FINRA Fines Broker-Dealer for Failing to Apply Class A Sales Charge Waivers for Certain Eligible Customers on its Mutual Fund Platform

On June 16, 2014, the Financial Industry Regulatory Authority, Inc. (“FINRA”) accepted a Letter of Acceptance, Waiver and Consent (the “AWC”) from Merrill Lynch, Pierce, Fenner & Smith Incorporated (the “Firm”) regarding an alleged failure to waive mutual fund sales charges for certain eligible customers.  FINRA found that from at least January 2006 through December 2011 (the “Relevant Period”), the Firm failed to establish, maintain, and enforce a supervisory system and written procedures reasonably designed to ensure eligible accounts received sales charge waivers as set forth in the mutual funds’ prospectuses.  As a result, the Firm failed to provide certain customer accounts with sales charge waivers for which they were eligible.  This article summarizes FINRA’s findings, which the Firm neither admitted nor denied in connection with executing the AWC.

Applicable FINRA Rules

NASD Rule 3010 requires member firms to establish and maintain a supervisory system reasonably designed to achieve and monitor the member’s compliance with the requirements of applicable securities laws and regulations, and with applicable NASD and FINRA rules.  NASD Rule 3010 also requires that the supervisory system, at a minimum, establish and maintain written procedures required by the Rule.  FINRA Rule 2010, identical to NASD Rule 2110, requires that a member firm, in the conduct of its business, observe high standards of commercial honor and just and equitable principles of trade.  (FINRA Rule 2010 replaced NASD Rule 2110 on December 15, 2008.  Any conduct prior to that date was subject to NASD Rule 2110; conduct on or after that date was subject to FINRA Rule 2010.)

In agreeing to the AWC, FINRA cited to the settlement of disciplinary proceedings with the Firm in each of 2008 (the “2008 AWC”), 2010 (the “2010 AWC”) and 2012 (the “2012 AWC”) relating to similar violations of FINRA and NASD Rules, including violations of NASD Rules 2110 and 3010 and FINRA Rule 2010, during and prior to the Relevant Period which resulted in fines paid by the Firm, undertakings to FINRA from the Firm, and remediation to affected customers from the Firm.  The FINRA notices with respect to the relevant disciplinary history can be found at: 2008 AWC2010 AWC and 2012 AWC.  

The Firm’s Mutual Fund Platform

The Firm maintained a retail brokerage platform on which it offered the customers in question the opportunity to purchase mutual funds from approximately 120 mutual fund families.  As described in their prospectuses and statements of additional information, these mutual funds offered their shares in several classes that differ in the nature and amount of the sales charges paid directly by shareholders, and in the continuing asset-based fees assessed on each class, with the result that the return to customers would vary depending on the class purchased.  Most of the mutual funds offered on the Firm’s platform disclosed in their prospectuses that they waive up-front sales charges for retirement plans, and 13 of them disclosed in their prospectuses that they offered such waivers to charitable organizations.

Failure to Provide Sales Charge Waivers to Eligible Accounts

During the Relevant Period, the Firm sold Class A shares with a front-end sales charge, or Class B or C shares with back-end sales charges and higher ongoing fees and expenses, to tens of thousands of retirement plan and charitable organization customers eligible to purchase Class A shares without a sales charge.  In doing so, the Firm failed to identify and apply sales charge waivers to eligible retirement and charitable organization accounts.  Moreover, the Firm became aware of its failure to identify and apply sales charge waivers to certain retirement account customers in 2006, but elected not to notify its customers or inform and adequately train its financial advisors to ensure that eligible customers received the waivers, and did not report its findings to FINRA until November 2011. The Firm first became aware of its failure to provide sales charge waivers to eligible charitable organizations accounts in or around April 2010, and did not report its findings to FINRA until January 2011.

The Violations

Set forth below is a summary of the specific violations cited by FINRA.

Failure to Identify and Apply Sales Charge Waivers to Retirement Accounts.  FINRA found that, during the Relevant Period, the Firm violated NASD Rule 2110 and FINRA Rule 2010 by failing to ensure that certain eligible retirement accounts received available sales charge waivers.  Specifically, FINRA found that the Firm failed to adequately identify and apply sales charge waivers to certain retirement account customers.  Because the Firm maintained the accounts on the Firm’s retail brokerage platform, FINRA found that the Firm treated these accounts similarly to other retail customer accounts for purposes of determining share class eligibility for mutual fund purchases, and routinely sold Class A shares with sales charges, or Class B or Class C shares that charged higher expense ratios than Class A shares, rather than selling them Class A shares without the sales charge under the waiver available to retirement plans.    The Firm learned it was not providing sales charge waivers to eligible retirement account customers in early 2006.  However, the Firm failed to notify its financial advisors of this failure and left the issue unresolved for over six years until December 2011.  The Firm self-reported the issue to FINRA in November 2011 and developed a remediation plan to restore affected customers to substantially the same financial position they would have been in if they had purchased Class A shares without sales charges.

