Registered principal and representative Kenneth C. Krull was found by the NASD to have made unsuitable recommendations to customers that involved switches from one front-end load mutual fund to another and was

• censured;
• barred in any principal or supervisory capacity;
• fined $20,000;
• suspended for one year in any capacity with the requirement that he requalify as a General Securities Representative prior to acting again in that capacity; and
• ordered to pay restitution of $171,140.93 in commissions to his customers with the proviso that such payment will be a condition for Krull's re-entry into the securities industry following his one-year suspension.

Krull appealed the NASD's decision to the SEC.

The NASD determined that during the period November 1990 through July 1993, Krull utilized in excess of 100 transactions to switch eight customers (ten accounts) in and out of a series of common stock mutual funds, all of which (with one exception) charged front-end sales loads. Typically, Krull recommended the same switches out of one fund and into one or more others to several, and sometimes all, of his customers during the same periods of time. Krull initiated all of the more than 100 switch transactions at issue, and the customers invariably followed his recommendations. The average length of time any fund position was held by a customer was about 11 months. Krull earned a total of $171,140.93 in commissions on the switches that the NASD found violative of its rules.

The switching practices that the NASD found violative are easily illustrated by reference to Krull's activities involving the Idex Fund, a common stock fund with a principal objective of "growth."

Purchase Dates: April 1991 through June 1992
Customers involved:all 8
Krull's Reason for Recommending Purchase: Idex rated five stars by Morningstar, below average risk, customers' desire growth, and superior 1-, 3-, 5- and 10-year statistics.

First Switch: June through November 1992
Customers involved: 7 of the original 8 purchasers (including one purchaser of Idex as recently as June 1, 1992 switching on June 26)
Switched into: two other funds with objectives similar to Idex
Krull's Reason for Switching:Idex was down in price and "just didn't appear to be doing well." He also stated that Idex intended to use derivatives and options in its portfolio, a risk that Krull "could not quantify."

Second Switch: December 1992 through April 1993
Customers Involved: 5 of the original 8
Switched into: Idex
Krull's Reason for Switching: At one point, he stated that the plan to include derivatives that had troubled him had not been put into effect. At another point, he testified that Idex "did go through with [that plan]," but that it did not seem to affect the fund's five-star Morningstar rating or its price. Somehow concluding that Idex "looked attractive again," Krull admitted that "it [had been] a mistake to get out of [Idex]," and that his customers would have been better off if they had simply retained their investments in the fund.

Third Switch: June 1993
Customers Involved: Same 5 described in Second Switch above.
Switched into: another fund
Krull's Reason for Switching: Morningstar had dropped its coverage, "because of the changes [Idex] had been through," and because another fund was "more attractive."

The NASD concluded that Krull's chief concern in undertaking the switching transactions was to maximize his commissions, rather than serving the best interests of his customers. It was determined that Krull made no effort to obtain discounted sales charges for his customers through the use of breakpoints, letters of intent, or rights of accumulation. Indeed, when Krull's customers did receive rights of accumulation, it was only because particular mutual funds automatically accorded that discount. Consequently, the NASD found suitability violations.

Clearly, there may well be legitimate reasons for moving a given client into or out of a particular fund within a short time. Similarly, notwithstanding your advice to the contrary, a client may insist upon switching to another fund. But as with all things in the securities industry, the better documented such a disfavored practice is, the more protection you will likely have if the client or the regulators subsequently question your judgment. Here's a sensible checklist to follow:

• Keep switching at a minimum, both for a given client and your accounts in general.
  
  
  
• At best, switching should only be done at the shareholder's request, and get that request in writing.
  
  
  
• Document your efforts to dissuade the client against switching, and quantify the costs and expenses at issue.
  
  
  
• Prior to executing switches, obtain a signed letter from the client acknowledging awareness of the new sales charge and explaning why the shareholder wants to make the switch.
  
  
  
• Submit all materials to your compliance department PRIOR to undertaking the transaction, and obtain PRIOR written authorization confirming your approval to engage in the proposed transaction. Failure to notify your compliance department in writing and to provide all customer correspondence may be deemed evidence of an effort to conceal.

Krull defended his actions to the SEC by arguing that if his trading was subjected to a churning analysis was no proof of misconduct. Krull asserted that the turnover ratios and cost-equity maintenance factors for the accounts under scrutiny were well within acceptable standards. The SEC quickly dismissed this line of defense, noting that "high initial sales charges of front-end load mutual funds make them presumptively unsuitable as trading vehicles." In essence, don't compare commission-based stock trading to front-end-load fund trading: the SEC's not buying it.

Krull introduced evidence that all his customers made money from the switching transactions at issue. In fact, the NASD and Krull agreed that two of the eight customers did better by following Krull's switching recommendations than if they had bought and held. However, the parties also agreed that six of the eight customers earned a total of $81,705 less than they would have if they had bought and held their initial investments, notwithstanding that the transactions were overall profitable. Consequently, the SEC affirmed the NASD's decision but reduced the ordered restitution by more than half to $81,705.

UPDATE!

On April 26, 2001, The United States Court of Appeals for the Ninth Circuit affirmed the SEC's decision.