MutualFundWire.com: NASD Cracks Down on CDSC Waiver Ploy at Citi
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Friday, August 11, 2006

NASD Cracks Down on CDSC Waiver Ploy at Citi


As many as 100 Citigroup Global Markets brokers may have been involved in behavior that cost the bank more than $1.1 million in fines and penalties. The NASD found that the five reps, and possibly more, cheated mutual funds by improperly claiming waivers for contingent deferred sales charges (CDSCs) by claiming that their customers were disabled. NASD officials added that they are continuing to investigate the behavior af additional reps. Altogether, the brokers used the ploy in 2,419 transactions worth $47 million, according to the NASD.

The NASD characterized the volume of trades with CDSC waivers through Citi's electronic order system -- which were made over a 13-month period from June 2001 to June 2002 -- as "an extraordinarily high number for approximately 100 brokers" and noted that Citigroup failed to scrutinize those transactions or make inquiry of the brokers entering those transactions. During the period, one rep entered disability-based CDSC waivers for more than 80 percent of his customer base, yet most of those customers were not disabled, and, in many cases, they subsequently used the proceeds to make new investments, according to the NASD.

The CDSC involves B shares of funds for which the fund compensates the broker at the time of the sale and recoups the commission through the use of annual fees and a declining back end load. By improperly having the back end load waived, the reps saved their customers the sales charge they had already collected at the expense of the fund firm. The disability waiver typically only covers fund shareholders who become disabled while they hold the fund shares.

Citigroup Global Markets agreed to pay $400,000 for supervisory and recordkeeping violations in connection with the ploy. The NASD also tacked on another $715,000 in restitution to the affected mutual fund entities. It also agreed to allow fund company distributors to submit claims for improper disability waivers prior to 2001 if they are uncovered. Citi did not admit or deny the claims.

The five brokers alleged to have used the tactic include Patricia Kwan, Timothy Behany, Edward M. VanGrouw, Carl Martin Trevisan and David Joseph Cottam. Kwan consented in November to be barred from association with any NASD firm and did not admit or deny the NASD findings. The complaint against the other four brokers is being litigated, according to the NASD.

Citi also agreed to review its policies, systems, procedures and training relating to CDSC waivers and to provide a quarterly certification to NASD that it has reviewed all CDSC disability waivers granted, has verified that they were appropriately granted for one year. It will also be required to provide appropriate training regarding CDSC waivers to its retail managers and representatives.

"Firms are obligated to be alert for supervisory 'red flags' and address systemic weaknesses that could permit widespread abusive behavior," said NASD Executive Vice President and Head of Enforcement James S. Shorris. "In this case, because Citigroup effectively failed to address a known problem, its representatives were able to improperly exploit the mutual funds' fee waiver provisions that were specifically reserved for disabled individuals - extending them even to hedge funds. This widespread failure contributed to the ability of Citigroup representatives to process over 2,400 improper waivers based on false disability claims."

The NASD said it found a number of issues with Citi's systems that enabled the behavior by reps and that the broker had failed to be alerted by red flags:

  • The firm's electronic order entry system provided an unsupervised method for its representatives to obtain CDSC waivers for customers. Citigroup failed to develop any exception reports, or otherwise provide for reasonable steps to ensure registered representatives' compliance with the applicable prospectus terms.

  • While Citigroup issued a Compliance Memo in 1999 to its managers and directors advising that CDSC waivers could not be granted "except in circumstances specified in the fund prospectus," the firm failed to implement policies or procedures reasonably designed to ensure compliance with this directive.

  • In those instances where a fund prospectus and/or dealer agreement specifically required the representative to obtain and/or submit certain documentation to support the CDSC waiver claim or, at minimum, to determine that the customer had become disabled, Citigroup had no system or procedures designed to ensure compliance with these documentation requirements and in fact failed to ensure that its registered representatives had obtained and/or submitted this information or otherwise complied with such requirements.
  • Following disciplinary actions filed in 1997 against two of the firm's registered representatives for obtaining CDSC waivers for their customers under false pretenses, the firm failed to implement any new procedures reasonably designed to prevent recurrence of such misconduct, and otherwise failed to conduct a meaningful follow-up and review in subsequent years to determine whether it had successfully addressed the problems noted in the cases.
  • In several instances, Citigroup registered representatives entered CDSC waivers for multi-million dollar mutual fund transactions by hedge funds, making the inexplicable claim that those entities were "disabled individuals" as defined by the IRS or in the applicable prospectus. Even when four of the transactions, totaling approximately $21 million, were blocked by the mutual fund companies, Citigroup failed to scrutinize those transactions.


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