker-dealer, whether in the form of dealer concessions or other compensation. Moreover, in the multiple-class scenario, the retail investor must develop some understanding of the Rule 12b-1 Distribution Plan adopted by a particular share class in order to comprehend fully the compensation received and/or to be received in connection with a particular transaction. Regulators have questioned the adequacy of the simpler confirmation in the context of the multi-class structure. In an effort to enhance investor understanding, the Commission in 2004 proposed new rules (Rules 15c2-2 and 15c2-3) and amendments to Rule 10b- 10 under the Exchange Act designed to enhance the information brokerdealers provide to their customers in connection with transactions in certain types of securities including mutual funds. 31 The proposed rules would require brokers to provide specified information at the point of sale and in transaction confirmations regarding the costs and conflicts of interest that arise in connection with the sale of mutual fund shares. Following substantial comments on its Initial Proposal, the Commission re-published its proposal for an additional comment period of approximately 30 days in In connection with the Re-Proposal, the Commission set forth a lengthy series of questions. One question requested comment as to whether it would be appropriate to require a broker-dealer to provide point-of-sale information with regard to all share classes that are under consideration at the point of sale. The issues raised in the Re-Proposal are still under consideration. The composition of the Commission has changed since these initiatives were commenced and the Division of Investment Management has a new director. Conclusion With the introduction of the multiple class structure and the complexities attendant to the share class selection process, the suitability obligation of the selling broker has become multidimensional. Financial intermediaries must now consider the appropriateness of both the fund and the share class recommended. In recommending a particular mutual fund transaction, a broker must have reasonable grounds for believing that the recommendation for purchase, sale or exchange is suitable. 33 Prior to the execution of a transaction for a non-institutional client, a broker must make reasonable efforts to obtain information concerning the client s financial status, the client s tax status, the client s investment objectives, and such other information considered reasonable in making recommendations. 34 As noted in the White Paper, a determination of share class suitability involves a consideration of all relevant factors in connection with the recommendation of a specific mutual fund share class for a specific investor. 35 The recent enforcement actions and regulatory initiatives provide firms and their compliance officers an opportunity to re-evaluate existing policies and procedures and various related systems. In the midst of the PowerPoint slides, the suitability grids, and the interactive calculators, compliance officers will be well served to remember the importance of the prospectus. It s required reading for brokers and their customers Merrill Lynch California Municipal Series Trust, Release Nos. IC (notice) (July 28, 1988) 53FR and IC (order) (August 23, 1988). Section 18(f) of the Investment Company Act of 1940 ( 1940 Act ) limits the capital structure of mutual funds, thereby effectively prohibiting the issuance of multiple classes of shares. Section 18(f)(1) generally makes it unlawful for any registered open-end [management investment] company to issue any class of a senior security. Section 18(g) defines senior security to include any stock of a class having a priority over any other class as to distribution of assets or payment of dividends. Section 18(i) requires that every share of stock issued by a registered investment company be voting stock, with the same voting rights as every other outstanding voting stock. 15 U.S.C. 80a-18(f) (i). Although some fund sponsors addressed this dilemma by creating separate funds with differing fee structures to serve different markets (e.g. retail funds and institutional funds), there were operational inefficiencies associated with this approach. Thus, the Merrill Lynch exemptive order was an important development in the industry s ability to serve different markets. 2. See Exemption for Open-End Management Class and Master-Feeder Funds, Release No. IC (Dec. 15, 1993), 58 FR (Proposing Release). 3. See Exemption for Open-End Management Class and Master-Feeder Funds; Class Voting on Distribution Plans, Release No. IC-20915, March 2, 1995, 60 FR (Adopting Release). 4. It is important to note that the adoption of Rule 18f-3 occurred at a time when compensation practices in the retail brokerage industry were evolving from transaction-based compensation to fee-based compensation. 5. See Bearing of Distribution Expenses by Mutual Funds, Release No. IC , October 28, Rule 12b-1 prohibits any registered open-end investment company from directly or indirectly financing any activity that is primarily intended to result in the sale of its shares, except pursuant to a plan of distribution that conforms to the rule s requirements. 6. See Exemption for Open-End Management Class and Master-Feeder Funds; Class Voting on Distribution Plans, Release No. IC March 2, 1995, 60 FR (Adopting Release). 7. Under the multiple class structure contemplated by Rule 18f-3 each share class must have a different arrangement for shareholder services and/or the distribution of

