NASD Slaps Merrill, Wells Fargo, Linsco With Fines For Improper Sales Of Class B And C Mutual Fund Shares

NASD has fined Merrill Lynch, Pierce, Fenner & Smith, Wells Fargo Investments and Linsco Private Ledger Corporation a total of $19.4 million for suitability and supervisory violations relating primarily to sales of Class B mutual fund shares as well as

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NASD has fined Merrill Lynch, Pierce, Fenner & Smith, Wells Fargo Investments and Linsco/Private Ledger Corporation a total of $19.4 million for suitability and supervisory violations relating primarily to sales of Class B mutual fund shares as well as some Class C mutual fund shares. These cases are part of NASD’s continuing investigation into mutual funds sales practices.

Merrill Lynch was fined $14 million, while Wells Fargo was fined $3 million and Linsco was fined $2.4 million. The amount of the fines approximate the additional commissions the firms received by selling Class B shares rather than Class A mutual fund shares. In addition, each firm is implementing a remediation plan to compensate affected customers — collectively involving more than 29,000 households and nearly 140,000 transactions.

NASD’s investigation examined transactions during an 18-month period between January 2002 and July 2003. Investigators focused on 23,000 households at Merrill Lynch with 105,000 Class B and C share transactions; 4,500 households at Wells Fargo with 12,000 Class B and C share trades; and approximately 2,000 households with 22,400 Class B and C share trades at Linsco.

During this period, the three firms recommended and sold Class B and/or Class C share mutual funds to customers without considering or adequately disclosing on a consistent basis that an equal investment in Class A shares would generally have been more advantageous to those customers in view of all relevant considerations. Before recommending a share class, brokers must consider the customer’s anticipated holding period and all costs associated with each share class including front-end sales charges, annual expenses and contingent deferred sales charges. The firms also had inadequate supervisory and compliance procedures relating to the manner in which the firms’ sales personnel recommended and sold Class B and Class C shares.

Class A shares typically charge a front-end sales charge and also may be subject to an asset-based sales charge, but it generally is lower than the asset-based sales charge imposed by Class B or Class C shares. Mutual funds may offer discounts, called breakpoints, on the front-end sales charge for Class A shares if an investor makes a large purchase, already holds other mutual funds offered by the same fund family, or commits to regularly purchasing the mutual fund’s shares. To determine the appropriate discounts, an investor is often allowed to aggregate his purchases with holdings of other family members. Class B shares typically do not charge a front-end sales charge, but they do impose asset-based sales charges that may be higher than those associated with Class A shares. Class B shares also normally impose a contingent deferred sales charge (CDSC) which the investor may pay at the time the investor sells the shares. While the investor holds the shares, the CDSC normally declines and eventually is eliminated after a certain number of years. After the CDSC is eliminated, Class B shares often “convert” into Class A shares. When they convert, they will be subject to the same, lower asset- based sales charge as the Class A shares.

Class C shares usually do not impose a front-end sales charge on the purchase but they are often subject to a CDSC if sold within a short time of purchase, usually one year. Class C shares also typically impose higher asset- based sales charges than Class A shares, and since their shares generally do not convert into Class A shares, their asset-based sales charge will not be reduced over time. So even though investors do not pay a front-end sales charge for Class B or Class C shares, the potential CDSCs and the higher ongoing fees significantly affect the return on mutual fund investments, particularly at higher dollar levels.

In resolving this matter, the firms have agreed to a remediation plan that generally covers investors who, between January 1, 2002 and today, purchased Class B shares totaling $50,000 or more depending upon the expenses and charges of the fund and who under any ordinary circumstance would have been better off had they purchased A shares instead. The offer will also be extended to a limited number of Class C share investors who, during the same time frame, made purchases totaling at least $500,000 where customers paid an initial sales charge, or at least $1 million in the absence of a sales charge and who, in view of all relevant circumstances, would have been better off had they purchased A shares instead. A number of mutual fund transaction exclusions from the plan also apply.

The firms will contact affected customers within five months. Those customers will be given the opportunity to convert their Class B or Class C shares to Class A shares in a way that will restore the customers to the position they would have been in had they originally purchased Class A shares. Affected customers who have sold some or all of their Class B or Class C shares will be eligible to receive a cash payment in addition to, or instead of, receiving Class A shares.

Each firm will establish a response center to assist affected customers. The entire remediation process is expected to take approximately nine months to complete.

The three firms settled these actions without admitting or denying the allegations, but consented to the entry of NASD’s findings.

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