SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 40768 / December 10, 1998 Admin. Proc. File No. 3-9394 ___________________________________________________ : In the Matter of the Application of : : KENNETH C. KRULL : 7302 77th Drive N.E. : Marysville, Washington 98270 : : For Review of Disciplinary Action Taken by the : : NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. : ___________________________________________________: OPINION OF THE COMMISSION REGISTERED SECURITIES ASSOCIATION -- REVIEW OF DISCIPLINARY PROCEEDINGS Violation of Rules of Fair Practice Unsuitable Recommendations Involving Mutual Fund Switches Registered principal and representative of member firm of registered securities association made unsuitable recommendations to customers that involved switches from one front-end load mutual fund to another. Held, association's findings of violation are sustained, and the sanctions it imposed are modified in part. APPEARANCES: Fredrick D. Huebner, of Cable, Langenbach, Kinerk & Bauer, L.L.P., for Kenneth C. Krull Alden S. Adkins, Norman Sue, Jr., and Shirley H. Weiss, for NASD Regulation, Inc. Appeal filed: August 27, 1997 Briefing completed: December 16, 1997 I. Kenneth C. Krull, formerly a registered representative and principal of Investment Management and Research, Inc. ("IMR" or "the firm"), a member of the National Association of Securities Dealers, Inc. ("NASD"), appeals from NASD disciplinary action. The NASD found that Krull violated Article III, Sections 1 and 2 of the NASD's Rules of Fair Practice by recommending that customers make unsuitable switches in mutual funds. [1] It censured Krull, barred him in any principal or supervisory capacity, fined him $20,000, and suspended him for one year in any capacity with the requirement that he requalify as a general securities representative prior to acting again in that capacity. The NASD also ordered Krull to pay restitution of $171,140.93 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. [2] We base our findings on an independent review of the record. II. The facts in this matter are largely undisputed. During the period November 1990 through July 1993, Krull switched eight customers (with ten accounts)[3] in and out of a series of common stock mutual funds, all of which (with one exception) charged front-end sales loads. [4] Krull's trading exhibits clear patterns. He often 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. All of the more than 100 switch transactions at issue were initiated by Krull, 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. Krull's modus operandi can be illustrated by his activities with respect to Idex Fund, a common stock fund with a principal objective of "growth." At Krull's recommendation, all eight customers purchased Idex between April 1991 and June 1992. Krull stated that he recommended Idex because it was rated five stars by Morningstar,[5] had below average risk, met the customers' objective of growth, and had superior 1-, 3-, 5- and 10-year statistics. Despite Idex's apparently impressive credentials, Krull purportedly became disenchanted with the fund in very short order. Between June and November 1992, he switched seven of the eight customers into two other funds with objectives similar to those of Idex. One customer had purchased shares of Idex on Krull's recommendation as late as June 1, 1992. Less than a month later, on June 26, the customer sold Idex at Krull's suggestion. According to Krull, Idex was down in price and "just didn't appear to be doing well." He also stated that Idex management had announced its intention to gain for Idex the ability to include derivatives and options in its portfolio, a risk that Krull "could not quantify." In a very short space of time, Krull's new negative assessment of Idex turned positive. On the basis of his recommendation, five customers switched back into Idex during the period December 1992 through April 1993. In attempting to explain this abrupt change, Krull gave inconsistent explanations. 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. Thus he explained 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. Krull's renewed enthusiasm for Idex was short-lived. All five customers sold Idex in June 1993 on Krull's recommendation. Krull stated that he changed his opinion of the fund because Morningstar had dropped its coverage, "because of the changes [Idex] had been through" that made it imprudent to retain it,[6] and because another fund was "more attractive." The rapidity with which Krull shifted his recommendations is also illustrated by his activity with respect to Franklin Rising Dividends Fund, a common stock fund with the principal objectives of "income and growth." Between June and October 1992, all eight customers made purchases of Franklin on Krull's recommendation. According to Krull, he recommended the fund because of its five- star rating, its one-year