NASD s Focus on Mutual Fund Abuses: The State of Play and What s to Come

Transcription

1 NASD s Focus on Mutual Fund Abuses: The State of Play and What s to Come Barry R. Goldsmith and Ira D. Gluck For years, the mutual fund business appeared to be an example of a clean, disciplined industry. This reputation helped foster development of products that offered low-cost professional management, diversification, and risk control to fit a wide range of investor needs. The growth in sales and market penetration of mutual funds has been staggering, and has involved participation by a large segment of the investing public. Net assets of U.S. mutual funds increased from $448 million in 1940 to $6.4 trillion in 2002, and during the same period the number of shareholder accounts increased from just over 296,000 to nearly 251 million. 1 In light of disturbing revelations in the past several months of a wide range of abuses, however, it is evident that the mutual fund industry has seriously undermined investor trust. Portfolio managers have traded ahead of mutual fund investors, released portfolio information differentially and selectively, and made deals with preferred customers to permit market-timing and late trading. While NASD 2 does not have jurisdiction or authority over mutual funds or their advisors, it does regulate the sales practices of broker-dealers who sell mutual funds to investors. It also has jurisdiction over the broker-dealer affiliates of mutual fund complexes that are part of the underwriting and distribution chain for investment company securities. Accordingly, broker participation in illegal or unethical sales practices is a very direct concern of NASD. NASD has approached these problems on two different fronts. The first is in the area of rulemaking proposals for better and more extensive disclosure. The second is through tough and swift enforcement. DISCLOSURE On January 29, 2004, the Securities and Exchange Commission (SEC) issued a set of proposed rules intended to enhance the information disclosed by broker-dealers at the point of sale to the customer and in confirmation statements received by customers for mutual funds, insurance securities (unit investment trusts), and 529 municipal securities. 3 These rules would require additional disclosure regarding conflicts of interest and costs imposed on customers in connection with the distribution of these securities. The proposed rules also call for amendments to the registration form for mutual funds to disclose sales loads and revenue-sharing arrangements more effectively. In a similar vein, on December 17, 2003, the SEC issued proposed rules regarding additional and reorganized disclosure for breakpoint discounts for mutual funds with front-end sales charges. 4 These rules would require fund companies to disclose in their prospectuses information about arrangements that result in sales-charge discounts; the methodology used to value accounts; and the availability of such information on the fund s website. These rulemaking efforts by the SEC have a compelling basis. Investors deserve clear and easy-to-read disclosure that is informative and discloses all the costs associated with the purchase of a given mutual fund-not just the load and fees that affect investor costs, but any other arrangements that affect the price paid by the investor. Investors also should be aware of commission expenses and compensation arrangements between the broker and the fund. One of the bedrock principles of our free market system is that all participants have access to accurate information about prices and costs that can influence their decisions. When this information is hidden or distorted, buyers are not able to make informed decisions about where to invest their money. NASD also has been involved in proposed rulemaking with respect to the sale of mutual funds to investors. On September 17, 2003, NASD issued Notice to Members asking for comments on proposed amendments to NASD Rule 2830 (Investment Company Securities). 5 The amendments would require regulated broker-dealers to disclose their revenuesharing and differential cash compensation arrangements relating to the sale of investment company securities. The proposed changes would require that a broker-dealer disclose these compensation arrangements in writing when a customer first opens an account or purchases fund shares. Broker-dealers also would be required to update this information twice a year and make updates available to each of their customers. These proposed rules are designed to alert investors to the financial incentives that a broker-dealer or its registered 1

