Legal: Regulators Declare War on Fund Sales

Regulators are focusing on mutual fund sales practice violations. They've brought two widely watched actions against brokers and managers, and more are coming. If you think you're safe because you do a quality business, think again. The case against broker Richard Hoffman illustrates why. In December 1998, SEC enforcement staff accused Hoffman, a rep with FSC Securities in Palm, Pa., with fund churning

Regulators are focusing on mutual fund sales practice violations. They've brought two widely watched actions against brokers and managers, and more are coming. If you think you're safe because you do a quality business, think again. The case against broker Richard Hoffman illustrates why.

In December 1998, SEC enforcement staff accused Hoffman, a rep with FSC Securities in Palm, Pa., with fund churning and unsuitable fund sales. Kirk Montgomery, the compliance officer at Atlanta-based FSC during the time at issue, was charged as well.

But in January 2000, Carol Fox Foelak, an SEC administrative law judge, dismissed the charges against both men. Six months later, she awarded Montgomery more than $200,000 as partial repayment for his legal fees, ruling that the charges were unjustified. The SEC is appealing the legal-fee decision.

According to Fox Foelak's decision in the case, 400 of Hoffman's clients had held a Kemper fund for more than a year (and most continued to hold it). A few had become dissatisfied with its performance and sold it for a Templeton product recommended by Hoffman. The SEC claimed that Hoffman failed to inform clients of the sales charges involved, and that the Templeton fund was unsuitable for his clients.

Not true. Fox Foelak found that “Hoffman fully informed the customers about their options and about the costs and risks of changing. … His explanation was easy to comprehend, as he demonstrated at trial.” The broker kept boxes of prospectuses in his car, reviewed them with clients, and methodically explained options, she stated in her decision. No clients ever complained. Several clients testified on Hoffman's behalf, whom Fox Foelak described as the “antithesis of a fast-talking, overbearing, aggressive salesman.”

More recently, the NASDR settled a case against a broker and branch manager at St. Louis-based Stifel Nicolaus. In April 2001, broker Michael Grimes and his branch manager William Lasko consented to fines and suspensions over alleged violations concerning sales of B shares.

Over a two-year period, 15 clients purchased more than $250,000 each of B shares from Grimes. In addition to exceeding the limit set by the fund, the NASDR argued that A shares would have been more “cost-effective” for his customers.

The NASDR also cited Grimes for generating $21,000 in gross from sales of B shares to 29 clients at a time when load-waived A shares for the same fund were available.

More of these cases are coming. At a May compliance conference, Barry Goldsmith, NASDR enforcement chief, said the regulator has “a number of investigations going on in several of our offices” dealing with fund switching and the sale of B shares.

Socialized Medicine?

Reps should be aware that at least in the sale of mutual funds, regulators can step in and decide you charge too much. To stay safe, focus on disclosure, attorneys say.

“I perceive that the SEC and the NASD have a much lower tolerance for mutual funds than other products such as wrap accounts,” says Tom Mason, a Tucson, Ariz.-based lawyer who regularly serves as an arbitration witness.

Los Angeles-based securities attorney Tom Fehn says, “If clear disclosure is made in such situations, I think there wouldn't be a problem.”

Meanwhile, Prudential Securities this year set a limit of $100,000 for sales of B shares. Last summer, A.G. Edwards capped B share sales at $100,000 for one fund family, and $250,000 if the investment is in multiple families. Brokers at other firms contacted for this story were unaware of a specific B-share limit. “The firm takes care of it,” says one.

But how you sell funds and disclose the risks and costs is something to watch carefully. The two cases brought so far have an element of “uncontained zeal,” Fehn says. They “were meant to send a message.” And the regulators aren't done talking.


Allen Plummer is a freelance writer based in Richmond, Va.

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