superior performance, the disciplined approach of its manager, and the better protection it offered in a shaky economy. Yet, almost immediately, Krull began switching his customers into a variety of other funds. Thus, between December 1992 and June 1993, seven of the eight customers sold their shares of Franklin. Interestingly enough, although three customers began selling their Franklin shares on Krull's recommendation in early December 1992, a fourth was switched out of another fund and advised to buy more Franklin later that very same month. That customer was subsequently switched into other funds in February and April 1993. When questioned about the Franklin trading pattern in this customer's account, Krull conceded that, "looking back on it, it doesn't [make any sense]." It has long been established that a pattern of mutual fund switching, such as the one shown by the record in this case, is presumptively violative of NASD rules. In a statement of policy issued under Article III, Section 2 of those rules (now Conduct Rule 2310),[7] the NASD's Board of Governors made it clear that trading in mutual fund shares, particularly on a short-term basis, violates a salesman's responsibility for fair dealing. The Board further pointed out that "normally [fund shares] are not proper trading vehicles and such activity on its face may raise the question of Rule violation." More than twenty years ago, we expressed our views with respect to the issue presented by this case, as follows: Mutual fund shares generally are suitable only as long-term investments and cannot be regarded as a proper vehicle for short-term trading, especially where such trading involves new sales loads . . . [W]here . . . . . a pattern of similar switching transactions in fund shares is established, it is incumbent upon the person responsible to demonstrate the unusual circumstances which justified such a clear departure from the manner in which investments in mutual funds are normally made. (emphasis in original, footnote omitted). [8] In accordance with the foregoing, the NASD considered all of the various justifications advanced by Krull for his many switching transactions. It concluded that, as to 115 such transactions (and 2 others in part), Krull failed to make the requisite showing that the transactions were suitable for his customers. Indeed, the NASD found Krull's explanations "implausible and lacking any reasonable basis." Based on our independent review of the record, we agree with that conclusion and with the NASD's determinations of violative transactions. [9] The NASD also took note of other circumstances in connection with the switching transactions, further demonstrating that Krull's chief concern was maximizing the amount of his commissions rather than serving the best interests of his customers. Krull made no effort to obtain discounted sales charges for his customers through the use of breakpoints, letters of intent, or rights of accumulation. [10] Indeed, when Krull's customers did receive rights of accumulation, it was only because particular mutual funds automatically accorded that discount. Moreover, like the NASD, we do not credit Krull's claim that, when switching a customer from one fund to another, he was never able to find a suitable fund within the same fund family where there would have been no charge or only a small charge for making a switch. While, at various times, Krull placed customers in different funds within the same family, he did not do so by means of a direct switch, but rather interposed funds from different fund families. During the relevant period, IMR's written policies required that switching be "kept to a minimum," that it be done "only at the shareholder's request," and that the salesman "must make a diligent effort to dissuade the customer" from effecting the switch. Krull was admittedly aware of these policies. Nonetheless, he deliberately flouted them. Another firm policy during the period in question required the salesman to obtain a signed switch letter from his customer stating, among other things, that the customer realized that the switch would entail a new sales charge, and giving the reason for the switch. IMR policy required that the salesman send all of these letters to the firm's compliance department. Krull was aware of that requirement. Yet, although he obtained switch letters from his customers, he never sent them to IMR for review. We agree with the NASD that Krull deliberately failed to send in his customers' switch forms in an effort to conceal his improper activity. III. Krull does not contend that his myriad switching transactions, or any of them, complied with the long-established suitability standards outlined above. Instead, he asks us to treat this case as if he were charged with churning or excessive trading. He argues that his trading was not excessive when analyzed in terms of turnover ratios and cost-equity maintenance