Next Financial Pays $500,000 to Customers Scammed in Mutual Fund Switching Scheme

In the wake of a mutual fund switching scandal, Next Financial Group, Inc. (CRD#: 46214) of Houston, Texas has agreed to refund $500,000 to the customers of one of its former registered representatives. Next Financial Group will also pay a $100,000 fine to the Texas State Securities Board (TSSB).

What happened to lead to this outcome? From March 26, 2007 to September 27, 2019, the broker in question worked for Next Financial Group. For five years, this registered representative allegedly moved clients in and out of Class A mutual funds to generate commissions for their benefits, to the detriment of Next Financial clients. From 2014 to 2018, the broker made hundreds of trades of Class A mutual funds, which carry a front-end sales charge of at least 5%, which is paid to brokers as a commission. Although this class of mutual funds may not have been suitable for all clients, the broker bought and sold these funds on behalf of his clients anyway. To lend a sense of legitimacy to his endeavors, the registered representative allegedly claimed this was part of a “research-based mutual fund trading strategy,” according to a press release issued by the Texas State Securities Board, which alleges that Next Financial Group failed to properly supervise the broker. Even though the broker-dealer’s computer system flagged the trades, Next Financial allegedly failed to act — and was thus fined $100,000 by the Texas securities regulator. Additionally, as mentioned before, the firm must pay back wronged investors to the tune of half a million dollars. In light of these recent events, the broker who allegedly engaged in mutual fund switching is no longer registered with the Texas State Securities Board.

What is mutual fund class switching? To understand how this broker at Next Financial allegedly misled investors in this case, one must understand the major mutual fund share classes: Class A, Class B, and Class C. Each class carries different fees, and not every class is suitable for every investor. Still, unscrupulous brokers may convince investors to purchase shares in an unsuitable class to generate greater commissions for themselves. In an Investor Alert, the Financial Industry Regulatory Authority (FINRA) educates investors about the different fees and expenses involved in different mutual fund classes. Let’s examine the classes and their characteristics.

Class A:

• generally includes a front-end sales charge (which is paid to the broker as a commission)
• not all your money is invested (because the front-end sales charge is deducted from the initial investment)
• breakpoint discounts may be available (for example, if you purchase 10,000 or more shares)
• Class A shares are designed to be held for long periods (i.e. three to five years or more)

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)
• yearly expenses may be higher than Class A, and you may pay a sales commission when you sell shares of Class B mutual funds

Class C

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

Due to these disparities in the fees assessed for different mutual fund share classes, this broker’s clients incurred significant losses due to excessive upfront sales charges and other fees. The broker engaged in short-term trading, recommending that clients buy shares in a certain mutual fund and then, only a few months later, recommending a completely different mutual fund that they claimed was less volatile. Every time the customers switched mutual funds — which were almost always Class A — they incurred front-end large charges, resulting in a commission for the broker and less money for the customer.

A disciplinary order issued by the Texas State Securities Board provides further insights into how the broker committed this alleged scheme and how Next Financial Group allegedly failed to supervise this broker’s activities.

Next Financial’s Written Supervisory Procedures (WSP) prohibit “mutual fund switching” and the broker-dealer’s computer system generated SunGuard customer account surveillance reports when suspicious activity was detected. The Texas State Securities Board alleges that Next Financial did not follow its own Written Supervisory Procedures (WSPs). According to the disciplinary report issued by the Texas State Securities Board, during the five years that the broker in question was later found to have engaged in mutual fund switching, the SunGuard system generated 969 alerts for this broker’s customers’ accounts. Of these, 681 identified potential incidents of mutual fund switching. Next Financial, however, allegedly disregarded 108 of these reports entirely. When the firm did ask the broker for an explanation, sometimes the broker failed to provide one, and then the firm seemingly forgot to follow up. One report was closed due to age after three years. Other times, the broker did not respond to an inquiry for months; when they finally did, the firm accepted and closed the alerts the same day as receiving an answer from the broker. Despite what the TSSB now calls a “clear pattern” of misconduct by the broker in question, the TSSB alleges that Next Financial never contacted customers as part of its follow-up to these alerts, thus failing to detect and prevent short-term mutual fund trading. The firm’s failure to supervise constitutes a violation of §115.10 of the Rules and Regulations of the Texas State Securities Board.

All told, the broker in question earned approximately $1 million in commissions for these Class A shares. At least 50 Texas investors found themselves caught up in this scheme. If you have questions about mutual fund switching, don’t hesitate to contact the securities attorneys of Fitapelli Kurta. Call (877) 238–4175 or email info@fkesq.com to speak with a securities attorney today.