Broker Churning Takes Industry by Surprise
September 4, 2000
Churning abuses by broker/dealers usually involve variable annuities or other insurance products, which is why industry attorneys were surprised when the SEC announced last week that it had fined Dean Witter Reynolds, now part of Morgan Stanley Dean Witter of New York, nearly half a million dollars for failing to prevent mutual fund churning by one of the firm's Atlanta brokers.
Inappropriately switching mutual funds in order to gain sales commissions "is not a common occurrence" among broker/dealers, financial planners or registered investment advisors, said Richard Wessel, the Atlanta district administrator with the SEC who oversaw the case against Dean Witter. Problems with mutual fund sales at the broker/dealer level usually involve share classes, said Amy Hyland, a spokesperson for NASD.
The SEC and the NASD have occasionally found broker/dealers guilty of selling inappropriate mutual fund share classes in order to gain higher commissions, or of failing to disclose back-end loads, said Pamela Wilson, an attorney with Hale & Dorr of Boston. But, only perhaps once or twice have these regulators found broker/dealers guilty of actually churning mutual funds, she said.
The most recent incident of switching involved FSC Securities of Atlanta, said Jim Hamilton, a senior writer and analyst with CCH, a legal research and publishing company in Riverwoods, Ill. The SEC charged the broker-dealer with abusive mutual fund switching for nearly four years between January 1992 and December 1995, according to SEC records.
The case against the Dean Witter broker could harm Morgan Stanley and the fund industry in general, particularly since this is a rare occurrence, said Mercer Bullard, president and founder of Fund Democracy LLC of Chevy Chase, Md., and former assistant chief counsel at the SEC's division of investment management. Morgan Stanley and Dean Witter, Discover & Co. merged in 1997.
"The greatest churning, or switching abuses involve insurance products because they have disproportionately high sales loads and expense ratios," said Bullard. "Also, the people selling these products don't have the same standards as mutual fund representatives, as evidenced by the commonplace insurance and annuity sales enforcement actions."
The SEC fined Dean Witter Reynolds $476,702 for failing to prevent mutual fund churning by one of the firm's brokers.
The SEC said the broker, who was not named, cost her customers $157,000 in unnecessary mutual fund switching fees. The broker made 48 fund switches and had customers hold these funds, intended for long-term investing, for only two to eight months, Wessel said.
Dean Witter neither admitted nor denied the charges.
The broker engaged in the activity between March 1994 and November 1996, according to the SEC. During that time, Dean Witter "failed reasonably to supervise the registered representative," the SEC said. Dean Witter had a system to prevent churning, but did not enforce it, the SEC said.
Dean Witter must pay customers $276,702 in charges and other expenses, plus interest, in addition to a civil penalty of $200,000, the SEC said. In addition, all Morgan Stanley Dean Witter branch managers must now oversee all open-end mutual fund transactions prior to their execution, the SEC said.
Morgan Stanley Dean Witter must also hire an independent party to review its fund switching policies and make recommendations, the SEC said.