Document Sample
                         AND ONLINE BROKERS


                                                         October 4-5, 2001
                                                        New York, New York

                                                     Margaret A. Bancroft


                                                                                                                      New York

Copy right 2001 Dechert. All rights reserv ed. Materials hav e been abridged f rom laws, court decisions and administrativ e rulin gs and should not be
considered as legal opinions on specif ic f acts or as a substitute f or legal counsel.
                                        Mutual Funds
When is a recomme ndation made?
The suitability standard of NASDR Rule 2310 applies with full force and effect to
“recommendations” made with respect to mutual funds. If a “recommendation” is made, the
Rule imposes an affirmative obligation to delve into a customer‟s financial status, tax status,
investment objectives and other information to determine the suitability of the recommended
investment for a customer. Mutual funds typically wish to market and sell fund shares, without
having to assess suitability. Therefore, the definition of “recommendation” is crucial.

      The Rule does not apply to situations when a broker acts as a mere order taker for a
       customer who tells the broker what he wishes to buy or sell a fund without any
       “recommendation” by a broker. Notice to Members 96-60 (September 1996).
      The definition of what constitutes a recommendation, as discussed in Notice to Members
       96-60 is elusive and presents particular problems for the mutual fund industry. Late in
       1996, the Investment Company Institute sought clarification from the NASDR as to what
       constitutes a recommendation in the context of fund advertisements and sales literature.
      In March 1997, the NASDR responded providing partial guidance.
      This spring, in Notice to Members 01-23, NASDR addressed on- line communications in
       the context of what constitutes a recommendation.

                                            * * * *

The Share Class Issue

A recent crackdown by NASDR on the manner in which class B mutual fund shares are
marketed has caused a number of brokerage houses to take steps to police their sale. To date, the
brokerage houses include Prudential, Paine Webber, American Express and others. Their action
followed up on a widely publicized step taken by NASDR against Stifel, Nicolaus & Company
of St. Louis, M.O. and two individuals, a broker and his supervisor for violating NASDR Rules
2110 and 2310.

NOTE, NASDR Notices to Members and Interpretive Letters are available on their website
to both me mbers and non-members:

NASDR found that between June 1996 and May 1998, the broker made unsuitable sales totaling
over $7 million to 44 customers in Class B mutual fund shares, and that the supervisor and the
firm failed to supervise the broker with respect to the unsuitable sales.

Class A mutual fund shares ordinarily impose a front-end sales charge at the time of purchase
and may impose an ongoing asset-based distribution charge as well, though it generally is lower
than the asset-based distribution charge imposed by other mutual fund share classes. Class B
mutual shares generally do not impose a front-end sales charge, but impose asset-based
distribution charges that may be higher than those that an investor might incur in purchasing
Class A shares. Class B mutual fund shares also typically impose a contingent deferred sales
charge (CDSC), which is paid when the investor‟s shares are sold. The CDSC normally declines
and eventually is eliminated the longer the investor holds the shares. Because the expense ratio 1
charged on Class A shares is generally lower than for the Class B shares, and because the mutual
fund may offer a large-purchase discount from the front-end sales charge for Class A shares, the
purchase of A shares may in some circumstances be more advantageous to an investor.

NASDR found that the broker engaged in two patterns of making unsuitable recommendations.
First, the broker recommended that 29 customers liquidate Class B shares (and some Class A
shares) of Fund Family A which, when purchases, were subject to either a back-end or front-end
sales charge. The broker then recommended that those customers use the proceeds to purchase
Class B shares of Fund Family B. As a result of these “switch” transactions, Stifel earned sales
commissions of about $21,000, or 4% , and the broker was paid 50% of that amount, about
$10,500, when those 29 customers purchased the Class B shares of Fund Family B.

