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State Sues Firm Over Mutual Fund Sales

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Times Staff Writer

Opening a new front in the state’s attack on investment industry practices, California Atty. Gen. Bill Lockyer sued brokerage firm Edward Jones & Co. on Monday, claiming it had defrauded investors by failing to properly disclose sales arrangements with a handful of favored mutual fund companies.

The case is the first that Lockyer has brought against a brokerage under a state securities fraud law that took effect Jan. 1. And it marks a split between California and federal regulators, who also are investigating alleged securities industry and mutual fund improprieties.

For the record:

12:00 a.m. Dec. 22, 2004 For The Record
Los Angeles Times Wednesday December 22, 2004 Home Edition Main News Part A Page 2 National Desk 2 inches; 74 words Type of Material: Correction
Brokerage lawsuit -- In an article in Tuesday’s Section A about federal and state investigations of brokerage Edward Jones & Co.’s mutual fund sales practices, Jones was said to have reached an agreement with the U.S. attorney’s office in eastern Missouri “without admitting or denying guilt.” That language appears only in the firm’s proposed agreements with the Securities and Exchange Commission, the New York Stock Exchange and the NASD, the brokerage industry’s self-regulatory organization.

Even as Lockyer was announcing his civil suit against St. Louis-based Jones, the company said it had settled an investigation by the Justice Department and had offered a $75-million settlement to the Securities and Exchange Commission.

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Lockyer, at a news conference in Los Angeles, called the proposed SEC settlement inadequate. Adopting a strategy used by New York Atty. Gen. Eliot Spitzer in fraud cases he has brought against a slew of financial companies in recent years, Lockyer disclosed private e-mails from Jones brokers in which some called the firm’s fund sales agreements “dirty.”

Jones is the nation’s largest brokerage in terms of individual offices, with more than 9,000 in all. Most of its brokers operate from one-person offices in small towns and suburban locations.

The company said in a statement that it “plans to vigorously defend itself in the charges brought by the California attorney general.”

The mutual fund industry has been racked for 15 months by allegations of widespread wrongdoing involving often-secret deals between fund companies and favored big-money clients.

The California case trains the spotlight on the brokerage industry and its role in selling funds to investors.

The suit focuses on the long-standing brokerage practice of selling so-called shelf space to fund companies: Over the last decade, many brokerages have offered to place certain funds on “recommended” or “preferred” lists in return for cash payments or other compensation beyond standard sales commissions.

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Jones has preferred-sales agreements with seven mutual fund companies. The arrangements meant that Jones brokers were prodded to sell funds of the preferred firms even if those funds weren’t necessarily the best choices for individual customers, Lockyer said.

The seven fund companies are Los Angeles-based American Funds, Federated Investors Inc., Goldman Sachs & Co., Hartford Financial Services Group Inc., Lord Abbett Mutual Funds, Putnam Funds and Van Kampen Investments.

Since 2000, the funds on Jones’ preferred list have accounted for 98% of its fund sales and brought the firm $300 million in payments, Lockyer said.

The agreements were fraudulent because Jones failed to adequately disclose them to investors as required under the state’s enhanced securities law, he said.

“They deceived hundreds of thousands of Californians while selling billions of dollars’ worth of mutual funds,” he said.

The American Funds were Jones’ most popular fund products. Half of Jones’ fund sales nationwide since January 2000 were of American Funds, Lockyer said.

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American Funds spokesman Chuck Freadhoff declined to comment Monday on the Jones case. The other six fund companies either declined to comment or did not return phone calls.

None of the seven fund firms has been charged with wrongdoing in the Jones case.

The brokerage industry has long contended that preferred-fund lists are a way for the firms to narrow down fund choices from among the thousands available. The industry term for the agreements is “revenue sharing.”

But critics say the arrangements can create serious conflicts of interest for brokers: They know they will earn extra compensation for their firm, and in many cases, for themselves, if they sell funds on the preferred list.

Lockyer’s suit included a number of e-mails sent in recent years from Jones brokers to a company suggestion box.

