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12b-1 ImpassE Morgan Stanley Lawsuit Could Spell Bigger B Share Blues


The B in B shares stands for "Bogus."

That's what a lawsuit against powerhouse Morgan Stanley charges.

A class-action lawsuit filed against Morgan, Morgan Stanley Investment Advisors, the firm's mutual fund advisory affiliate, and the firm's distributor, will challenge the soundness of offering expense-laden B shares to investors, and could spell trouble for all mutual funds that sell B shares among their multiple-share class offerings.

Losing Proposition

The suit charges that Morgan Stanley brokers who invested clients' assets in the fee-heavy share class knew that B shares were a losing proposition, and were looking to line their own pockets rather than invest in a class of shares more financially favorable to investors.

The lawsuit, filed on Feb. 24 in U.S. District Court, Middle District of Tennessee in Nashville by the law firm of Falls & Veach of Nashville, Tenn., charges the firm with violations of securities laws, breach of fiduciary duty and negligence. The allegations center around four separate cases, each charging that different financial advisors employed by Morgan Stanley on repeated occasions inappropriately invested plaintiffs' assets in the B share classes of several of Morgan Stanley's proprietary funds.

According to the suit, brokers regularly sell their clients on the benefits of B-shares, as they don't charge up-front fees so that 100% of an investment can go to work from day one. But, the suit claims, brokers knowingly fail to disclose to investors that they will pay more in fees and realize a smaller profit than if A or C shares were selected. While fund prospectuses usually warn investors that investments in B shares may carry higher overall fees and expenses than other share classes, there's no "may" about it, according to the plaintiffs.

"Morgan Stanley fails to disclose the overwhelming probability that investing in Class B shares will result in the payment of unnecessary and excessive fees to defendants," according to the suit.

Moreover, the plaintiffs allege that the current multiple class structure blatantly provides the incentive for brokers to continue selling pricey B-shares. "Morgan Stanley also fails to disclose that it makes more money per dollar invested in Class B and that its broker compensation structure creates more attractive incentives for the sale of Class B shares," the suit reads.

"B shares are entirely appropriate for many investors. Moreover, we fully disclose all relative fees and costs to our clients," said Bret Gallaway, a Morgan Stanley spokesman. "This class-action lawsuit has no merit, and we plan to defend against it vigorously," he added.

The Investment Company Institute echoes that sentiment. "Share classes were set up to give investors a choice for investing. B shares are one option for mutual fund shareholders for the payment of their broker's services," said Chris Wloszczyna, an ICI spokesman.

By design, B shares, and the multiple-class structure of mutual funds, first won formal regulatory approval in 1995, although individual funds had been creating alternate share classes under individual exemptive orders from the SEC as early as 1988.

The B share class proved appealing to investors because it carried no front-end sales charge. Instead, B shares assess a contingent deferred sales charge (CDSC). Investors pay a back-end, asset-based exit fee if they redeem generally within the first six to eight years after investing.

The CDSC typically begins at 4% or 5% in the first year and steps down 1% or so every year until the charge eventually disappears. The period of time for the CDSC varies from fund complex to complex, as does the step-down schedule.

12b-1 Special

In addition to the CDSC, investors who remain invested in B shares are usually charged a continuing annual, asset-based 12b-1 fee of up to 1% on their investment. That fee allows the fund sponsor to gradually recoup the commissions it paid to selling brokers out of its own pocket when the initial sale was consummated. But brokers usually receive a 25 basis-point cut of that ongoing 1% fee as payment for their continued service and maintenance of the account, and to maintain loyalty to the fund. These fees are in addition to a fund's regular management fee and other fund expenses.

After a certain period of time, which again varies from company to company, B shares typically convert to A shares or an equivalent share class that doesn't carry any back-end sales charges, and typically assesses a considerably lower on-going maintenance fee.

Morgan Stanley's CDSC begins at 5% in the first year and gradually steps down to 1% in the sixth year, disappearing altogether in year seven. Three years later, at the 10-year anniversary, those B shares convert to A shares. But from day one, and continuing until that conversion takes place, investors face annual 1% maintenance fees. When shares are converted to A shares, the annual fee drops from 1% to 25 basis points.