The broker‟s recommendations to purchase Class B shares were deemed unsuitable because, at
the time of those purchases, the prospectus of Fund Family B described a sales promotion
whereby its Class A shares could be sold at net asset value without payment of any front-end
sales charge to shareholders whose purchase was attributable to redemption proceeds within 60
days of the purchase from a registered open-end management company not distributed or

    A mutual fund‟s expense ratio measure the fund‟s total annual expenses expressed as a percentage of the
    fund‟s net assets. The expense ratio includes the asset-based sales charge and other ongoing fees that
    are deducted from a mutual fund‟s assets to pay for the services of the mutual fund‟s investment adviser
    or transfer agent or for other expenses. Front-end sales charges and CDSCs are not included in the
    expense ratio because they are charged directly to the investor.

managed by Fund Family B, if the shareholder either: (1) paid an initial sales charge, or (2) was
at some time subject to a deferred sales charge with respect to the redemption proceeds. The
Class A shares offered investors lower ongoing fees and expenses and higher dividends than
Class B shares. If the 29 customers had purchased Class A shares of Fund Family B, Stifel and
the broker would have received no transaction-based sales commissions.

Second, the broker recommended the purchase of Class B shares of Fund Family B to 15
customers who each made purchases over $250,000. As a result of these transactions, Stifel
earned sales commissions of over $290,000, or 4%, and the broker was paid over $145,000. The
prospectus of Fund Family B imposed a maximum purchase limitation of $250,000 in the
aggregate on Class B share purchases by a single investor. The prospectus also stated that if an
investor was making a purchase of $50,000 or more that qualified for a reduced sales charge, the
investor should consider purchasing Class A shares. Each of the 15 customers who purchased
the Class B shares would have been entitled to a reduction of front-end sales charges for the
purchase of Class A shares due to the size of the transactions, either because of: (1) the size of
the individual purchases, (2) rights of accumulation, or (3) the customers‟ signed letters of intent.
The ongoing distribution charges were lower for Class A shares than for Class B shares.
Because each customer purchased over $250,000, the reduced sales charges and reduced
distribution charges made the Class A shares the more cost effective investment. If the 15
customers had purchased Class A shares of Fund Family B, Stifel would have received 2.25% or
less in sales commissions, and the broker‟s share would have been reduced accordingly.

NASD Conduct Rule 2110 states that a member, in the conduct of his business, “shall observe
high standards of commercial honor and just and equitable princ iples of trade.” The SEC clearly
applied this obligation to the sale of mutual fund shares when it noted that:

“The NASD is rightly concerned when a broker-dealer and its representatives fail to secure for
their customers the benefit of a reduced sales charge in the sale of mutual funds. We concur
with the NASD that, where a broker-dealer or representative is aware of large amounts of money
being invested in a mutual fund over a relatively short period of time,…it is incumbent upon
them to obtain the lowest possible price for the customer. A failure to do so results not only in
the customer being deprived of a benefit to which he or she is entitled, but also in the broker-

dealer and representative receiving increased commissions at the customer’s expense. As the
NASD points out, such conduct is inconsistent with just and equitable principles of trade.” 2

Additionally, NASD Conduct Rule 2310 (the suitability rule), provides that in recommending to
a customer the purchase, sale or exchange of any security, a member “shall have reasonable
grounds for believing that the recommendation is suitable for such customer upon the basis of
the facts, if any, disclosed by such customer as to his other security holdings and as to his
financial situation and needs.” The SEC has noted that a broker has an obligation not to
recommend “the purchase of a security „which he knew was not adapted to their needs‟” 3 or “a
cause of action clearly contrary to the best interests of the customer.” 4 The SEC has stated that
the “reasonable basis” test “is subsumed within the suitability rule, because a broker cannot
determine whether a recommendation is suitable for a particular customer unless he has a
„reasonable basis‟ to believe the recommendation could be suitable for at least so me customers.”5
In this case, the NASD found that the broker could not have had a reasonable basis to believe
that either pattern of recommending Class B share purchases could be suitable for at least some
customers and, therefore, the broker‟s recommendations were unsuitable.

Lastly, NASDR found that Stifel, acting through the supervisor, failed to adequately supervise
the broker to ensure compliance with NASD Rules 2110 and 3010 (supervision).                      The
supervisor, the broker‟s branch office manager, had questioned the broker about the transactions
and requested switch letters for the transactions. However, the supervisor did not pursue his
inquiry, was not aware that the 29 customers who liquidated shares of Fund Family A were
qualified to purchase Class A shares of Fund Family B, and did not question the suitability of the
purchases of Class B shares of Fund Family B. The supervisor also failed to question the
suitability of the purchases of Class B shares by the 15 customers who would have benefited
from purchasing Class A shares instead.

