Regulators take aim at switching
December 21, 1998
Regulators have stepped up pressure in recent weeks on mutual fund companies and those who sell funds regarding their costs and disclosure of those costs.
In SEC enforcement actions, new NASD Regulation directives and pronouncements from state securities regulators, government lawyers are making an issue of expenses and the adequacy of expense disclosure. Most recently, on Dec. 10, the SEC issued an opinion in a lawsuit over so-called mutual fund "switching," a practice that generates increased sales commissions for brokers who sell funds. The decision was striking because the SEC disciplined a broker for switching even though his clients did not lose money by following the broker's switching recommendations.
On the same day, the SEC announced that it had sued and immediately settled a case against FSC Securities Corp., a broker/dealer based in Atlanta, arising out of alleged switching. The SEC also sued another broker/dealer, Spectrum Administration of Seal Beach, Calif., for allegedly failing adequately to disclose expenses associated with selling class B shares of mutual funds. Unlike A shares, with their up-front commission charges, investors pay sales charges for B shares through a higher Rule 12b-1 fee and a sales charge levied if investors sell their funds quickly, usually in less than seven years.
The SEC's actions came a week after other regulators took their own steps regarding fees, expenses and disclosure. NASD Regulation, the organization that enforces NASD rules, warned mutual fund companies about their expenses and issued new requirements for increased disclosure in mutual fund sales literature. And on Dec. 3, the trade group which represents state securities regulators, the North American Securities Administrators Association (NASAA), said that "more needs to be done" with respect to fee disclosure.
Focusing attention on fund switching is a new development in regulators' scrutiny of fund expenses. Although the SEC has brought switching claims before, securities lawyers said SEC switching cases have been infrequent.
In the opinion issued Dec. 10 regarding the switching allegations, the SEC warned intermediaries about the practice, saying switching tends to have the effect of placing the interests of the fund salesperson ahead of those of clients. The SEC said flatly that mutual funds with front-end loads are not generally suitable for investors who buy and sell frequently.
The SEC's opinion came on an appeal of the case of Kenneth C. Krull, a registered representative in Marysville, Wash. The SEC largely echoed the earlier decision by NASD to suspend Krull for one year and fine him $20,000. However, it reduced the amount Krull was required to repay investors from approximately $171,000 to about $82,000, saying that $82,000 better represented the out-of-pocket expenses which investors incurred as a result of Krull's switching recommendations. Krull's attorney did not return a call seeking comment.
In the FSC case, the SEC fined the firm $50,000 for failing to adequately supervise its employees to prevent them from switching. FSC neither admitted nor denied liability in the case. Richard Hoffman, the registered representative accused of mutual fund switching, and Kirk Montgomery, Hoffman's compliance supervisor, are contesting the SEC's allegations. Hoffman did not return a call seeking comment. Montgomery, who is no longer employed at FSC, could not be reached.
In a separate action, also announced Dec. 10, the SEC alleged that Spectrum and two of its salespeople, Michael Flanagan and Ronald Kindschi, committed fraud by recommending that clients invest $100,000 or more in mutual fund B shares without fully disclosing the expenses involved and alternatives which would have reduced expenses. SEC enforcement attorneys said investors were eligible for volume discounts because the amount of their investments exceeded so-called breakpoints, a fact which the SEC alleged Flanagan and Kindschi did not disclose.
Adam Rabin, a spokesperson for Spectrum, called the SEC's allegations "baseless and unwarranted." Spectrum, Flanagan and Kindschi all plan to contest the allegations, Rabin said. Flanagan and Kindschi were not available for comment, Rabin said.
The FSC and Spectrum cases originated with the SEC's Atlanta district office. The cases are similar in that they both involve allegations of the absence of disclosure of significant expense information, said William Dixon, an SEC lawyer in Atlanta. The SEC is not contending that B shares are a bad investment, Dixon said. Rather, the SEC is insisting that intermediaries disclose the costs of B shares, particularly when there are potential volume discounts available by investing in A shares, Dixon said.
Dixon said it was difficult to know if improper switching was on the rise. But the number of alleged switching cases may increase as more people invest in mutual funds, he said.
Also in the past month, NASDR has been reviewing whether it should impose detailed requirements on how prominently mutual fund sales literature should present fee and expense information. NASDR also told its members that when they advertise that some fees do not apply, they must at the same time disclose fees and expenses which are incurred.
State regulators, who have been largely out of the mutual fund regulatory business since Congress passed legislation in 1996 taking away states' powers to approve mutual fund prospectuses, also broadcast that they were concerned about fees in a statement issued early this month. Fund fees should be readily disclosed and easily comparable, said the statement by Philip Feigin, the executive director of the NASAA, the organization of state securities regulators.
"While fee disclosure is better than it's been, investors still struggle to figure out what they're paying," Feigin said.
Meanwhile, The Investment Company Institute said last month that expenses for equity funds have decreased over the past 18 years. The SEC is studying fund fees and is expected to issue a report next year.