2 representatives may have in connection with recommending particular funds. The rules also would ensure that investors receive timely information about two types of compensation arrangements. The first of these compensation arrangements consists of cash payments by fund sponsors to broker-dealers to induce fund sales. Typically, these payments are made to gain shelf space at the broker, or to secure a place for a fund on a preferred sales list. 6 The second of these compensation arrangements involves either the payment by a broker-dealer of a higher compensation to its own registered representatives for selling certain funds or the imposition of higher costs or lower payouts to registered representatives with respect to sales of certain funds in order to drive selling activity to other funds preferred by the broker-dealer. On December 9, 2003, NASD issued Notice to Members requesting comment on proposed amendments to Rules 2210 (Communications With the Public) and 2211 (Institutional Sales Material). 7 The proposed amendments would require all broker-dealer communications with the public that contain mutual fund performance information to present specified information about the fund s expenses and performance in a prominent text box. These proposals are intended to improve investor awareness of mutual fund costs, facilitate comparisons among funds, and make standardized performance more prominent. Mutual fund fees and expenses directly affect an investor s return. When a mutual fund promotes its performance, it needs to give investors a balanced and easily comparable presentation by disclosing fees and expenses in a common format. ENFORCEMENT Any conduct we see in the mutual fund area that cheats the public and degrades the integrity of our securities markets will not be tolerated. Any broker-dealer or registered person that misleads a customer or games the system can expect to be the subject of an NASD enforcement action. NASD s heightened scrutiny in the area of mutual funds and variable annuities resulted in more than 80 new disciplinary actions in 2003 and 2004, and well over 200 since the beginning of To combat abuses that fall within its regulatory authority, NASD has concentrated its enforcement efforts in four main areas: Cash and non-cash compensation practices and arrangements; The suitability of the mutual funds that brokers sell, in particular abuses in connection with the sale of B shares; Whether broker-dealers are delivering the benefits to their customers to which they are entitled, such as breakpoint and net-asset-value transfer discounts; and Market-timing and late trading abuses. Cash and Non-Cash Compensation Practices and Arrangements On November 17, 2003, NASD, along with the SEC, announced an enforcement action against Morgan Stanley DW Inc. (Morgan Stanley) for giving preferential treatment to certain mutual fund complexes in return for millions of dollars in brokerage commissions and other payments. 8 Morgan Stanley agreed to resolve the NASD and SEC actions by paying $50 million in civil penalties and surrendered profits, all of which will be returned to injured investors. In this case, NASD found that from January 2000 until October 2003, Morgan Stanley operated two programs that gave favorable treatment to 16 mutual fund companies out of the total universe of 115 fund families that could be sold by the firm s sales force. This exclusive group of 16, or what Morgan Stanley called its Partner s Program, received enhanced access to the sales force and additional visibility within the firm. The preferential treatment received by these 16 fund families included: Placement on a preferred list of funds that financial advisors were to consider first in making recommendations of fund products; Higher visibility on Morgan Stanley s sales systems and workstations than that afforded to non-paying funds; Eligibility to participate in the firm s 401(k) programs and to offer offshore fund products to Morgan Stanley customers; and Payment of special sales incentives to Morgan Stanley financial advisors. Under the program, every time Morgan Stanley sold its customers shares of these favored funds, the fund family was obligated to pay Morgan Stanley a percentage of the sales price over and above ordinary commissions and loads. Unfortunately, Morgan Stanley s customers had no knowledge 2

3 of this and believed that recommendations made by the firm s sales force were based on the merits of the investment, not on its payout to the firm or its registered persons. The extra compensation paid for preferential treatment included millions of dollars paid by the mutual funds in commissions to Morgan Stanley for trades executed on the fund s portfolio. The commissions were sufficiently large to pay for the special treatment as well as the costs of trade execution. This violates NASD Conduct Rule 2830(k), which specifically prohibits the offer or acceptance of directed brokerage commissions in exchange for favoring or disfavoring a given fund in the firm s sales efforts. The payments that the funds made to Morgan Stanley to attract new investors and assets were coming at the expense of the current shareholders of the funds. Rather than the fund management company paying Morgan Stanley in cash, the mutual funds the company managed paid a multiple of that amount in the form of extra commission dollars. NASD believes that the abuses identified in the Morgan Stanley case are not necessarily limited to that one firm. NASD already is in the midst of conducting an examination sweep to look at more than a dozen broker-dealers, specifically with a view to determining how investment companies pay for inclusion on firms featured mutual fund lists or why they receive favored promotional or selling efforts. NASD is looking at different types of firms, including full-service, discount, and online broker-dealers. In addition, NASD is reviewing over 20 mutual fund distributors, which it also regulates, to see what the distributors role may be in these types of practices. NASD Conduct Rule 2830(1) prohibits the award of noncash compensation, such as lavish trips and entertainment, to registered persons for the sale of their own broker-dealer s mutual fund shares. On September 16, 2003, NASD