Compliance November 12, 2019

MSSB Share Class Calculator Errors Led to SEC Settlement

According to the SEC, Morgan Stanley Smith Barney’s share class calculator had two operating errors that caused it not to provide the most beneficial share class to eligible customers; the firm was also accused of not consistently providing this benefit to certain eligible clients.

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Morgan Stanley Smith Barney (MSSB) has agreed to settle litigation filed by the U.S. Securities and Exchange Commission (SEC).

Background information included in litigation documents shows that from at least July 2009 through December 2016, in connection with investment recommendations to certain retirement plan and charitable organization brokerage customers, MSSB represented that, in the process of selecting the most economical share class, it used “share class limits and other tools,” including a share class selection calculator, designed to provide customers with the least costly mutual fund share class.

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While MSSB did have a share class selection calculator for this purpose, the SEC alleged three issues occurred which harmed customers. First, the share class calculator had two operating errors that caused it not to provide the most beneficial share class to eligible customers in certain circumstances. Second, from July 2009 to mid-2012, MSSB did not use the share class calculator for certain legacy retirement plan brokerage customers and other tools employed did not consistently provide the most beneficial share class to eligible customers. Finally, according to the SEC, MSSB failed to code the share class calculator to provide the lowest share class available to certain charitable organizations eligible for sales charge waivers and did not otherwise have a mechanism for doing so.

“As a result, MSSB recommended and sold these eligible customers more expensive share classes when less expensive share classes were available, contrary to MSSB’s representations to those eligible customers,” the SEC’s lawsuit states. “MSSB’s recommendations of more expensive share classes negatively impacted the overall return on the eligible customers’ investments. In addition, MSSB received greater compensation from the eligible customers’ purchases when selecting the more expensive share class.”

Technically speaking, these actions represent violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act. These provisions prohibit, respectively, obtaining money or property by means of any untrue statement of material fact and engaging in a course of business which operates as a fraud or deceit in the offer or sale of securities.

MSSB provided the following statement to PLANADVISER: “We are pleased to have resolved this matter and have corrected the systems issues that were the cause.”

In stating its acceptance of MSSB’s settlement offer, the SEC notes that the firm has already provided remediation to impacted customers. In dollar terms, MSSB’s reimbursement payments include a total of $7,558,409 relating to transactions during the applicable statutory limitations period and a total of $6,271,173 before that period. MSSB also offered conversion to all eligible customers holding share classes with higher ongoing fees and expenses to the share classes with the lowest expenses for which they are eligible, at no cost to the customers.

According to the SEC, many mutual funds provide sales charge waivers for Class A shares to qualified retirement accounts. Certain mutual funds also provide sales charge waivers for Class A shares to qualified charitable accounts.

“Such waivers are important to investors because they allow investors to buy shares at the fund’s current net asset value,” the SEC’s lawsuit states. “Even when not eligible to purchase load-waived Class A shares, qualified retirement customers may be eligible to purchase Class R shares.”

As the SEC explains, eligibility requirements for load-waived Class A shares and R shares, if available, vary by fund family and are disclosed in the prospectus and statement of additional information for each relevant fund. The sales charges and fees associated with different share classes affect mutual fund shareholders’ returns.

“A mutual fund investor eligible for a sales charge waiver in Class A shares will likely obtain a higher return by investing in Class A shares than incurring the ongoing sales-related costs associated with Class B and Class C shares in the same fund,” the lawsuit explains. “However, in the absence of a sales charge waiver, the investor may be better off investing in Class R shares (if eligible) rather than Class A, B, or C shares because of the impact of the sales charge in Class A shares on the return and the lower ongoing fees and expenses associated with certain Class R shares.”

Compliance November 11, 2019

Full 9th Circuit Okays Panel’s Pro-Arbitration Decision

No judge of the 9th Circuit has requested a vote on a petition for rehearing Dorman vs. Charles Schwab, in which a three-judge panel held ERISA claims may in some cases be forced into arbitration.

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Back in August, a three-judge panel of the 9th United States Circuit Court of Appeals issued a major decision that was taken to have shifted the standing of mandatory arbitration provisions used in the operation of retirement plans governed by the Employee Retirement Income Security Act (ERISA).

In short, the panel concluded that a previous, precedent-setting 9th Circuit decision which had held that ERISA claims are generally not subject to arbitration provisions is “no longer good law” in light of interim Supreme Court rulings. The underlying case, Dorman vs. Charles Schwab, was initially filed in 2017. Subsequently, in January 2018, a district court judge denied a motion by Charles Schwab that sought to mandate the lawsuit proceed via individual arbitration, rather than as an ERISA class action in federal court. This denial kicked off the appeals process which led to the three-judge panel’s pro-arbitration ruling earlier this year.

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Now, the full 9th Circuit has backed the panel’s ruling. Technically speaking, the full court has been advised of the plaintiff’s/appellee’s petition for a rehearing “en banc,” and no judge of the court has requested a vote on said petition. Thus, the appellee’s petition for rehearing en banc has been denied.

Analysts tell PLANADVISER the 9th Circuit’s decision, now certified by the full appeals court, is significant because it is the first case in the nation to explicitly permit the implementation of an arbitration provision in a plan document. However, the full ramifications of this decision are still uncertain.

A Move Toward Mass Arbitration?

Moving forward, the decision has the potential to impact other cases proceeding in the 9th Circuit, which includes the district courts in Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington. Without the Supreme Court weighing in or other circuit courts taking up this matter in other cases, the decision likely won’t have a big impact outside of these states. 

Joan Neri, counsel in Drinker, Biddle & Reath’s ERISA practice in Florham Park, New Jersey, also notes the case’s impact in the ERISA landscape could be muted by the fact that it does not directly address how a fiduciary breach claim seeking plan-wide relief aligns with the individual recovery sought in arbitration.

“This is something that advisers and sponsors should continue to watch in the litigation sphere before making any amendments to a plan,” she recommends.

While generally speaking plan sponsors prefer arbitration to going to court, there are some downsides to forcing ERISA claims into the arbitration route, warns Tad Devlin, a partner with Kaufman Dolowich & Voluck in San Francisco.

“For non-experienced practitioners, the ERISA statute can be a labyrinth, so this would weigh some plan sponsors in favor of going before a federal judge who has heard these types of claims,” he says. “Another disadvantage to arbitration is that it is confined to a limited review, and the arbitration award likely would be final and binding and can be very difficult to challenge or overturn. It can be almost impossible to challenge at the judicial level on a petition to vacate the award. To do so, the sponsor would essentially have to show the award decision was fraudulent or corrupt. On the other hand, in a judicial setting, you have at your disposal the district court, the court of appeals and the highest court in the land.”

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