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[FundLaw] Defense Win in Mutual Fund Sales Practices Case

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  • Baker, John
    The SEC today posted the Initial Decision in its administrative proceeding against a registered representative, who was charged with violating the antifraud
    Message 1 of 2 , Feb 1, 2000
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      The SEC today posted the Initial Decision in its administrative
      proceeding against a registered representative, who was charged with
      violating the antifraud provisions of the 1933 and 1934 Acts in selling
      mutual funds, and the brokerage's compliance officer, who was charged with
      failure to supervise him. Hoffman, Initial Decision Release No. 158,
      http://www.sec.gov/enforce/alj/id158cff.htm (Jan. 27, 2000). The charges
      against the registered rep included improper switching, omitting to fully
      inform customers concerning sales charges, and making unsuitable
      recommendations. Both the registered rep and the compliance officer were
      completely exonerated.

      The case is somewhat unusual in that most improper sales practices
      are not the subject of SEC regulatory proceedings under the antifraud
      provisions (although of course they can be, and occasionally are). Instead,
      such practices more typically are the subject of NASD disciplinary
      proceedings under NASD Rule 2310 (the suitability rule). The SEC venue may
      have been helpful to Hoffman, as the ALJ ruled that a pattern of similar
      switching transactions does not justify a rebuttable presumption of
      unsuitable recommendations. Such a presumption applies in NASD disciplinary
      proceedings, but the ALJ declined to shift the burden of proof in this
      antifraud proceeding. The case is also somewhat unusual in that the
      Division of Enforcement rarely suffers such a complete loss. Lawyers who
      deal with sales practices will appreciate its detailed discussion.

      The ruling also seems to cut back (or, at least, refuse to extend)
      the broad supervisory responsibilities of compliance officers. While it
      might seem obvious that there is no failure to supervise a registered rep
      who did not act improperly, the ALJ also ruled that the compliance officer,
      a lawyer who had been given no real authority, was not the rep's supervisor
      at all. The ALJ, in the alternative, also ruled that his supervision in any
      case was reasonable under the attendant circumstances.

      John M. Baker <JBaker@...>
      Stradley, Ronon, Stevens & Young, LLP
      2121 K Street, N.W., Suite 800, Washington, DC 20037
      (202) 261-3512 Fax (202) 261-3581
      FundLaw Listowner
      Http://www.egroups.com/group/fundlaw/info.html
    • John M. Baker
      The SEC recently posted the Initial Decision in its administrative proceeding against two registered representatives who were charged with bad sales practices
      Message 2 of 2 , Feb 15, 2000
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        The SEC recently posted the Initial Decision in its administrative
        proceeding against two registered representatives who were charged with
        bad sales practices in selling Class B shares. Flanagan, Initial
        Decision Release No. 160 (Jan. 31, 2000), available online at

        http://www.sec.gov/enforce/alj/id160jtk.htm

        Flanagan is somewhat reminiscent of the recent Initial Decision in
        Hoffman, Initial Decision Release No. 158, http://www.sec.gov/enforce/a
        lj/id158cff.htm (Jan. 27, 2000), in that it also is a detailed
        examination of mutual fund sales practices in a contested SEC
        proceeding, and both cases represent defeats for the SEC in combating
        mutual fund switching. Hoffman, however, was essentially a suitability
        case, while Flanagan focuses on the quality of the reps' disclosures.
        (The ALJ in Flanagan ruled that suitability was not properly pled as an
        issue.)

        The registered reps in Flanagan employed a market timing strategy,
        which requires rapid exchanges between mutual funds in order to take
        advantages of anticipated moves in net asset values. Market timers are
        disruptive to fund operations, and most fund companies have a strong
        and well-founded prejudice against them. The reps used back-end loaded
        Class B shares, rather than front-end loaded Class A shares; the B
        shares had higher sales commissions.

        The ALJ ruled that the reps had important shortfalls in their customer
        disclosures. The reps failed to disclose that large investments in
        Class A shares entitled the investor to breakpoint discounts and that
        comparable discounts on sales charges were not available for large
        investments in Class B shares. In addition, the ALJ ruled, a
        reasonable "buy and hold" mutual fund investor would consider it
        material to know that, above breakpoints, Class A shares generally
        outperform Class B shares in the long run, and the reps failed to rebut
        the presumption that this information was not material to their
        customers or to show that a reasonable investor who is using a timing
        service has different standards of materiality than a reasonable "buy
        and hold" investor. However, the ALJ ruled, there was no obligation to
        disclose that the reps would receive materially higher commissions from
        Class B than Class A shares, where the customers were aware that the
        reps shared in commissions but not the relative amounts.

        On the switching issue, the ALJ noted that if a "pattern" of switching
        transactions in fund shares has been established in a proceeding
        brought by a self-regulatory organization, the self-regulatory
        organization has shifted the burden to the accused to demonstrate the
        unusual circumstances which justified it. In this case there was only
        a single switch, which the ALJ ruled was insufficient to shift the
        burden away from the SEC. The SEC was unable to meet this burden. As
        in other cases (including Hoffman), it seems that the party on whom the
        burden of proof falls in a switching case is rarely able to meet it.


        John M. Baker <JBaker@...>
        Stradley, Ronon, Stevens & Young, LLP
        2121 K Street, N.W., Suite 800, Washington, DC 20037
        (202) 261-3512 Fax (202) 261-3581
        FundLaw Listowner
        Http://www.egroups.com/group/fundlaw/info.html
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