announced a case against Morgan Stanley that resulted in a $2 million fine against the firm. 9 Morgan Stanley conducted prohibited sales contests for its brokers and managers to impel the sale of Morgan Stanley s own proprietary mutual funds. In addition to sanctioning the firm, NASD also censured and fined the head of retail sales, a senior member of the firm s management. Over a three-year period, between October 1999 and December 2002, the firm conducted 29 contests and offered or awarded various forms of non-cash compensation to the winners, including tickets to Britney Spears and Rolling Stones concerts, tickets to the NBA finals, tuition for a highperformance automobile racing school, and trips to resorts. Morgan Stanley apparently attempted to shield this focus on sales of its own mutual funds from those outside the firm. This is evidenced by messages from a regional manager directing branch managers and other employees to refrain from putting in writing details regarding contests promoting Morgan Stanley mutual funds. The obvious danger of such contests is that they give firm personnel a powerful incentive to recommend products that serve the registered representative s interest in receiving valuable prizes, rather than the investment needs of the customer. One of the most troubling things about this case is Morgan Stanley s failure to implement any systems or procedures that could detect or deter the misconduct. NASD is concerned that this is not an isolated instance of abuse. Accordingly, NASD is in the process of examining over 20 broker-dealers, both retailers and distributors, to review their cash and non-cash compensation practices for compliance with NASD Conduct Rule 2830(1). Suitability of Mutual Fund SalesClass B Shares Many mutual funds offer different classes of the same investment portfolio. Each class is designed to provide brokers and their customers with a choice of fee structure. While Class B shares generally do not incur a front-end sales charge, they typically are subject to higher ongoing charges and a contingent deferred sales charge upon the sale of those shares. In addition, investors who purchase Class B shares cannot take advantage of breakpoint discounts available on large purchases of A shares. Accordingly, the larger the dollar amount of the purchase of B shares, the greater the potential for harm. Recently, NASD has brought more than a dozen major cases against registered persons who have recommended that investors buy Class B shares of mutual funds, in which investors incur higher costs and registered persons receive greater compensation. Some of these cases have involved millions of dollars of unsuitable sales. For example, on June 25, 2003, NASD announced a disciplinary action against McLaughlin, Piven, Vogel Securities, Inc. (MPV) resulting in a $100,000 fine and $90,000 in restitution to customers for failure to supervise and unsuitable sales of Class B mutual fund shares. 10 From June 1998 through May 2002, MPV violated NASD s suitability rules by recommending the purchase of large volumes of Class B shares of mutual funds in the accounts of 21 MPV customers totaling approximately $9.3 million. These large purchases of Class B shares deprived customers of the lower, or potentially lower, sales charges available through Class A shares of the same funds. 3

4 Presently, NASD has more than 50 open and active investigations in this area. Based on what we have seen, there appear to be numerous instances where registered persons have recommended B shares to their customers inappropriately, when A shares should have been far more advantageous. We expect more enforcement actions in this area shortly. Breakpoint and Net Asset Value Discounts In early 2003, during routine examinations by NASD s Philadelphia District Office, we discovered that broker-dealers selling front-end load mutual funds were not delivering breakpoint discounts to investors in a proper manner. Breakpoints reflect a lower sales load in light of the size of the purchase, or an aggregation of purchases in related accounts. After spotting the problem, NASD then directed that certain broker-dealers conduct a self-assessment of their record of delivering breakpoint discounts for their sales of front-end load funds. NASD now has found that in one out of five transactions in which investors were entitled to a breakpoint discount, that discount was not delivered. Thus, many brokers imposed a higher sales load on thousands of mutual fund investors, in effect overcharging investors, by a conservative estimate, $86 million in the past two years alone. NASD has directed broker-dealers to make immediate refunds and, in conjunction with the SEC, has initiated enforcement actions against a number of broker-dealers where the failure to provide breakpoint discounts is the most serious and pervasive. The first of these cases was announced on February 12, The SEC and NASD jointly sanctioned seven firms and NASD separately sanctioned eight others for failure to deliver mutual fund breakpoint discounts during 2001 and The 15 firms agreed to compensate customers for the overcharges, pay fines in an amount equal to their projected overcharges that total over $21.5 million, and undertake other corrective measures. The SEC charged the firms with violations of Section 17 (a) (2) of the Securities Act of 1933 for failing to disclose to certain customers that they were not receiving the benefit of