FINRA does not regulate mutual funds directly, but regulates the broker-dealers and registered representatives that sell mutual funds. In this capacity, FINRA enforces rules on mutual fund advertising, sales practices, including the sales loads that broker-dealers may charge, the incentives provided to registered representatives and the execution of mutual fund portfolio transactions. FINRA’s regulatory purview covers the following areas:
Under FINRA Rule 2210, firms must ensure that their mutual fund communications with the public are based on principles of fair dealing and good faith, are fair and balanced, and provide a sound basis to evaluate the facts about any particular security or type of security, industry or service. No broker-dealer may omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communications to be misleading. No broker-dealer may make any false, exaggerated, unwarranted, promissory or misleading statement or claim in any communication with the public, or publish, circulate or distribute any communication that the broker-dealer knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading.
Members generally must file their retail communications concerning mutual funds with the FINRA Advertising Regulation Department within 10 business days of first use, unless a filing exception applies. A retail communication is defined as any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period.
FINRA Rule 2210 also requires an appropriately registered principal of a firm to approve each retail communication before the earlier of its use or filing with FINRA. While the rule does not require principal pre-approval for correspondence and institutional communications, firms must establish and maintain written procedures for their supervision and review. In addition, the Rule has a recordkeeping requirement mandating firms maintain files that contain its communications with the public.
Sales Charges and Breakpoints
FINRA Rule 2341(d) prohibits firms from selling mutual funds if their sales charges are deemed “excessive.” The rule imposes various limits on both front-end and deferred sales charges depending on whether the fund imposes an ongoing asset-based sales charge or service fee, such as a Rule 12b-1 fee, and whether the fund offers rights of accumulation or quantity or “breakpoint” discounts. Rule 2341(d) also limits ongoing fund service fees and other ongoing asset-based sales charges.
Breakpoint discounts are volume discounts to the front-end sales load charged to investors who purchase Class A mutual fund shares. The extent of the discount depends on the amount invested in a particular family of funds. FINRA Rule 2342 prohibits sales of mutual funds shares in amounts below a breakpoint if the sales are made “so as to share in higher sales charges.”
FINRA has observed that in some instances customers have not received breakpoint discounts. FINRA has addressed this issue through examinations and enforcement actions. Multiple enforcement actions in 2015 resulted in millions of dollars in fines and restitution to customers. These actions underscore the need for firms to establish and maintain systems and controls to ensure that customers receive the breakpoint discounts they are due.
A firm’s procedures should include training for staff involved in the sale of Class A shares of front-end mutual funds. FINRA provides a training outline, which includes important breakpoint topics that firms should address in their training. FINRA also developed a checklist and worksheet that can assist firms gather the necessary information in order to ensure customers receive their breakpoint discounts. FINRA also recommends that firms provide investors with a Written Disclosure Statement explaining the availability of breakpoint discounts either at the time of purchase or shortly thereafter.
Cash & Non-Cash Compensation
FINRA members and their registered representatives are compensated for the sale of mutual fund shares in various ways, and the disclosure that investors receive depends upon the particular compensation arrangement. For example, member compensation that is deducted from the initial investment or from fund assets, such as sales charges and Rule 12b-1 fees, is disclosed in the fee table that appears in the mutual fund prospectus. Other forms of member compensation, such as payments from a mutual fund adviser for "shelf space," should also be disclosed.
FINRA Rule 2341 regulates cash and non-cash compensation arrangements in connection with the sale and distribution of investment company securities. The Rule contains broad prohibitions on the payment or receipt of non-cash compensation by FINRA members and their associated persons in connection with the sale of such securities, and allows non-cash compensation to be awarded only if it is structured in accordance with one of several limited exceptions. The Rule also requires firms to maintain records regarding cash and non-cash compensation.
In addition, the Rule prohibits firms from accepting cash compensation in connection with the distribution of mutual funds unless the compensation arrangement is disclosed in the prospectus.
FINRA reminds members that compensation arrangements may never undermine a member’s obligation to properly supervise its registered representatives, or a registered representative's obligation to make only suitable recommendations to customers. Members must adopt and implement procedures reasonably designed to ensure that all communications of their registered representatives concerning investment company products, whether written or oral, are fair and balanced. In recommending an investment company, registered representatives must disclose all material information, including the fund’s expenses and sales charges, investment objectives and risks.
FINRA has highlighted sales practice concerns with certain complex fund products, including alternative mutual funds and non-traditional ETFs. While there is no standard definition of alternative mutual funds, if a fund’s strategy involves non-traditional asset classes, non-traditional strategies or illiquid assets, the fund may be considered an alternative fund. Alternative mutual funds, or alt funds, have seen a significant increase in sales over the past several years. They often are marketed as a way for retail investors to invest in sophisticated, actively-managed hedge fund-like strategies that will perform well in a variety of market environments. Many of these funds use various non-traditional asset classes and strategies.
FINRA recommends that firms refer to such funds based on their specific strategies, instead of bundling them under one umbrella category, such as alternative mutual funds. Firms must ensure that their communications with the public regarding alternative funds present a fair and balanced picture of both the risks and benefits of the funds, and may not omit any material facts or qualifications.
FINRA has provided guidance to firms on their sales practice obligations relating to leveraged and inverse ETFs. While these ETFs may be useful in some sophisticated trading strategies, they are highly complex financial products typically designed to achieve their stated objectives on a daily basis. Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. As such, inverse and leveraged ETFs that are reset daily may be unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.
FINRA has sanctioned firms for selling leveraged and inverse ETFs without reasonable supervision and without having a reasonable basis for recommending the securities.
FINRA's Office of General Counsel (OGC) staff provides broker-dealers, attorneys, registered representatives, investors and other interested parties with interpretative guidance relating to FINRA’s rules. Please see FINRA OGC Interpretative Guidance for more information.
OGC staff contact:
1735 K Street, NW
Washington, DC 20006