5 5 NSCP Currents July / August 2006 Special Edition shares and must pay all the expenses of that arrangement. Rule 18f-3(a)(1)(i). 8. It is important to note that the description of retail share classes incorporates share class characteristics that this author believes to be common in the industry. The specific attributes of any share class will, of course, be specific to a particular fund. Some funds may offer additional share classes that are available only to certain classes of investors. This article does not consider these offerings. 9. For example, with respect to purchases of Class A shares of $1 million or more at net asset value, a back-end or contingent deferred sales charge may apply if the shares purchased are redeemed prior to the expiration of a specified holding period (e.g. 18 months) as disclosed in the prospectus of a particular fund. 10. Many mutual funds permit investors to aggregate various investment holdings for purposes of applying the Class A breakpoint schedule. 11. For example, one common methodology calculates the CDSC as a percentage of a specified amount which is usually the lower of: (a) the aggregate net asset value of the shares at the time of redemption (including shares acquired by reinvestment of dividends or capital gains distributions) or (b) the original cost of the redeemed shares. 12. The specific point at which Class B shares flip to Class A shares varies, depending on the fund under consideration, and is of critical importance to the share class suitability analysis. 13. See the NASD s Mutual Fund Expense Analyzer which is available at See Mutual Fund Share Class Limits and Share Class Suitability: A White Paper from Morningstar, Inc., May 15, 2006 and available at Id. These findings are outlined in the Morningstar White Paper and have not been independently authenticated by this author. This author believe that an awareness of the Class B CDSC schedule would be critical this analysis. For example some Class B shares flip to Class A shares after a six-year holding period, whereas other Class B shares do not make the transition until the expiration of an eight-year holding period. 16. Id. 17. See Staff Report: Joint SEC/NASD/NYSE Report of Examinations of Broker-Dealers Regarding Discounts on Front-End Sales Charges on Mutual Funds available at Id. 19. See In the Matter of Prudential Securities Incorporated, Release No (July 10, 2003). 20. Id. 21. Id. 22. See See See Release No , IC (June 7, 2004). 25. See Exemption for Open-End Management Class and Master-Feeder Funds; Class Voting on Distribution Plans, Release No. IC March 2, 1995, 60 FR (Adopting Release). This article does not address the substantial additional institutional markets for which fund sponsors have designed and continue to design so-called institutional share classes. 26. Id. 27. Id. In the Proposing Release the Commission had requested comment on whether, instead of requiring extensive prospectus disclosure, it should work with the National Association of Securities Dealers, Inc. (NASD) to develop standards for basic information that representatives should communicate to their clients. The Adopting Release notes that the collaborative approach received substantial industry support. It is important to note that jurisdiction over the offer and sale of mutual fund shares is shared by the SEC and the NASD. Mutual funds are required to be registered with the SEC, as are many of their service providers investment advisers, underwriters and transfer agents. The SEC and the NASD have concurrent jurisdiction over firms that distribute fund shares (e.g. principal underwriters) and firms that engage in the sale of fund shares. These firms must register as broker-dealers with the SEC and become members of the NASD. As such, these firms are subject to myriad SEC and NASD rules, which include specific rules relating to disclosure and sales practices. See, in particular, NASD Conduct Rule 3010, NASD Notice to Members and NASD Notice to Members See Securities Confirmations, Release No , May 5, See Investment Company Institute, SEC No-Action Letter (Publicly Available April 18, 1979). 30. See Securities Confirmations, Release No , May 5, 1977, at n See Confirmation Requirements and Point of Sale Disclosure Requirements for Transactions in Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments, and Amendments to the Registration Form for Mutual Funds, Release No (January 29, 2004) (Initial Proposal). 32. See Point of Sale Disclosure Requirements and Confirmation Requirements for Transactions in Mutual Funds, College Savings Plans, and Certain Other Securities, and Amendments to the Registration Form for Mutual Funds, Release No (February 28, 2005) (Re-Proposal). 33. NASD Conduct Rule Id. 35. See Mutual Fund Share Class Limits and Share Class Suitability: A White Paper from Morningstar, Inc., May 15, 2006 and available at / Professional Services For: Investment Advisers Investment Companies Broker-Dealers 190 Office Park Way Pittsford NY 14534

6 NSCP Currents July / August 2006 Special Edition NSCP CURRENTS is published by the National Society of Compliance Professionals, Inc. 22 Kent Road, Cornwall Bridge, CT (860) / info@nscp.org NSCP Board of Directors Joan Hinchman, Executive Director, President and CEO Richard T. Chase Lisa D. Crossley Patricia M. Harrison Michelle L. Jacko Clifford Kirsch Elizabeth M. Knoblock Editor & Layout Frederick D. Vorck, Jr. Charles R. Lowry David H. Lui Diane P. Novak Henry Sanchez, Jr. Theodore J. Sawicki Timothy M. Simons Andrew C. Small Holly Smith Cathy Tuckwell Kathleen VanNoy-Pineda Judy Babb Werner Michael K. Wolensky Editor Joan Hinchman