applicable breakpoint discounts and, in all but one case, violations of Rule 10b-10 under the Exchange Act of 1934 for failing to disclose on customer confirmations the remuneration the firms received in connection with the front-end loads. NASD charged the firms with violations of Rule 2110, for failing to give customers the benefit of applicable breakpoint discounts and by failing to disclose to those customers that they were not receiving the benefit of applicable discounts. A second area where fund investors may be overpaying for their fund shares is in connection with net asset value (NAV) transfer programs. Certain mutual funds have programs allowing customers to purchase shares at NAV, without paying any sales charge. The programs apply to purchases made with proceeds from the sale of mutual funds from other fund families, where the customer paid front-end or back-end sales charges on the redeemed shares. When broker-dealers fail to identify and provide these opportunities to customers, the customers pay unnecessary sales charges. On February 26, 2004, NASD announced that it had censured and fined AXA Advisors, LLC $250,000 for failing to obtain sales charge waivers for mutual fund customers through NAV transfer programs for two different mutual fund families. 12 NASD also found that the firm failed to have an adequate supervisory system in place to identify and provide customers with sales charge waivers to which they were entitled. As a result, certain investors purchased Class A shares and paid front-end sales charges that they should not have paid, or purchased Class B shares which subjected them to contingent deferred sales charges and higher fees. NASD determined that from February 2000 through July 2003, AXA earned more than $700,000 in revenue on more than $18 million invested by the customers of the firm in these two mutual fund families offering NAV transfer programs. As part of the settlement, the firm was ordered to provide full restitution to all customers who paid sales charges on purchases that were subject to these programs over a four-year time period. AXA was also required under the terms of the settlement to retain an independent consultant to review and recommend revisions to its supervisory and compliance procedures in this area. NASD is initiating a broad-based review to determine whether other firms are meeting their obligations to provide sales charge waivers to their customers under similar types of programs. Examinations and investigations are underway and NASD will bring additional enforcement actions where warranted. Late Trading and Market-Timing A recent focus by NASD has been an investigation into late trading and impermissible market-timing. On September 5, 2003, NASD issued Notice to Members reminding broker-dealers of their obligations regarding mutual fund transactions. 13 The Notice reminded regulated entities that Investment Company Act Rule 22c-1(a) requires that mutual 4

5 funds be sold and redeemed at a price based on the net asset value of the fund computed after the receipt of orders. The Notice further indicated that it is a violation of NASD Rule 2110, and potentially of Rule 2120, for broker-dealers and their registered persons to effect, knowingly or recklessly, mutual fund transactions that are priced based on NAV that is computed prior to the time the order was given by the customer. In addition it may be a violation of NASD Rule 2110 for them, knowingly or recklessly, to facilitate certain market timing transactions in conjunction with, or with the acquiescence of, a mutual fund sponsor or affiliated entity in contravention of that fund s stated policies on such activity. In September 2003, NASD sought information regarding these practices from 160 broker-dealers. Our review indicates that a number of those examined clearly received and entered mutual fund orders after U.S. markets had closed for the day. Other broker-dealers were not always able to tell with clarity whether or not they had entered late trades. This imprecision indicates poor internal controls and record-keeping-issues that NASD also intends to pursue. NASD has identified a number of broker-dealers that were involved in market-timing. It remains to be determined whether the activities of these firms were impermissible under NASD rules or applicable federal statutes. These firms appear to have facilitated customers market-timing strategies in mutual funds or variable annuities, employed staff who agreed with a mutual fund or variable annuity to market-time the issuer s shares, or had an affiliate involved in some form of market-timing of mutual funds or variable annuities. On February 19, 2004, NASD announced the first of its market-timing enforcement actions. 