factors, the type of analysis applied when determining whether an account has been churned or excessively traded. We have previously considered and rejected this same contention,[11] and we reaffirm our prior determination here. The high initial sales charges of front-end load mutual funds make them presumptively unsuitable as trading vehicles. That circumstance makes it unnecessary and inappropriate to apply the kinds of tests for impropriety that are used in connection with the trading of other types of securities. Krull further argues that his switching activity in a customer's account was "functionally" the same as a "wrap account" in which a customer's mutual funds can be freely traded and the customer is charged an annual management fee. [12] According to Krull, the normal "wrap fee" is similar to the annual charges engendered by his switching activity. Krull asserts that to allow wrap accounts while penalizing his switching activity is arbitrary and capricious. Krull's comparison is wholly inapposite. For present purposes, it is sufficient to point out that the manager of a wrap account, whose annual fee is based on the account's assets, has no incentive to generate additional commissions by switching his client from one load fund to another. In fact, such a course of conduct would be counter-productive since it would reduce the assets on which the manager's fee is based. Krull concedes that he mistakenly relied on the various mutual funds to accord volume discounts to his customers. He argues, however, that, in making its findings of violation, the NASD overemphasized his failure to obtain lower sales charges. He contends that the small amount of benefits lost by his customers (a total of $10,422.12 according to Krull) was not material. Krull further states that the NASD, in finding switches into the Alger fund unsuitable, erred in citing his failure to take advantage of breakpoints and letters of intent since Alger does not accord such benefits. Similarly, he asserts that the NASD mistakenly cited the commission cost of acquiring Alger shares, and overlooked the fact that Alger does not charge a front-end sales load but merely imposes a contingent deferred sales charge if a purchaser sells his shares within six years. [13] The NASD disputes as too low Krull's count of the number of switch transactions that involved a missed discount. In any event, the NASD was clearly entitled to weigh Krull's failure to obtain volume discounts as a factor in determining the suitability of his recommendations. We cannot agree that the money lost by Krull's customers due to his disregard of their interests was immaterial. Nor do we consider that the NASD gave undue emphasis to this aspect of Krull's conduct. It does appear that, in some instances, the NASD, in considering switches into Alger, mistakenly took into account commission cost to the customer and Krull's supposed failure to obtain volume discounts. But this circumstance does not aid Krull. Wholly apart from its consideration of these factors, the NASD found that, with respect to all of the violative transactions, Krull's explanations for switching customers were "implausible and lacking any reasonable basis." We agree. In light of the pattern of switching shown by this record, Krull's failure to justify his switches into Alger is alone sufficient to warrant the findings against him on those transactions. [14] In light of the foregoing, we sustain the NASD's findings of violation. IV. Krull argues that he was denied due process based on the following circumstances. Although the NASD's District Business Conduct Committee ("DBCC") found that Krull had engaged in improper switching transactions and assessed substantial sanctions, it did not provide for restitution. Thereafter, the National Business Conduct Committee ("NBCC") called the case for review on its own motion and remanded it to the DBCC "to consider [its] rationale regarding the sanctions, including the issue of restitution." On remand, the DBCC required disgorgement of the commissions Krull had received as a result of his improper switching activities. Krull then appealed to the NBCC which, with some modifications, sustained the DBCC's findings and its assessment of sanctions, although it changed the disgorgement to restitution. Krull characterizes the remand order as a "peremptory command" that the DBCC require restitution, and argues that the NBCC's order clearly shows that it had prejudged his case. He further contends that he was entitled to an in-person evidentiary hearing before the NBCC; that, without such a hearing, the NBCC was not entitled to make a de novo review of the record when it heard his appeal; and that the NBCC's decision showed bias against him since it ignored DBCC findings in his favor, including the DBCC's conclusion that he acted in good faith. Krull's contentions are wholly lacking in merit. The NBCC's remand order