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.
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.”