Compliance June 10, 2011

Judge Dismisses Case Regarding 12(b)-1 Fees

A judge this week dismissed a case alleging that because brokers are being paid for investment advice by 12(b)-1 fees, they should also be registered as investment advisers. 
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Judge Leonard B. Sand in the U.S. District Court in the Southern District of New York presided over the case, Bradley C. Smith v. OppenheimerFunds Distributor Inc., and ultimately dismissed it on grounds that the plaintiff wasn’t protected by the Investment Adviser Act of 1940 as he argued he was.

According to the court memorandum, the plaintiff, a resident of North Carolina, owns Class C shares of Oppenheimer Gold & Special Minerals Fund and Class C shares of the Oppenheimer Small & Mid-Cap Fund, a series of Oppenheimer Quest for Value Funds.  The plaintiff has held shares in both Funds since June 9, 2006.

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The Board of Trustees for each fund decides how to compensate broker/dealers (B/Ds) for selling shares. Here, the funds pay distribution fees pursuant to Rule 12b-1 to OppenheimerFunds, the funds’ distributor, which in turn forwards these payments to retail B/Ds such as Merrill Lynch, who distribute shares in the funds. The plaintiff alleged that since October 1, 2007, OppenheimerFunds have made these payments in the form of asset-based compensation, and that such compensation violates the Investment Advisers Act (IAA) of 1940.

“Special compensation” 

The court memorandum explained that B/Ds are regulated by the Securities Exchange Act of 1934, whereas the IAA applies to investment advisers. The IAA also applies to full-service B/D firms who provide investment advice to their customers. A B/D firm providing investment advice must comply with the IAA by registering as an investment adviser, maintaining recordkeeping and reporting procedures, adopting policies to prevent violations of the securities laws, and maintaining compensation arrangements in accordance with the IAA.  Firms registered as both B/Ds and investment advisers are called “dual registrants.” The plaintiff alleged that his mutual fund shares are held in a brokerage account at B/D Merrill Lynch.

The IAA contains a “Broker-Dealer Exclusion” for a B/D who gives advice that is only “incidental” to his conduct as a B/D “and who receives no special compensation therefore.” Such B/Ds are exempted from the IAA’s registration and reporting requirements. According to the plaintiff, “special compensation” includes anything other than transactional commissions. Therefore, the plaintiff contended that B/D dual registrants who receive any form of compensation other than transactional commissions cannot offer investment advice under the IAA to holders of brokerage accounts.

Judge Sand wrote in the memorandum that the plaintiff has “failed to assert a viable predicate violation of the ICA necessary to make out a claim under ICA section 47(b). Plaintiff is not left without a remedy for the broker-dealers’ alleged underlying violations of the IAA. Those violations involved the broker-dealers’ receipt of asset-based compensation for brokerage accounts, or their failure to register as investment advisers while receiving such compensation. Under this theory of liability, the ultimate fault would lie with the broker-dealers themselves, and Plaintiff may sue them for violating the IAA… Moreover, Plaintiff’s claims—including his federal claims—rely on alleged breaches of fiduciary duty. Plaintiff is of course free to raise such fiduciary duty claims in state courts. Accordingly, Defendants’ motion to dismiss Plaintiff’s First Cause of Action is granted.”

The dismissal order can be read here.

Compliance June 10, 2011

Nonprofit Weighs in on Electronic Disclosure Debate

The Pension Rights Center, a nonprofit consumer rights organization, believes that current safe harbor rules balance the interests of participants and beneficiaries, and the interests of efficient plan administration. 
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In a letter to the Employee Benefits Security Administration (EBSA), the Pension Rights Center expressed its belief that “the safe harbor should be strengthened by requiring that participants affirmatively consent to the electronic delivery of a Summary Plan Description or the Periodic Pension Benefit Statement, even for employees who work with computers daily.”

The Center pointed out that for individual account plans, the Department of Labor’s (DoL) disclosure rules do not require all investment-related information to be delivered individually to participants. The final regulations for fee disclosure to participants use a layered approach to disclose investment information so that supplemental investment information may be presented on a website. The Center recommends that paper copies be provided upon request.

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The Center’s second point was that electronic disclosure should not be the exclusive means of reducing the burden of disclosure requirements for plan administrators. The Center has previously testified that use of model notices and standard language, combining disclosure notices, and tailoring disclosure requirements to the specific notice might be ways to streamline disclosure requirements.

Lastly, the Center brought to EBSA’s attention that email is not necessarily the only form of electronic communication that should be addressed. “We are especially concerned about voice mail and other automated information provided over a telephone connection as a means of electronic disclosure,” the Center wrote in its letter. “It is our view that required pension disclosures cannot be delivered in an understandable manner by voice mail nor are most participants able to record or otherwise retain copies of these disclosures for future reference. Pension disclosures generally are complicated. Voices can be difficult to understand. Automatic phone calls are often ignored. Call-backs can be difficult at best. The Pension Rights Center recommends that the Department of Labor adopt a rule prohibiting use of any voice delivery technology to provide required disclosures.”

The Department of Labor accepted comments on its request for information regarding electronic disclosures until June 6. The Pension Rights Center complete letter is available here. 

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