Morgan Stanley Fined $1.5 Million for Mutual Fund Share Class Deception

The Securities and Exchange Commission (SEC) has fined Morgan Stanley Smith Barney (MSSB) $1.5 million, according to AdvisorHub. On November 7, 2019, the SEC issued a press release alleging that Morgan Stanley engaged in illegal business practices by providing certain customers with false information about mutual fund share classes. The SEC alleges that Morgan Stanley failed to recommend the lowest share classes and instead misled investors into investing in higher classes, leading to them paying unnecessary fees. According to the SEC, Morgan Stanley did not use its share-class calculator even though it had advertised this feature, and then later made calculation errors — which Morgan Stanley attributes to faulty coding. The alleged deceptive business practices happened between July 2009 and December 2016. How many accounts were allegedly affected? This alleged misconduct was widespread, affecting 16,748 retirement accounts and 1,772 charitable accounts.

In order to understand how Morgan Stanley allegedly misled investors in this case, one must understand share classes: Class A, Class B, Class C, and the institutional class (Class I). Each class carries different fees, and not every class is appropriate for every investor. Still, unscrupulous brokers may convince investors to purchase shares in an unsuitable class in order to generate greater commissions for themselves. In an Investor Alert, the Financial Industry Regulatory Authority (FINRA) educates investors about mutual fund classes and their respective fees and expenses. Let’s take a look at the different mutual fund share class and their characteristics.

Class A:

• not all your money is invested
• typically includes a front-end sales charge
• breakpoint discounts may be available (for example, if you purchase 10,000 or more shares)

Class B:

• all your money is immediately invested
• contingent deferred sales charge (CDSC), a.k.a. “back-end load” (often eliminated after six years)
• two years after elimination, often converts to Class A (leading to a lower cost)
• Annual expenses may be higher than Class A, and you may pay a sales commission when you sell Class B shares

According to FINRA, “If you intend to purchase a large amount of Class B shares (over $50,000 or $100,000, for example), you may want to discuss with your investment professional whether Class A shares would be preferable. The expense ratio charged on Class A shares is generally lower than for Class B or C shares. The mutual fund also may offer large-purchase breakpoint discounts from the front-end sales charge for Class A shares.”

Class C:

• full dollar amount is invested
• If held for a long time, the total cost could be higher than Class A or even Class B shares

“Often Class C shares impose a small charge (often 1 percent) if you sell your shares within a short time, usually one year. They typically impose higher asset-based sales charges than Class A shares and, since they generally do not convert into Class A shares, those fees will not be reduced over time,” according to FINRA.

Class I:

• The institutional share class
• Often available to retail investors through an employer-sponsored retirement plan
• Should include only no-load mutual funds (no upfront fee comes out of your investment)

Due to these disparities in the fees assessed for different mutual fund share classes, Morgan Stanley’s customers affected by this alleged fraud lost a combined $12 million in excessive upfront sales charges and other fees. In addition to the $1.5 million penalty, Morgan Stanley also disgorged $45,759. The company asserts that 99% of customers have been reimbursed.

The Morgan Stanley case is not the first time a brokerage firm has found itself in hot water when it comes to recommending different mutual fund share classes. The SEC and FINRA have been cracking down on this behavior for more than a decade, targeting firms that fail to apply breakpoint discounts to eligible mutual fund accounts, sell overpriced shares, and fail to disclose conflicts of interest. Indeed, in June 2014, FINRA fined “Merrill Lynch, Pierce, Fenner & Smith, Inc. $8 million for failing to waive mutual fund sales charges for certain charities and retirement accounts. FINRA also ordered Merrill Lynch to pay $24.4 million in restitution to affected customers, in addition to $64.8 million the firm has already repaid to disadvantaged investors.”

To curtail fraud, FINRA mandates that all member firms have written supervisory procedures (WSPs) in place. Despite the presence of WSPs, fraud can and still does occur. So how can investors protect themselves from mutual share class fraud? At the minimum, investors should ask the following questions:

• Where do mutual funds fit into my overall financial plan?
• What is my time horizon? (For example, if you plan to hold mutual funds for a long time, Class C shares might not be the most suitable option for you.)

· Is my financial professional receiving a commission for selling these mutual funds? (Your investment professional may receive higher fees for recommending different share classes, so always do your research before purchasing mutual funds.)

If you need help deciding between different funds or share classes, FINRA’s Fund Analyzer tool is an excellent resource.

If you fear you may have been placed in an unsuitable mutual fund class or if you just have questions about mutual fund share classes, you may benefit from contacting a securities attorney. Call (877) 238–4175 or email info@fkesq.com for your free case consultation with the securities attorneys of Fitapelli Kurta.