NASD REGULATORY CASES OF NOTE

NASD REGULATION, INC.

NATIONAL ADJUDICATORY COUNCIL

WENDELL D. BELDEN
Disciplinary Proceeding No. C05010012
November 12, 2001
Hearing Officer-
Alan W. Heifetz

SOURCE CITE

 2110

 2310

Registered person made unsuitable recommendations in connection with  purchase of $2.1 million in Class B fund shares. NASD rules investment should have been made in Class A shares with applicable discounts.

1. fined $40,000;

2. suspended in all capacities for 90 days;

3. required  to requalify by examination before functioning in any principal capacity;

4. restitution to the estate of JRB in the amount of $55,567.03, plus interest;

5. costs and fees

One of the most hotly contested issues among brokers is whether to put clients in mutual fund Class A (front loads) or Class B (back loads).  The debate tends to focus on whether it is better to recommend Class A shares, which have a one-time, upfront fee and comparably lower internal expenses; or, on the other hand, should one recommend Class B shares, which have no upfront fees but have a contingent deferred sales charges and comparably higher internal expenses.  Then of course there is another school of thought that argues against buying any load funds whatsoever, and points to the data indicating that no-load funds tend to outperform their load cousins. 

Consequently, many industry salespersons will likely argue over some aspects of a recent disciplinary case in which the NASD sanctioned a registered person for recommending Class B (rather than Class A) mutual fund shares.  Given the complexity of the matter, let’s try to first clarify who’s who and then what they did.  

CAST OF CHARACTERS 

Wendell D. Belden is the sole owner of and a registered representative/principal with Southmark, Inc. 

D.J. Kadagianis an investment advisor who owns Four Seasons Asset Management, an investment management firm.  Four Seasons essentially operates a timing service to enable mutual fund shareholders to switch between equity and money market funds.  Four Seasons’ customers were commingled within an omnibus account in order to facilitate timing transfers and to take advantage of rights of accumulation privileges. 

JRB was a neighbor of Belden and a retired commercial airline pilot who in 1997 approached Belden about investing his $2.1 million in retirement savings in accordance with a long-term growth objective.  In time, JRB decided he wanted to sell other airline pilots the managed account program that Southmark had with Four Seasons, and accordingly negotiated an employment agreement with Southmark and filed a Form U-4 to take the Series 6. At the time of the Office of Hearing Officers’ Hearing, he was deceased. 

Scott Pilgrimwas a C.P.A. employed by Southmark (he eventually became the firm’s President). He was paid a salary, did not sell securities, and did not receive commissions. He placed Southmark’s customers’ trades with Kadagian.   

SETTING THE SCENE 

CDSCs were a particular concern for Kadagian because if a given fund decided to terminate its relationship with market timers (which often occurred), clients forced out of such funds would be penalized with the back-end charges.  Notably, because of the large volume of business Four Seasons did with certain funds, Kadagian was entitled to rights-of-accumulation privileges (essentially volume discounts) and generally offered Class A shares to his clients without any front-end loads.  Despite Kadagian’s preferences and advice (and likely in light of Belden’s perception of his firm’s economic realities), all of Southmark’s clients that invested through Four Seasons were placed in Class B shares. 

Prior to undertaking any investments on JRB’s behalf, Belden met with the client and discussed the advantages of diversifying the retirement savings among five different mutual funds within two fund families: MFS and Van Kampen. Southmark’s gross commission on such purchases was 4%.  According to those discussions, in 1997 Belden invested JRB’s savings through Four Seasons as follows: 

Applicable CDSC charges for the MFS and Van Kampen families of funds:

Although JRB invested with Southmark through Four Seasons, Kadagian did not deal directly with JRB and received no commissions on the sales of the fund.  Four Seasons did receive a 2% fee for its timing service management of the account (which was one-half of Southmark’s annual fee 4% fee charged to its customers).

Pilgrim, who supposedly handled the technical aspects of order entry between Southmark and Four Seasons, discussed JRB’s transactions with Kadagian.  Kadagian stated that such a large investment should be placed in Class A shares, not B shares (which was Belden’s proposal). Notwithstanding Kadagian’s concerns and advice, Belden put JRB into Class B shares.

Pilgrim contacted JRB and told him that he was being cheated, which purportedly caused the customer to end his involvement with Southmark and transfer his business directly to Four Seasons. Upon said transfer he exchanged his B shares for A shares and incurred a CDSC of $84,412.58.

In its disciplinary complaint, NASD’s Department of Enforcement alleged that Belden had made unsuitable recommendations in connection with JRB’s purchase of $2.1 million in Class B fund shares.  Perhaps in an excess of candor,  Belden admitted the investments were made to maximize Southmark’s commissions, which totaled $84,207.85 . The Staff argued that given the facts and circumstances of JRB’s needs, solely investing the $2.1 million in Class A funds would have been appropriate and that no compelling reason had been advanced to the contrary. 

Van Kampen Purchases   

Our point of analytical departure is Southmark’s $32, 207.85 commission on the $805,189.45 in Van Kampen investments.  Keep in mind that Four Seasons’ original agreement with Southmark provided for access only to the Van Kampen Enterprise Fund and a Van Kampen money market fund. Consequently, JRB’s entire $2.1 million could have been invested within the Van Kampen family.  The initial front load for Van Kampen Class A shares is 5.74%, but if $500,000 worth of Class A shares are purchased the charge drops to 2% --- and at $1 million the charge is totally eliminated.  As Belden structured JRB’s Van Kampen investments, the aggregated investment of $805, 189.45 in the two funds was above $500,000 but short of the $1,000,000. As explained above, Belden acknowledged the existence of Van Kampen’s policy not to accept a $500,000-plus Class B order and he not so subtlely ensured that neither investment within the family was so structured.  Turning my aunt into a man, the Staff argues that if Belden had invested the same $805,189.45 into Van Kampen Class A shares, JRB would have saved between $14,000 to approximately $16,500 in commissions (depending on whether a cumulative discount would have been granted). 

Next, given the fact that the Southmark-Four Seasons arrangement did not originally provide for any investments outside of Van Kampen, the Staff scrutinized the MFS purchases. Most damning was the fact that MFS has a policy that allows it to reject orders to purchase $1 million plus of Class B shares because Class A’s are offered at net asset value.  Assuming there was a meritorious explanation for investing the $1.3 million in the MFS family of funds (rather than in Van Kampen shares), the Staff noted that the same dollar purchase of MFS Class A shares would have reduced Southmark’s Class B commission of $52,000 to a Class A commission of $13,000.

After eight years, JRB’s Class B funds would automatically be converted to Class A shares (at the latter’s expense schedule). Assuming that dollar-one from day-one was invested in Class A shares, total expenses after eight years would have amounted to $179,315.09.  Using the same theory for the Class B shares actually purchased, the total expenses would have amounted to $294,723.58.  Perhaps delving into the even more remote school of if my female cousin were a man she’d be my male cousin,the Staff introduced an analysis provided by Van Kampen Investments, Inc. showing that the Class A shares would have outperformed the Class B shares (increased value) during the time that JRB actually owned the latter by some $25,000.00.  As should be expected, Belden countered that this analysis was flawed because it assumed only a $16,263.78 initial Class A sales charge, when, in fact, JRB would have been charged some $46,804 in front-end loads. The Panel rejected his argument because it failed to allow for the fact that at $1 million in purchases the initial Class A sales charges would have been totally waived --- nor did Belden’s calculation provide for the impact of charges over a period of six years CDSC (in the event of premature sale).

The Panel cited NASD Conduct Rule 2310 for guidance on whether Belden had