The Financial Industry Regulatory Authority (“FINRA”) has, in recent months, increased its regulatory focus on investor awareness regarding closed-end funds (“CEFs”). In October of last year, FINRA issued an Investor Alert entitled “Closed-End Fund Distributions: Where is the Money Coming From.” The alert sought to educate investors about CEFs and, specifically, about the sources of the periodic guaranteed distributions that make CEFs attractive to investors. This alert followed on the heels (relatively speaking) of six-figure fines levied against Merrill Lynch and UBS in July 2009 for supervisory failures relating to unsuitable short-term sales of CEFs. Bottom line, FINRA is paying attention to the marketing and sale of CEFs and, as such, attorneys need to take proactive steps to educate their brokerage clients about potential litigation that can result from CEF transactions.
A CEF is an investment company that pools money from investors to buy securities. In that regard, they are similar to mutual funds. However, CEFs differ from mutual funds in three key areas: the issuance of shares in a CEF, the valuation of those shares and the sources of the returns those shares generate for investors. First, unlike mutual funds, which continuously sell newly-issued shares and redeem outstanding shares, CEFs offer a fixed number of shares in an initial public offering that are then traded on secondary exchanges. Second, unlike the price of a share of a mutual fund, which is based on the fund’s net asset value (“NAV”) (the value of the fund’s assets minus its liabilities divided by the number of outstanding shares), the share price of a CEF may trade at a premium or discount to NAV depending on investor interest in the CEF. Finally, unlike mutual funds, which pay dividends to investors based strictly on the fund’s performance, CEFs pay guaranteed distributions (generally on a monthly or quarterly basis) to investors. However, as is emphasized in FINRA’s October 2013 investor alert, these distributions can be comprised not only of what the CEF generates in the form of interest income, capital gains and dividends, but also of investors’ principal in the CEF. Thus, in certain cases, the guaranteed distributions being paid by a CEF may take the form merely of a return of the capital an investor invested in the first place. As such, while mutual funds and CEFs may appear to an unsophisticated investor to be substantially similar investment options, brokerage clients must take proactive steps to ensure that the key material differences between mutual funds and CEFs are explained to the potential CEF investor. And, from the practitioner’s standpoint, it is key that such differences are explained in a manner that will serve as definitive evidence that the investor was aware of, and had substantive knowledge regarding, the particular characteristics of a CEF before a purchase of shares in that CEF is made.
In addition, the purchase of shares in CEFs, particularly at the CEF’s initial public offering, carry relatively large fees which make them attractive churning targets for nefarious brokers. This scenario played out in the cases which led to the FINRA-imposed fines against Merrill Lynch and UBS in 2009. In those cases, brokers encouraged their clients to purchase shares in CEFs at the initial public offerings. Such purchases carried with them a sales charge of 4.5%, of which a significant portion went to the broker as his commission. The shares were also, however, subject to a 30 to 90 day “penalty bid period,” during which, if the original investor sold his share in the CEF on the secondary market, the broker who made the original sale would lose his commission. Armed with this information, the offending brokers in those cases encouraged their clients to purchase shares in CEFs at the initial public offering and to hold those shares for slightly longer than the penalty bid period, only to then encourage their clients to sell the shares (often at a loss) after the expiration of the penalty bid period and use the proceeds from that sale to purchase shares in another CEF at its initial public offering, which, of course, generated another significant commission for the broker.
The gist of FINRA’s disciplinary action against Merrill Lynch and UBS was that CEF shares purchased at an initial public offering were long-term investment vehicles, a fact illustrated by the high fees charged for the purchase of CEF shares at initial public offerings. Yet, FINRA found that neither Merrill Lynch nor UBS had any supervisory or surveillance mechanisms in place to detect short-term trading in CEFs. This is a critical issue for brokerage clients. Plainly stated, how is a brokerage client monitoring transactional activity associated with CEFs? If such monitoring is similar in nature to that performed with respect to mutual funds (i.e. periodic account review meetings between broker and client, a routine updating by the client of his or her investment objectives, etc.), FINRA is suggesting that such monitoring is insufficient. Instead, brokerage clients must take affirmative steps demonstrate that they are aware of, and have taken steps to address, potential churning of CEFs by its brokers. Although, in many cases, this will be achieved through implementation of automated processes that can electronically identify suspicious trading activity, brokerage clients can take proactive steps to ensure that such suspicious activity is thoroughly investigated (and that such investigation is both initiated and performed pursuant to written policies and procedures). Moreover, in addition to the monitoring performed with respect to products about which investors are generally aware, brokerage clients should introduce additional client and broker training specific to CEF transactions and implement mandatory documentation of a client’s understanding of what he or she is purchasing in buying shares in CEFs. Such “front-end” steps are critical for preventing and defending suitability and churning claims arising from CEF transactions.
The inherent confusion from CEFs is that they appear to an unsophisticated investor to be similar to mutual funds, but with the added benefit of a guaranteed, periodic distribution. Yet, the manner in which the limited number of CEF shares are traded on the open market, thus creating potentially unexpected volatility in the valuation of CEF shares, not to mention the fact that the required distributions may come from the investor’s principal investment, a fact about which many investors are unaware, create potential issues that could lead to litigation. To prevent such litigation, brokerage clients must adjust (read: increase) level of documentation and monitoring over CEFs, as small steps in these areas will pay dividends in the form of savings associated with reduced litigation and regulatory oversight and penalties.