14 NASD fined State Street Research Investment Services, Inc. (SSR) $1 million for failing to prevent market-timing of State Street Research mutual funds as a result of its inadequate supervisory systems. SSR also agreed to pay more than $500,000 in restitution to the individual State Street Research mutual funds to compensate for the losses attributed to market timing activity. NASD found that, from 2001 thorough August 2003, SSR s inadequate supervisory system improperly permitted the customers of at least one other securities firm, Prudential Equity Group, Inc., formerly known as Prudential Securities, Inc., to buy and sell shares of SSR funds alternatively, beyond the annual limits set forth in the prospectuses. NASD found that by November 2001, SSR s operations personnel had reason to believe that the Boston office of Prudential Securities customers had been able to exceed these limits. SSR s supervisory procedures and systems were not adequate to prevent and detect customers circumventing restrictions designed to limit the number of exchanges made in excess of the prospectus limits. The firm s written supervisory procedures and systems failed to provide for adequate follow-up to the block letters it sent to brokerage firms. Some customers were able, through the establishment of new customer accounts, to continue trading in SSR funds even after one of their accounts had been blocked. Moreover, SSR s systems and procedures were not able to ensure that accounts were blocked in a timely manner. The SSR action highlights the need for firms to follow up on red flags. While SSR did make some efforts to prevent markettiming, it did not follow through to ensure proper compliance with the measures it had put in place. Firms must respond quickly and effectively to market-timing issues once they are placed on notice that such activities are occurring. CONCLUSION Because of various jurisdictional restrictions, NASD must work with other federal, state, and self-regulatory authorities to solve the problems revealed in recent months in the mutual fund industry. NASD has jurisdiction over all broker-dealers that sell these products to investors and will exercise its authority rigorously to take actions against violators. All of these issues compensation arrangements, revenue sharing, breakpoints, after hours trading, and market-timing are important to NASD because they are important to investors. We are committed to building and maintaining the integrity of our financial markets. We view our mission in the area of broker-dealer sales of mutual funds as an important component of that overall goal. BARRY R. GOLDSMITH Executive Vice President NASD Enforcement in Washington, DC. barry.goldsmith@nasd.com IRA D. GLUCK Assistant Director, Strategic Programs NASD Enforcement in Washington, DC. ira.gluck@nasd.com 5

6 1 Investment Company Institute Mutual Fund Fact Book (43rd ed., 2003), available at 2 NASD, the world s largest private-sector provider of financial regulatory services, was established in 1939 under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of Every broker-dealer in the U.S. that conducts a securities business with the public is required by law to be a member of NASD. NASD s jurisdiction covers nearly 5,200 securities firms that operate more than 92,000 branch offices and employ more than 653,000 registered securities representatives. NASD writes rules that govern the behavior of securities firms, examines those firms for compliance with NASD rules, MSRB rules, and the federal securities laws. NASD also disciplines those who fail to comply with those rules. Last year, 2003, NASD filed a record number of new enforcement actions (1,410) and barred or suspended more individuals from the securities industry than ever before (827). 3 See Securities Act Release No (January 29, 2004); Exchange Act Release No (January 29, 2004); Investment Company Act Release No (January 29, 2004). 4 See Securities Act Release No (December 17, 2003); Exchange Act Release No (December 17, 2003); Investment Company Act Release No (December 17, 2003). 5 See NASD Notice to Members 03-54, Compensation for the Sale of Investment Company Securities (September 2003), available at nasdr.com/pdf-text/0354ntm.txt. 6 On February 11, 2004, the SEC proposed an amendment to Rule 12b-1 under the Investment Company Act of1940 that would prohibit mutual funds from directing commissions from their portfolio brokerage transactions to broker-dealers to compensate them for distributing fund shares. See SEC Adopts Enhanced Mutual Fund Expense and Portfolio Disclosure; Proposes Improved Disclosure of Board Approval if Investment Advisory Contracts and Prohibition on the Use if Brokerage Commissions to Finance Distribution; Press Release ; February 11, 2004, available at 7 See NASD Notice to Members 03-77, Disclosure of Mutual Fund Expense Ratios in Performance Advertising (December 2003), available at 8 See NASD Press Release, NASD Charges Morgan Stanley with Giving Preferential Treatment to Certain Mutual Funds in Exchange for Brokerage Commission Payments (November 17, 2003), available at In the Matter of Morgan Stanley DW, Inc., Exchange Act Release No (November 17, 2003). 9 See NASD Press Release, NASD Fines Morgan Stanley $2 Million for Prohibited Mutual Fund Sales Contests (September 16, 2003), available at 10 See NASD Press Release, NASD Brings Enforcement Action For Class B Mutual Fund Share Sales Abuses and Issues Investor Alert on Class B Shares (June 25, 2003), available at 11 See NASD Press Release, Fifteen Firms to Pay Over $21.5 Million in Penalties to Settle SEC and NASD Breakpoints Charges (February 12, 2004), available at 12 See NASD Press Release, NASD Fines AXA Advisors $250,000 For Failure to Waive Sales Charges On Customers Mutual Fund Transfers (February 26, 2004), available at 13 See NASD Notice to Members 03-50, Mutual Fund Transactions (September 2003), available at 14 See NASD Press Release, NASD Fines State Street Research Investment Services $1 Million For Market-Timing Supervision Violations; Firm Ordered to Pay More Than $500,000 In Restitution (February 19, 2004), available at 6