The SEC last week won a key case in its efforts to discourage registered representatives from selling class B shares of mutual funds when cheaper A shares are available.
Two registered representatives and an investment advisor violated federal securities laws when the representatives deliberately structured investors' purchases of class B shares of mutual funds in a way that earned them higher commissions at the expense of their customers, an SEC administrative law judge ruled last week. Judge James T. Kelly fined and temporarily barred Michael Flanagan and Ronald Kindschi from working for broker/dealers for failing to explain fully to customers that the customers' large B-share purchases of mutual funds could have been done more cheaply had the investors purchased A shares.
Because of the amount of their purchases, the investors were eligible for volume discounts - known as breakpoints - had they bought A shares, Kelly wrote. It was not sufficient for Flanagan and Kindschi to disclose the lower cost of A shares only by providing the investors with fund prospectuses and having a general discussion of the relative merits of A shares and B shares, Kelly wrote.
"The (SEC's Enforcement) Division has shown that a reasonable buy and hold' mutual fund investor would consider it material to know that, above breakpoints, Class A shares generally outperform Class B shares in the long run," Kelly wrote.
Kelly ordered Flanagan to pay the SEC $22,469 in fines and reimbursements for commissions. Kindschi was ordered to pay $11,262 in fines and reimbursements for commissions. In addition, Kelly censured Spectrum Administration of Seal Beach, Calif. - the firm with which Flanagan and Kindschi worked in executing customers' investment strategies - for the B share violations.
Neither the lawyer for Kindschi, Flanagan and Spectrum nor Kindschi returned calls seeking comment. Flanagan could not be located.
Kelly issued a decision in the case on Jan. 31. The decision appears to be the first case that the SEC has successfully prosecuted that outlines the duty that registered representatives owe their customers to disclose the relative expense of B shares compared to A shares when breakpoints are available, SEC lawyers said.
Historically, mutual funds were sold either without a sales charge or with a "load," or with up-front sales charges. Class A shares carry up-front sales charges. Funds began offering class B shares in the 1980s. B shares include no sales charge up front, but instead are subject to higher annual expenses. Those expenses effectively spread the sales charge over a period of more than five years.
While investors who purchase class A shares usually are eligible for volume discounts that reduce their expenses, B shares rarely offer breakpoints.
In at least five cases, Flanagan and Kindschi used B shares when their clients' investments were eligible for lower-cost A shares, Kelly wrote. Some of those investments were made in Putnam Investments' funds, Kelly wrote. Putnam, as a matter of a policy, refuses to execute sales orders for B shares for purchases of $250,000 or more, Kelly wrote.
Because of that limit, Flanagan and Kindschi spread investors' purchases out, buying Putnam funds shares worth more than $250,000 in the aggregate, but never purchasing $250,000 of funds at one time, Kelly wrote. In one series of transactions, for example, Kindschi supervised purchases of $249,999.99 in a Putnam fund on June 22, 1993 and a second purchase of $35,000.01 on July 1, 1993 as part of the same investment plan, Kelly wrote.
Kelly likened the conduct to that of money launderers, who take a large transaction and break it down or "smurf" it. Flanagan and Kindschi smurfed investors' transactions to evade such limits without telling the investors, Kelly wrote.
In drawing his conclusion, Kelly largely disregarded the expert testimony of a former high-ranking SEC official, Kathryn B. McGrath, a lawyer in the Washington office of Morgan, Lewis & Bockius LLP of Philadelphia. McGrath, who served as director of the SEC's division of investment management from 1983 to 1990, testified that the SEC would not have permitted B shares to be sold to the public if the SEC believed that B shares could not outperform A shares.