    In the Matter of Harold R. Fenocchio, SEC, Exch. Act Rel. No. 12194, 1976 SEC LEXIS 2209, *8-9.
    Herbert R. May, 27 S.E.C. 814, 824 (1948).
    Powell & McGowan, Inc., 41 S.E.C. 933, 935 (1964).
    In the Matter of F.J. Kaufman and Company of Virginia, et al., Sec. Exch. Act Rel. No. 27535, 1989
    WL 259961 (S.E.C.).

NASDR also found that Stifel failed to establish, maintain and enforce written supervisory
procedures and supervisory systems to detect and prevent sales practice violations with respect to
the sale of mutual fund products in that Stifel: (1) had no automated or manual system in place
to detect mutual fund breakpoints, purchase limitations, or other marketing promotions, or
patterns in Class B share purchases; (2) had written supervisory procedures that simply listed
potential rule violations, and gave no direction to supervisors as to how to detect and prevent
breakpoint problems and Class B share purchase suitability problems, and how to evidence their
supervisory review; and (3) had written supervisory procedures that did not name the principal
responsible for supervision of each area of business, including the sale of mutual fund products.

The broker was suspended for 30 days and was fined $30,000. The supervisor was suspended
for 10 days in a supervisory capacity, and was fined, together with the firm, $25,000. Stifel
consented to a total fine of $41,000 (of which $25,000 is joint and several with the supervisor)
and undertook to engage legal counsel and a consultant to review Stifel‟s supervisory system. 6

Additionally, Stifel consented to exchange the Class B shares sold to the customers for Class A
shares at no charge. If every customer elects to exchange their shares, the costs of the restitution
offer will be approximately $225,000, which will be paid by Stifel.

                                          Variable Annuities
Variable life insurance and variable annuities are securities and their distribution is subject to
NASDR rules.

Earlier this year, NASDR announced that it had filed six enforcement actions against five firms
and one individual for the improper sale of variable annuities. The actions follow two years of
warnings from securities regulators, and signify that the regulators are serious in their efforts to
address what they consider abuses in the marketing of variable annuities. In announcing the
actions, Mary L. Schapiro, President of NASDR, said: “[I]t is extremely important that firms
selling variable annuities have supervisory systems in place that will be able to detect if
unsuitable sales are taking place.”

    This Letter of Acceptance, Waiver and Consent also involved other violations regarding the registration
    of principals, limit order protection, and limit order display.

The six actions fall into three categories: one against an individual broker for a specific sale;
four against selling broker-dealers for systemic deficiencies in their sales process; and one action
against an annuity issuer/underwriter for allegedly misleading sales literature.

In the case against the individual broker, shortly after the death of one spouse, the broker sold an
annuity contract and mutual fund shares into a revocable trust for the benefit of the other spouse
-- a 76 year-old widow. Funds for the purchase were derived from the redemption of mutual
fund shares that were subject to a contingent deferred sales charge and from a margin loan.
NASDR found that the respondent had failed to determine whether (1) the tax-deferral benefits
of the annuity contract would outweigh its fees and costs, and (2) whether the tax deferral feature
of the annuity would be operative in the revocable trust. NASDR concluded that the broker did
not have reasonable grounds for believing that the transactions were suitable.           (Letter of
Acceptance, Waiver and Consent, No. C05010009). This is the only one of the six cases that
involved a direct challenge to the suitability of a specific transaction.

In the four actions against selling broker-dealers, NASDR focused on systemic failures in the
sales of supervision process, based upon detailed scrutiny of the supervisory process and records.
In one action -- involving the largest fine ($32,500) -- NASDR found, in a review of 335 mutual
fund and variable annuity contract transactions, that the firm sometimes failed to obtain
information required for suitability determinations, including information on net worth, annual
income, investment objectives, risk tolerance, time horizon for liquidity, tax status, and other
qualified investment information. NASDR also found that the broker-dealer‟s procedures did
not require review of the allocation of premium payments to investment portfolios in relation to
the customers‟ investment objectives.         (Letter of Acceptance, Waiver and Consent, No.

