Memo #
32047

SEC Sanctions Broker-Dealer/Investment Adviser for Use of Faulty Share Class Selection Calculator
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[32047]

November 11, 2019 TO: Chief Compliance Officer Committee
SEC Rules Committee RE: SEC Sanctions Broker-Dealer/Investment Adviser for Use of Faulty Share Class Selection Calculator

 

The SEC has settled an enforcement proceeding with a firm dually registered as a broker-dealer and investment adviser that used a share class selection calculator that proved to be faulty.[1] As a result of the defects in the calculator, the Respondent placed certain retirement and charitable organization brokerage customers that were eligible for cheaper share classes into more expensive ones. Use of the faulty calculator and representations the Respondent made concerning its use resulted in the Respondent violating the antifraud provisions of Sections 17(a)(2) and (3) of the Securities Act. The Respondent was censured, ordered to cease and desist from further violating these provisions, and ordered to pay disgorgement of $42,389.41,[2] prejudgment interest of $3,369.58, and a civil monetary penalty of $1,500,000 for these violations. In assessing these penalties, the Commission acknowledged that the Respondent had already reimbursed customers that were put into more expensive share classes in excess of $25 million.[3] This case is briefly summarized below.

According to the Order, from at least July 2009 through December 2016, the Respondent represented that, in the process of selecting the most economical share classes, 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.” 

At account opening, the Respondent provided its customers a disclosure document entitled “Important New Account Information” and a brochure, “Mutual Fund Share Classes and Compensation.” As of January 2015, the Respondent’s brochure discussed the calculator the firm used “to provide customers with the least costly share class option over the anticipated holding period of the investment.”

The Order found that, while the Respondent did have a share class selection calculator for purposes of picking the least costly share class, there were three issues with the calculator that impacted certain retirement plan and charitable organization brokerage customers. These three issues were:

  1. The calculator had two operating errors that caused it not to provide the most beneficial share class to such customers in two specific circumstances. These two circumstances involved (i) retirement accounts with recurring trades that were transferred from other brokerage firms, which failed to receive the benefits performed by the Respondent’s calculator; and (ii) when the Respondent’s financial advisors failed to confirm whether retirement accounts met certain minimum eligibility criteria.  
  2. From July 2009 to mid-2012, the Respondent did not use the share class calculator for certain legacy retirement plan brokerage customers and other tools the Respondent used did not consistently provide the most beneficial share class; and
  3. The Respondent failed to code the share class calculator to provide the lowest share class available to those customers that were eligible for sales charge waivers and did not otherwise have a mechanism for doing so.

These issues with the calculator resulted in the Respondent recommending and selling to its customers that were retirement plan or charitable organizations more expensive share classes when less expensive classes were available, contrary to the Respondent’s representations to such customers. The continued use of the defective calculator and the Respondent’s misrepresentations to customers about the effectiveness of the calculator resulted from the Respondent failing to adequately test and validate the calculator to determine whether it worked as designed.   

Placing the Respondent’s customers in more expensive share classes both negatively impacted the customers’ overall return on their investments and increased the compensation received by the Respondent for these sales. This conduct resulted in the Respondent violating the antifraud provisions of the Securities Act of 1933 and the SEC sanctioning it for such violations.

 

Tamara K. Salmon
Associate General Counsel

 

endnotes

[1] See In the Matter of Morgan Stanley Smith Barney, LLC, (the “Respondent”) SEC Release No. 33-10726 (November 7, 2019) (the “Order”), which is available at: https://www.sec.gov/litigation/admin/2019/33-10726.pdf. 

[2] While the Order does not explain the amount of this disgorgement, it notes that, despite reasonable efforts, the Respondent was unable to locate and/or contact 226 former account holders, representing $45,758.99 in remediation proceeds.

[3] The Order notes that this amount includes payment of amounts covering unlawful activity outside the statutory limitation period, which was August 16, 2012 to the time of the Order.