Judge Dismisses Case Regarding 12(b)-1 Fees

A judge this week dismissed a case alleging that because brokers are being paid for investment advice by 12(b)-1 fees, they should also be registered as investment advisers. 

Judge Leonard B. Sand in the U.S. District Court in the Southern District of New York presided over the case, Bradley C. Smith v. OppenheimerFunds Distributor Inc., and ultimately dismissed it on grounds that the plaintiff wasn’t protected by the Investment Adviser Act of 1940 as he argued he was.

According to the court memorandum, the plaintiff, a resident of North Carolina, owns Class C shares of Oppenheimer Gold & Special Minerals Fund and Class C shares of the Oppenheimer Small & Mid-Cap Fund, a series of Oppenheimer Quest for Value Funds.  The plaintiff has held shares in both Funds since June 9, 2006.

The Board of Trustees for each fund decides how to compensate broker/dealers (B/Ds) for selling shares. Here, the funds pay distribution fees pursuant to Rule 12b-1 to OppenheimerFunds, the funds’ distributor, which in turn forwards these payments to retail B/Ds such as Merrill Lynch, who distribute shares in the funds. The plaintiff alleged that since October 1, 2007, OppenheimerFunds have made these payments in the form of asset-based compensation, and that such compensation violates the Investment Advisers Act (IAA) of 1940.

“Special compensation” 

The court memorandum explained that B/Ds are regulated by the Securities Exchange Act of 1934, whereas the IAA applies to investment advisers. The IAA also applies to full-service B/D firms who provide investment advice to their customers. A B/D firm providing investment advice must comply with the IAA by registering as an investment adviser, maintaining recordkeeping and reporting procedures, adopting policies to prevent violations of the securities laws, and maintaining compensation arrangements in accordance with the IAA.  Firms registered as both B/Ds and investment advisers are called “dual registrants.” The plaintiff alleged that his mutual fund shares are held in a brokerage account at B/D Merrill Lynch.

The IAA contains a “Broker-Dealer Exclusion” for a B/D who gives advice that is only “incidental” to his conduct as a B/D “and who receives no special compensation therefore.” Such B/Ds are exempted from the IAA’s registration and reporting requirements. According to the plaintiff, “special compensation” includes anything other than transactional commissions. Therefore, the plaintiff contended that B/D dual registrants who receive any form of compensation other than transactional commissions cannot offer investment advice under the IAA to holders of brokerage accounts.

Judge Sand wrote in the memorandum that the plaintiff has “failed to assert a viable predicate violation of the ICA necessary to make out a claim under ICA section 47(b). Plaintiff is not left without a remedy for the broker-dealers’ alleged underlying violations of the IAA. Those violations involved the broker-dealers’ receipt of asset-based compensation for brokerage accounts, or their failure to register as investment advisers while receiving such compensation. Under this theory of liability, the ultimate fault would lie with the broker-dealers themselves, and Plaintiff may sue them for violating the IAA… Moreover, Plaintiff’s claims—including his federal claims—rely on alleged breaches of fiduciary duty. Plaintiff is of course free to raise such fiduciary duty claims in state courts. Accordingly, Defendants’ motion to dismiss Plaintiff’s First Cause of Action is granted.”

The dismissal order can be read here.