In two actions, NASDR criticized insurance-related broker-dealers for using applications that
elicited incomplete information. In one, the application asked about financial status, but did not
ask about the customer‟s investment objectives. In the other, the application asked whether an
applicant‟s financial objective was either “retirement” or “other,” but did not ask for other
information about a customer‟s investment objectives. (Letters of Acceptance, Waiver, and
Consent, Case Nos. C06010003 and C06010004). In another action, NASDR did not find fault

with written procedures, but criticized an insurance-related broker-dealer for failing to enforce its
written procedures where documentation was missing from the firm‟s records in some of the
transactions examined.     The missing documents included annuity order tickets, exchange
transaction forms, annuity replacement disclosure letters, financial advisor‟s worksheets for
annuity replacements, and signatures on financial advisor‟s worksheets for annuity replacements.
(Letter of Acceptance, Waiver, and consent, Case No. C06010005.)

In the case against the annuity issuer/underwriter, NASDR alleged that the underwriter
distributed misleading and unbalanced sales literature that: (1) failed to adequately d isclose that
variable annuity contracts purchased for tax-qualified retirement plans provide no additional tax
benefit to the purchaser; (2) contained on a web-site used by the firm language that implied that
tax benefits are available to a tax-qualified retirement plans only if the plan is funded with
annuity contracts; and (3) failed to adequately disclose that the investment vehicles funding the
tax-qualified retirement plans were sub-accounts of variable annuity contracts as opposed to
mutual funds. (Disciplinary Proceeding No. C05010011).

On the same day that these actions were announced, NASDR issued an “Investor Alert” entitled
“Should You Exchange Your Variable Annuity?” The Alert provides information to assist
investors in determining whether they should exchange their variable annuity contracts. It
discusses the potential tax consequences associated with exchanges and describes other benefits
and dangers of features often included in the new contracts. Among other things, the Alert warns
that: (1) bonus or credit payments applied to new contracts are usually offset by higher or
additional contract or surrender charges, and (2) a new or longer surrender charge period may
apply to the new contract. The Alert also says that in many instances the broker selling the new
annuity is getting paid a higher commission than he or she would for the sale of another
securities product, such as a stock, bond, or mutual fund.

These actions come on the heels of warnings that have been expressed by securities regulators
for two years. Two years ago NASDR issued Notice to Members 99-35, which provided a set of
guidelines to assist members in developing procedures on suitability and supervision for variable
annuity sales. Among other things, these guidelines called for brokers to obtain comprehensive
customer information when recommending a variable annuity and to assess suitability with

reference to both contractual features and underlying subaccounts. They also called for special
disclosure in recommending a variable annuity for a tax-qualified plan.

At about the same time, Paul Roye, Director of the Division of Investment Management
(Division), commented that the SEC‟s examination program would focus on the sales activities
of agents and the supervision they receive in the sale of variable products. Later, he expressed
concern about the potential for sales practice abuses from bonus products, questioning whether
their costs were less visible than their benefits, and noting concern about exchanges for bonus
products.   Meanwhile, NASDR issued yet another Notice to Members in July 2000 re-
emphasizing its concerns.

This rhetoric was strengthened at an ALI-ABA Conference in October 2000, a which Mr. Roye
called for firms engaged in the distribution of bonus products to ensure that adequate safeguards
are in place to prevent unsuitable sales. NASD Regulation conducted a series of “special
examinations” in 1999 and 2000 that focused on variable annuity sales, and in 2000, the SEC
staff requested information from several insurers on sales of bonus products and exchanges for
bonus products. Privately, NASDR officials have expressed concern about the motivation for
brokers to sell variable annuity contracts, noting that commissions on the sale of annuities is
usually higher than commissions for selling mutual funds.

The announced cases make it clear that broker-dealers must have supervisory procedures in place
that address the guidelines that have been promulgated by the NASD, including a detailed
assessment of suitability based on the financial circumstances of the customer. They also make
it clear that a broker-dealer must carefully adhere to its written procedures, carefully document
each sale, and that there will be no tolerance for sloppiness. The actions also suggest that
applications to purchase an annuity may in some circumstances require analysis as to whether
they elicit sufficient information.