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.

What Sales Charges Must Be Disclosed?

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:

A fund may not be described as "no-load" or having "no sales charge" if it carries a front-end load, a CDSC, 12b-1 or service fees exceeding 0.25% of average net fund assets per year, or (for closed-end funds) underwriting fees, commissions, or other offering expenses.

Exam Tip: Gotchas

• Customer purchases mutual fund -> sales charges apply -> BD must disclose all charges, breakpoints, and LOIs -> failure to disclose = NASAA dishonest practice.

What Must Be Disclosed About Breakpoints?

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) available at or above a dollar amount 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 let a customer aggregate the value of prior purchases (and often household holdings) toward a breakpoint on a new purchase

When Is a Below-Breakpoint Purchase a Violation?

The disclosure duty applies to a discount at or above a breakpoint, not to every purchase that happens to sit just below one. A below-threshold purchase only becomes a violation when the facts show an available discount the customer never learned about, such as:

• An available letter of intent that would let the customer commit to the remaining amount over time
• Rights of accumulation from existing holdings that would push the purchase over the threshold
• Deliberate structuring of the purchase specifically to stay under the breakpoint and preserve a higher commission (breakpoint selling)

Example (undisclosed rights of accumulation): A customer wants to invest $49,000 and already holds $5,000 in the same fund family, which the fund's rights of accumulation would count toward the $50,000 breakpoint. The agent processes the $49,000 purchase at the full sales charge without mentioning that the existing $5,000 holding would push the customer over the breakpoint. That is a breakpoint-disclosure violation: an available discount existed and the agent did not disclose it.

Breakpoint selling is the narrower, more deliberate version of this violation: the agent (or the firm) structures the purchase specifically to stay under the threshold, for example by splitting one large order into several smaller ones, in order to preserve a higher commission.

Exam Tip: Gotchas

• "Breakpoint selling" and "failing to disclose an available breakpoint discount" are related but not identical. Both require more than "the purchase happened to land below a breakpoint": look for an LOI, aggregation rights, or deliberate structuring before calling a below-threshold purchase a violation.

How Is Share Class Suitability Evaluated?

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.

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

The customer's expected holding period is not a separate item on that list. It feeds into the fourth factor, the fee comparison:

• A longer holding period generally favors Class A's front-end load and lower ongoing 12b-1 fee
• A shorter holding period generally favors Class C, which carries no front-end load and no long-term CDSC exposure

Weighing holding period is how a broker-dealer applies the fee comparison, not an additional factor alongside it.

Exam Tip: Gotchas

• The share class recommended must be suitable for the customer's investment size and time horizon; recommending a higher-cost class without a suitability basis is a dishonest practice.

When Does Recommending a Fund Switch Become a Violation?

• 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.

What About Holding Duplicative Portfolios?

Recommending a purchase that leaves the customer simultaneously holding shares in different fund portfolios with similar objectives and policies is also a dishonest practice, unless the broker-dealer has reasonable grounds to believe the recommendation is suitable based on the customer's objectives, financial situation, other holdings, and any associated fees. This is the same suitability test as switching, applied to a new purchase instead of a liquidation.

What Should You Check on Exam Day?

• A broker-dealer must adequately disclose all sales charges (front-end load, CDSC, 12b-1 fees) when soliciting fund shares.
• A fund cannot be called "no-load" if it has a front-end load, a CDSC, or 12b-1/service fees above 0.25% of average net assets per year.
• Failing to disclose an available breakpoint or letter of intent is a dishonest practice. A below-threshold purchase is only breakpoint selling when an LOI, rights of accumulation, or deliberate structuring made the discount actually available.
• Share class recommendations need a suitability basis tied to objectives, financial situation, holdings, and fees; holding period feeds into the fee comparison, it is not a separate factor.
• Switching between similar funds, and recommending a purchase that leaves the customer holding duplicative similar portfolios, are both violations unless suitable.