Mutual Fund Fraud: Expensive Sales Charges for Investors, Big Commissions for Brokers
Mutual funds are investments that allow investors to pool their wealth and invest in a selection of stocks. Investors can choose from passively and actively managed mutual funds—passive mutual funds are often referred to as index funds. Actively managed funds cost more and need to perform exceptionally well to generate a return for the investor. If properly managed, mutual funds can provide consistent returns. Mutual fund fraud, on the other hand, can result in investors paying significant, unnecessary fees.
Brokers may recommend mutual funds as a way for investors to diversify their portfolios, but these investment vehicles may not be suitable for every investor. Mutual funds are ripe for fraud because they sometimes come with exceptionally high commissions for brokers. Your broker may refer to this commission as a “transaction fee.” Investors should carefully consider the risks of mutual funds, and investigate whether they could save money by purchasing shares directly from the fund instead of buying them through a broker.
Mutual Funds Explained
Loads and Expense Ratios
Different classes come with different “loads,” or sales fees. In addition to sales fees, investors should also consider their mutual fund’s expense ratio, which is the percentage of the fund’s total value spent on administrative and marketing expenses. These costs are also called 12b-1 fees.
Active and Passive Mutual Funds
Actively managed mutual funds pay a manager to pick out stocks. Passively managed mutual funds simply follow an index, like the S&P 500. Passive index funds are likely to generate a consistent—but not very exciting—return.
Actively Managed Funds: Class A, B, and C
Actively managed mutual funds come in three basic structures: Class A, Class B, and Class C.
- Class A mutual funds charge higher front-end loads but have lower expense ratios. Higher upfront costs make these types of mutual funds better suited for wealthier investors who plan to hold their shares for a long time. The upfront charges take away from the amount of money invested in the funds, so these investments need more time to generate a solid return.
- Class B mutual funds do not come with a front-end load but charge a back-end load instead. A back-end load is a charge that the investor pays when they sell their fund shares. Class B shares can also be converted to Class A shares.
- Class C mutual funds charge their sales load as a percentage of the assets. Instead of paying fees when they purchase or sell their investment, investors pay fees throughout the year. Class C shares cannot be converted.
Mutual Funds vs. Exchange-Traded Funds (ETFs)
Mutual funds and Exchange-Traded Funds are very similar, although ETFs have enjoyed a boost in popularity in recent years.
- Mutual funds only trade once during the day.
- ETFs trade throughout the day, just like regular stocks.
- Certain mutual funds are actively managed, whereas ETFs are passive, meaning they stick with the securities they selected initially.
- Because mutual funds have to pay for a manager, ETFs have a reputation as a lower-cost option. However, they may generate less capital gain in the long run.
What is the Difference Between Hedge Funds and Mutual Funds?
Mutual funds shares are available to the public, unlike hedge funds that are private investments. Due to their private and high-risk nature, hedge funds are only available to accredited investors with deep pockets and especially high incomes.
Unlike hedge funds, mutual funds are heavily regulated, making them supposedly less susceptible to fraud. But mutual funds fraud remains a threat to the everyday investor.
Mutual Fund Fraud Example
Mutual fund fraud can take a few different forms.
Victor Chilelli and Ofer Abarbanel
The SEC recently filed an emergency action against Victor Chilelli, Ofer Abarbanel, and an offshore fund. The regulator alleges that Chilelli and Abarbanel perpetrated a scam designed to appear as a legitimate mutual fund investment.
Ofer Abarbanel and Victor Chilelli told investors they would invest their money in treasury bills that would mature in one to three months. They also stated they would enter reverse repurchase agreements with the Treasury securities serving as collateral. Instead, the SEC alleges that the two fraudsters routed all investments to shell companies. When investors attempted to redeem $106 million in investments, Abarbanel and Chilelli refused, trying to move the funds to a different account that investors could not access. The SEC is seeking disgorgement as well as civil penalties.
This case highlights the need for investors to thoroughly research their investments. Ofer Abarbanel and Victor Chilelli falsely claimed that their sham LLCs were “broker/dealers, institutional investors, institutional investment manager(s), banks, mutual funds, and insurance and/or reinsurance companies.” Brokers who recommended this fund may be liable for investor losses.
Mutual Fund Breakpoint Fraud
Class A mutual funds from the same family come with breakpoint sales discounts. The “breakpoint” is a dollar amount of mutual fund shares that qualifies the investor for a sales charge discount. If an investor is close to the breakpoint level, it makes sense to purchase more shares because the reduction in a sales charge will result in overall savings.
FINRA offers the following example of how a mutual fund breakpoint works:
- A purchase of $49,500 in Class A mutual fund shares might come with a sales charge of 5.75%, or $2,846.25.
- The mutual fund has a breakpoint of $50,000. If the investor purchased $50,000 worth of shares instead of $49,500, they could instead pay a 4.5% sales charge, which equals $2,250, or $596.25 less.
- By increasing the mutual fund purchase by $500, the investor could reduce their sales charges by $596.25, for an overall savings of $96.25.
Letters of Intent (LOI)
If an investor cannot reach the breakpoint with one payment, there may still be a way to take advantage of breakpoint savings. Investors can sometimes sign a letter of intent (LOI) that states the investor is committed to purchasing a certain number of shares of a mutual fund family within a specified timeframe, usually around 13 months.
Rights of Accumulation (ROA)
Besides breakpoints, certain mutual funds also offer “rights of accumulation.” If you purchase more shares of a mutual fund family, a sales charge discount could apply. Rights of accumulation may apply even if the investor purchased mutual shares with different brokerage accounts or at different firms. It is the broker’s responsibility to understand how a given mutual fund’s rights of accumulation work.
FINRA Rule 2342: Brokers Are Required to Tell Investors About Breakpoints
Since broker commission is based on the sales charge, brokers might be tempted not to disclose breakpoint discounts.
FINRA rules require that brokers inform their investors of any available breakpoint discounts. FINRA Rule 2342 states that brokers are not allowed to recommend a purchase of mutual fund shares in an amount just below the breakpoint level to earn a bigger commission for themselves. So that the regulator can determine if breakpoint fraud has occurred, FINRA requires brokers to retain proof that they disclosed the available breakpoints.
FINRA Fine for Failure to Inform Investors of Breakpoint Discounts
FINRA fined a broker $5,000 and suspended him for one month following allegations of breakpoint fraud. According to the Acceptance, Waiver, and Consent agreement, an investor paid $19,687 in unnecessary mutual fund sales charges.
Can I Lose All My Money on a Mutual Fund?
Yes. Depending on their underlying investments, mutual funds can expose investors to a fair amount of risk. FINRA requires that brokers accurately communicate the risks associated with any mutual fund shares that they recommend. Keep in mind that mutual funds may initially produce good dividends and capital gains, only to lose money as market conditions change.
- Index mutual funds simply aim to match the stock market’s performance. These are some of the lowest risk mutual funds since they do not depend on the success of any one particular stock or market sector.
- Mutual funds that follow a certain sector, like hospitality, are more likely to suffer losses due to unforeseen circumstances. For instance, many hospitality investments suffered in the wake of the Covid-19 pandemic.
- Leveraged mutual funds are especially risky because they invest with borrowed money. Borrowed money amplifies the risk of major losses.
Investment Fraud Lawyers for Mutual Fund Claims
Securities attorneys can evaluate your mutual fund fraud claim and walk you through the steps to recover your money. Contact Kurta Law if you believe your broker misrepresented a mutual fund, recommended an unsuitably risky mutual fund, or failed to inform you of breakpoint discounts.