did not evidence prejudgment. It was entirely appropriate for the NBCC, in a case where the DBCC had found serious misconduct involving a respondent's customers, to obtain the DBCC's determination in the first instance as to whether or not, assuming the misconduct had occurred, some provision should be made to compensate customers for their losses. Moreover, the NASD's procedures did not deny Krull due process. Krull received the in-person evidentiary hearing to which he was entitled from the DBCC, and he presented oral argument before the NBCC. In accordance with NASD rules, the hearing at the NBCC level was properly limited to oral argument and the submission of briefs,[15] and the NBCC's de novo review, which that body conducts in every proceeding in which it hears an appeal from DBCC disciplinary action,[16] was properly limited to that argument and consideration of the parties' briefs and the record compiled before the DBCC. [17] We find no evidence of bias in the NBCC's decision. Indeed, the NBCC painstakingly reviewed each of the 147 transactions that the NASD's complaint charged were improper and exonerated Krull as to 30 of those transactions and parts of two others. Contrary to Krull's assertions, the DBCC did not find that he acted in good faith. On the contrary, it found that Krull knowingly violated IMR policy with respect to switching, and deliberately failed to send the firm his customers' switch forms in order to conceal his improper activity. Finally, we note that our own findings are based on a de novo review of the record. V. Krull argues that restitution and disgorgement are generally ordered only when customers suffer a loss, and that neither is appropriate here since all of his customers made money. In fact, the remedy of disgorgement is designed primarily to deprive wrongdoers of their ill-gotten gains. [18] An order requiring restitution, however, seeks primarily to return customers to their prior positions by restoring the funds of which they were wrongfully deprived. [19] As noted above, instead of ordering Krull to disgorge the $171,140.93 in commissions that he earned from his improper conduct, an appropriate remedy, the NASD ordered restitution of that amount to Krull's customers. As Krull points out, all of his customers made money from the transactions he recommended. However, the parties stipulated that, although two of the eight customers did better by following Krull's switching recommendations than if they had pursued a buy-and-hold strategy, six customers earned a total of $81,705 less by following Krull's recommendations than they would have earned simply by buying and holding their initial fund investments. Under the circumstances of this case, we deem it appropriate to order restitution only with respect to those six customers in the total amount of $81,705. [20] We shall accordingly reduce the amount of required restitution to that figure. [21] VI. Krull argues that the NBCC failed to justify increasing his suspension from the 90 days assessed by the DBCC to one year. He points out that he has no prior disciplinary history, and notes that the DBCC indicated that he "deserve[d] a second chance." He further asserts, among other things, that he has had no subsequent customer or compliance complaints, that "a senior compliance officer" at his current broker-dealer employer reviews all of his transactions, and that he no longer employs his former switching techniques. In our view, the sanctions assessed by the NASD (as modified above) are justified. For more than two years, Krull ignored his fundamental obligation of fair dealing by engaging in a pattern of short-term switches that placed his own interests in garnering commissions above those of his customers. Krull made no effort to reduce or eliminate sales charges on his customers' behalf. Moreover, his misconduct was knowing and deliberate. Krull was aware that his actions violated firm policy, and he deliberately sought to conceal those activities from his employer. Under the circumstances, we do not consider the sanctions imposed by the NASD (with the above modification) excessive or oppressive. An appropriate order will issue. [22] By the Commission (Chairman LEVITT and Commissioners JOHNSON, HUNT, CAREY AND UNGER). Jonathan G. Katz Secretary **FOOTNOTES** [1]: Article III, Section 1 (now Conduct Rule 2110) requires adherence to high standards of commercial honor and just and equitable principles of trade. Article III, Section 2 (now Conduct Rule 2310) requires that, in recommending a security to a customer, a salesman must have reasonable grounds for believing that his recommendation is suitable. [2]:The NASD also assessed costs. [3]:One customer and his wife had three separate accounts. [4]:More than 10 different mutual funds were involved in Krull's switching activity. Instead of a front-end sales load, customers who purchased the Alger Fund Small Capitalization