Compensation in Connection with Investment Company Shares
NASAA's 1997 Statement of Policy specifically addresses compensation issues that arise when broker-dealers sell mutual fund shares. These rules target common abuses around sales loads, breakpoints, and fund switching.
Sales Load Disclosure (NASAA 1997 Statement, Section A)
When soliciting the purchase of investment company (mutual fund) shares, a broker-dealer must adequately disclose all sales charges to the customer.
Types of sales charges:
| Sales Charge | When Paid | Description |
|---|---|---|
| Front-end load | At purchase | Percentage deducted from the investment amount upfront |
| Contingent deferred sales charge (CDSC) | At redemption | "Back-end load" that typically declines the longer shares are held |
| 12b-1 fees | Ongoing (annual) | Asset-based fee for distribution and marketing expenses |
When a Fund cannot Be Called "No-Load"
A fund may not be described as "no-load" or having "no sales charge" if it has:
- A front-end load
- A contingent deferred sales charge (CDSC)
- 12b-1 fees or service fees exceeding 0.25% of average net fund assets per year
- Underwriting fees, commissions, or other offering expenses (for closed-end funds)
Exam Tip: Gotchas
- A fund with 12b-1 fees of 0.20% can be called no-load. But if those fees reach 0.26%, it cannot. The threshold is 0.25%.
- Customer purchases mutual fund -> sales charges apply -> BD must disclose all charges, breakpoints, and LOIs -> failure to disclose = NASAA dishonest practice.
Breakpoint Disclosure (NASAA 1997 Statement, Section A.3)
Breakpoints are dollar thresholds at which the front-end sales charge decreases. As a customer invests more, the percentage charged declines.
- Failing to disclose a relevant sales charge discount (breakpoint) is a dishonest practice
- The broker-dealer must also disclose the availability of a letter of intent (LOI), which allows a customer to commit to future purchases to qualify for a reduced sales charge
- Rights of accumulation allow a customer to aggregate prior purchases to qualify for a breakpoint on new purchases
Breakpoint Selling - A Serious Violation
Breakpoint selling means deliberately structuring a purchase just below a breakpoint to avoid the sales charge discount and earn a higher commission.
Example: A customer wants to invest $49,000. The breakpoint is at $50,000. The agent should inform the customer that an additional $1,000 investment would qualify for a reduced sales charge. Failing to do so is breakpoint selling.
Exam Tip: Gotchas
- Breakpoint selling is always a violation. If the customer is near a breakpoint, the agent must disclose it.
Share Class Suitability (NASAA 1997 Statement, Section A.4)
When recommending a specific share class of a multi-class fund (e.g., Class A, Class B, Class C), the broker-dealer must have reasonable grounds to believe the share class is suitable and appropriate.
| Share Class | Fee Structure | Generally Suitable For |
|---|---|---|
| Class A | Front-end load (breakpoint discounts available) | Larger investments, longer holding periods |
| Class B | Back-end load (CDSC), higher 12b-1 fees | Smaller investments, longer holding periods |
| Class C | Level load (lower CDSC, ongoing higher 12b-1) | Shorter holding periods |
The suitability assessment must consider:
- The customer's investment objectives and financial situation
- Other securities holdings
- The associated transaction or other fees of each share class
Exam Tip: Gotchas
- Class A shares with breakpoint discounts are generally more suitable for larger investments. Recommending Class B or C for a large purchase may be unsuitable.
Switching / Mutual Fund Replacement (NASAA 1997 Statement, Section B.2)
- Recommending that a customer liquidate or redeem investment company shares to purchase shares in a different fund with similar objectives is a dishonest practice unless the broker-dealer has reasonable grounds to believe the switch is suitable
- Switching generates new sales charges without clear benefit to the customer
- The broker-dealer must consider the customer's investment objectives, financial situation, other holdings, and any associated transaction charges
Switching from Fund A to a nearly identical Fund B just to generate a new round of sales commissions is a classic exam-tested violation.
Exam Tip: Gotchas
- Switching between similar funds without justification is a violation even if the customer agrees to it.