Failure to Identify and Apply Sales Charge Waivers to Charitable Organizations.  FINRA found that, from January 2004 through August 2011, the Firm violated NASD Rule 2110 and FINRA Rule 2010 by failing to ensure that certain eligible 501(c)(3) charitable organizations received available sales charge waivers.  As with certain retirement account customers, the Firm routinely treated qualified charitable organizations as ordinary retail accounts for purposes of determining their eligibility for sales charge waivers.  Of the approximately 120 fund families available for purchase by charitable organizations on the Firm’s retail platform, 13 offered sales charge waivers to charitable organizations.  FINRA found that the Firm repeatedly sold such organizations Class A shares with sales charges, or Class B or Class C shares that charged higher expense ratios than Class A shares, rather than selling them Class A shares without the sales charge under the waiver available to charitable organizations.  FINRA found that the Firm became aware of the failure to provide sales charge waivers to these qualified accounts around April 2010 and self-reported to FINRA in January 2011. The Firm subsequently developed a plan to restore affected customers to substantially the same financial positions they would have been in, had they purchased Class A shares without a sales charge.

Failure to Establish an Adequate Supervisory System and Written Procedures.  FINRA found that, during the Relevant Period, the Firm violated NASD Rules 3010 and 2110 and FINRA Rule 2010 by failing to establish and maintain an adequate supervisory system and written procedures to identify and apply Class A sales charge waivers to eligible retirement account and charitable organization customers, who, as a consequence, did not receive the benefit of the available sales charge waivers.

For example, FINRA found that the Firm’s policies and procedures for mutual fund purchases on the retail brokerage platform were not designed to adequately supervise the administration of mutual fund sales charge waivers for certain retirement accounts.  In addition, the Firm did not maintain adequate policies, procedures or practices to train its financial advisors to identify and apply manual sales charge waivers to eligible retirement account customers.  The Firm also did not provide its financial advisors or supervisors with any other guidance or training to help them identify mutual funds that offered sales charge waivers to retirement account customers.  FINRA found that the Firm unreasonably relied upon its financial advisors to determine opportunities for customers to receive Class A shares with sales charge waivers while failing to have adequate written policies or procedures to help financial advisors or supervisors make this determination, and controls to detect instances in which sales charge waivers should have been applied.

With respect to charitable organization customers, FINRA found that the Firm failed to maintain an adequate system and written procedures reasonably designed to identify applicable sales charge waivers in mutual fund prospectuses for charitable organizations because, among other things, (i) the Firm’s supervisory procedures did not require any actions to determine whether special pricing provisions available to charitable organizations on Class A shares were provided to qualifying customers and (ii) the Firm did not have any systematic controls in place to prevent or detect instances where the waiver should have been, but was not, provided.  Although the mutual fund prospectuses disclosed the sales charges waiver available to charitable organizations, the Firm failed to identify the availability of the waiver and communicate that information to its financial advisors, and did not have procedures in place to monitor whether financial advisors were informing customers of available sales charge waivers or ensuring that eligible customers were receiving such waivers.

FINRA found that after the Firm became aware of these issues, it failed to implement a supervisory system to follow up and ensure that eligible customers purchased Class A shares with sales charge waivers.  For example, FINRA determined that the Firm began developing technological improvements to more readily identify retirement account customers eligible for sales charge waivers two years after becoming aware of the problem, but never fully funded or implemented the developments.  FINRA found that the Firm had concluded that the cost of implementing system updates to automatically apply waivers to charitable organization customers would be prohibitive.  As a result, FINRA found that the Firm failed to establish and maintain an adequate supervisory system and written procedures to ensure that eligible retirement account and charitable organization customers purchased Class A shares with sales charge waivers.

Sanctions

The Firm consented to a censure and a fine of $8 million.  The Firm has voluntarily paid remediation of approximately $64.8 million to certain retirement plan account and charitable organization customers affected by this issue.  As part of the settlement, the Firm has agreed to provide additional restitution in the amount of $24.4 million to affected customers.

Merrill Lynch, Pierce, Fenner & Smith Inc., Letter of Acceptance, Waiver and Consent No. 2011029999301 (June 16, 2014).

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

 

Topics:  Broker-Dealer, Brokers, Compliance, Enforcement Actions, FINRA, Waivers

Published In: General Business Updates, Finance & Banking Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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