Portfolio ("Alger") were subject to a contingent deferred sales charge if they sold their shares within a six-year holding period. [5]:Morningstar, Inc. has established a system for rating mutual funds that assigns a rating of one to five stars based on a risk-adjusted performance measurement in which performance equals total return. [6]:Krull did not identify the changes to which he was referring. [7]:IM-2310-2 entitled "Fair Dealing with Customers." [8]:Winston H. Kinderdick, 46 S.E.C. 636, 639 (1976). See also Terry Wayne White, 50 S.E.C. 211, 212-213 (1990); Charles E. Marland & Co., Inc., 45 S.E.C. 632, 635-636 (1974). [9]:We note that, in totaling the number of such transactions in each customer's account, the NASD's National Business Conduct Committee ("NBCC") made two minor errors. The NBCC stated that there were 4 violative transactions in the account of customer Norman Adcock and 14 in the account of customer John DenHoed. In fact, the text of the NBCC's decision shows that there were only 3 violative transactions in Adcock's account and 15 in DenHoed's. [10]:Mutual funds generally discount sales charges based upon the size of a customer's purchase. The levels at which the discounts become effective are called breakpoints. Breakpoints can be reached in a single purchase. However, they can also be obtained over a period of months pursuant to a letter of intent ("LOI") or under so-called rights of accumulation ("ROA"). The LOI is a statement given the fund by a customer stating his intention to purchase a certain amount of fund shares over a stated period. The ROA is a cumulative discount accorded by the fund when a customer's aggregate purchases of fund shares reach a certain level. [11]:See Winston H. Kinderdick, supra, 46 S.E.C. at 640. [12]:"In a wrap fee program, the client is typically provided with portfolio management, execution of transactions, asset allocation, and administrative services for a single fee based on assets under management." Investment Company Act Release No. 21260 (July 27, 1995), 59 SEC Docket 2807, 2808. See also Rule 204-3(g)(4) under the Investment Advisers Act. [13]:See n. 4, supra. [14]:See Winston H. Kinderdick, supra, 46 S.E.C. at 639. Krull claims that his customers held onto their Alger positions. However, it appears that several customers incurred sales charges when they sold their Alger shares. [15]:Procedural Rule 9311(e) (now Rule 9346(a)) as then in effect. [16]:See, e.g., Thomas P. Reynolds Securities, Ltd., 50 S.E.C. 721, 726-7 (1991). [17]:See note 15, supra. [18]:See, e.g., Hately v. SEC. 8 F.3d 653, 655 (9th Cir. 1993); SEC v. Commonwealth Chemical Securities, Inc., 574 F.2d 90, 102 (2d Cir. 1978); Michael David Sweeney, 50 S.E.C. 761, 768 (1991). [19]:William Jackson Blalock, Securities Exchange Act Release No. 37955 (November 15, 1996), 63 SEC Docket 682, 685, aff'd, No. 97-8296 (11th Cir. 1997) (Table); David Joseph Dambro, 51 S.E.C. 513, 518 (1993). [20]:Krull must make payments to these customers in the amounts indicated in the parties' stipulated computation. It seems appropriate that, for this purpose, the three accounts held by one customer and his wife should be treated as one. [21]:We have previously rejected the contention, raised here by Krull, that restitution is appropriate only in cases of fraud. See Franklin N. Wolf, Securities Exchange Act Release No. 36523 (November 29, 1995), 60 SEC Docket 2417, 2431 n.43. See also Michael David Sweeney, supra. Krull further contends that the NASD improperly required him to make restitution of Alger commissions that were never paid by his customers. However, as just noted, we are modifying the NASD's order by providing for restitution in accordance with the parties' stipulated computation. [22]:We have considered all of the parties' contentions. They are rejected or sustained to the extent that they are inconsistent or in accord with the views expressed herein. UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. 40768 / December 10, 1998 Admin. Proc. File No. 3-9394 ___________________________________________________ : In the Matter of the Application of : : KENNETH C. KRULL : 7302 77th Drive N.E. : Marysville, Washington 98270 : : For Review of Disciplinary Action Taken by the : : NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. : ___________________________________________________: ORDER MODIFYING DISCIPLINARY ACTION TAKEN BY REGISTERED SECURITIES ASSOCIATION On the basis of the Commission's opinion issued this day, it is ORDERED that, with the exception of the amount of restitution, the sanctions imposed and the costs assessed by the National Association of Securities Dealers, Inc. against Kenneth C. Krull be, and they hereby are, sustained; and it is further ORDERED that the amount of restitution ordered by the Association be, and it hereby is, reduced from $171,140.93 to $81,705. By the Commission. Jonathan G. Katz Secretary