“Remembering how secretive St. Louis has been about how this works for us,” one e-mail complained, “I’ve come to believe that ‘kickback’ describes this deal better than the term ‘revenue sharing.’ There is something dirty about the mutual fund business that has been developing over the last five years.”

After the Wall Street Journal in January published an article about Jones’ arrangements, one of the firm’s brokers e-mailed the suggestion box to say he or she was “a bit disgusted now to work for a firm who portrays the image of being proper and moral in its practices, and now to find out that we play a little dirty to get more revenue.”

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One of Jones’ marketing points to investors for years has been that the firm did not have financial products of its own, such as house-label mutual funds, and so did not have the conflicts of interest that bigger Wall Street firms had.

“ ‘Who pays us the most ... who helps us the most’ seems to be all I ever hear about funds ...,” one Jones broker e-mailed the firm. “What about, ‘Who makes our clients the best returns with the least risk?’ Maybe it’s time the SEC shook up the fund business. When everyone except the client wins, there’s something wrong.”

The SEC brought a shelf-space case against a brokerage firm 13 months ago, when it alleged that Morgan Stanley had failed to properly disclose agreements it had with 14 fund companies. Morgan settled that case by paying $50 million.

Since then, the SEC has largely focused on bringing fraud cases against mutual fund companies for trading abuses.

Under the enhanced state securities law, Lockyer in January announced that he would focus his investigation of the fund industry on sales agreements with brokerages. Working with the SEC, he in recent months settled two cases -- one with PA Distributors, which markets the Pimco funds, and the other with Franklin Resources Inc., which manages the Franklin and Templeton funds.

Lockyer and the SEC also have been jointly investigating American Funds’ practices.

By refusing to join the SEC’s proposed settlement with Jones, Lockyer is striking an independent pose similar to what New York’s Spitzer often has adopted. Spitzer, who uncovered the first fund-industry trading abuses in September 2003, has at times criticized the SEC as being too soft on the industry.

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Jones said its offer to the SEC, the New York Stock Exchange and to the brokerage industry’s self-regulatory organization, the NASD, was to create a $75-million investor restitution fund and to “revise, enhance or create customer communications concerning revenue-sharing agreements.” The offer has been accepted by SEC staff but is subject to approval by the agency’s commissioners, Jones said.

The SEC did not return a call for comment.

Without admitting or denying guilt, Jones also struck a deal with the U.S. attorney’s office in eastern Missouri to avoid possible criminal and civil charges in exchange for its promised reforms, which include offering customers free trades if they wish to sell any of their fund holdings.

Referring to Jones’ settlement offer, Lockyer said, “It seemed to us that $75 million for a national settlement is inadequate when you’ve got $300 million in illegal commissions plus all the harm to investors.”

Lockyer’s suit, filed in Sacramento County Superior Court, seeks return of all profit that Jones gained as a result of allegedly violating the state’s securities law, plus restitution and damages for investors who bought funds from Jones.

The complaint also seeks civil penalties of as much as $25,000 for each violation of the law, which would go to state coffers. Lockyer did not say how much he was seeking altogether but hinted that a huge sum could be at stake, saying a violation occurs not only “every time a sale is consummated” but also “every time an offer is made” to sell a fund.

As of October, Jones had about 294,000 California clients, Lockyer said. Its preferred-fund sales in California since 2000 total $5.8 billion.

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The tough talk may give Lockyer a strong negotiating stance, analysts said, but the case would be far from a cinch if Jones went to court, they said.

“Lockyer has clearly become a hard-nose,” said Geoff Bobroff, a fund industry consultant in East Greenwich, R.I. “Proving fraud in a court of law will be another challenge.”

For one thing, he said, sales agreements between brokerages and fund companies have become so widespread that many lawyers say the deals had the tacit approval of the SEC.

“Brokers could argue there has been a change in the rules in the middle of the game,” said Roy Weitz, editor of Tarzana-based FundAlarm.com, an industry watchdog website.

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