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.
Of course, Morgan Stanley isn't a rogue firm in the lot. Other fund groups' B shares sport similar fees. A random sampling has shown that an investor in Merrill Lynch's Focus Twenty Fund would face a 4% CDSC if redeeming in years one and two, a 3% charge in years two, three and four, a 2% fee during years four and five, and a 1% fee during years five and six. The CDSC vanishes after year six, and shares covert in year eight. Still, investors face eight long years of annual 1% 12b-1 fees until conversion.
Saddled with Double the Fees
Investors in the B shares of either the Prudential Equity Fund or Salomon Brothers All Cap Value face a similar 1% annual 12b-1 fee, but only until the B shares convert in year seven; the same year in which both CDSC schedules hit zero after topping out at 5% during the first year of investment and dropping by one percentage point in each subsequent year.
The suit's charges that "Morgan Stanley's Class B shares represent an inferior investment choice because an investor in Class B will end up paying more fees to Morgan Stanley than if the investor had selected Class A and/or C" is supported by several share class models provided by Dr. Edward S. O'Neal of the Babcock Graduate School of Management at Wake Forest University in Winston-Salem, N.C.
According to the data, O'Neal's computations show that over a period of 10 years, a $50,000 investment in the B share class of one of Morgan Stanley's equity funds would have saddled investors with double the fees that would have been charged had the investment been made into the same fund's A share class; roughly just under $8,000 versus $4,000 (see accompanying chart.)
Those beefier fees, of course, can produce a drag on the fund's performance return to investors, according to performance data from O'Neal. On a smaller $10,000 investment over a typical 10-year period, there was never a single month during which B shares were a better investment choice over either A, or C shares.
Results can be more significant where larger investments are made because most fund sponsors offer breakpoint sales charge discounts on larger purchases made to A shares, something not available on B shares.
In an effort to stem the tide of large purchases being made by brokers into B shares, in recent years fund firms have voluntarily capped the amount of a single B-share purchase they will accept to no more than $100,000 in many cases, redirecting heftier investments to A shares.
"Are there rogue brokers/financial planners out there knowingly selling B shares on a big ticket because they earn higher commissions than a breakpoint A share sale? I suspect there may be, but I don't think it's a widespread problem," said Burton Greenwald, president of B.J. Greenwald & Associates, a consulting firm in Philadelphia. Of course, despite broker guidance, investors could still demand B shares in order to have all of the money invested from the outset, he added.
There is something to be said for investing 100% of your money in a fund, especially one that's doing quite well, said Carl Frischling, partner with the law firm of Kramer Levin Naftalis & Frankel, in New York. "I'm sure there are abuses," he said. But that doesn't necessarily make B shares an inherently bad investment. "This lawsuit is litigating against the advisor, saying they improperly brought B shares to market, and against the distributor, alleging improper sales practices," he said. It may all come down to cases of individual suitability, Frischling noted.
This isn't the first time the issue of conflicts of interest over fund share classes has been raised by O'Neal, who previously worked at the SEC's Office of Economic Analysis, which investigates the impact of proposed mutual fund regulations.
In an article, "Mutual Fund Share Classes and Broker Incentives," which appeared in the September/October issue of Financial Analysts' Journal, a publication of the Association for Investment Management and Research of Charlottesville, VA, O'Neal sounded the alarm.
Driven by the Money
"In most circumstances and for most share class structures, brokers have monetary incentives to sell the class of shares that is least advantageous to investors," O'Neal wrote. "The adverse incentives are potentially damaging to the mutual fund industry and should provoke a reconsideration of multiple share classes and the accompanying broker compensation arrangements," he added.
In addition, it's not just the lack of financial sophistication on the part of investors who turn to brokers for financial advice and guidance that leads to problems, but the highly complex calculations that would be required for brokers to determine which share class is superior for each client, O'Neal suggested.
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