State Investigates Fund Firms

California regulators jumped into the mutual fund trading scandal Friday as Atty. Gen. Bill Lockyer announced an investigation into whether three large fund companies based in the state failed to tell investors that they had paid brokerage firms to recommend their funds.

The companies under scrutiny are Pimco Funds, the Newport Beach-based bond giant; Capital Research & Management Co. of Los Angeles, which runs the American Fund group; and Franklin Templeton Investments of San Mateo, according to people familiar with the matter. The companies were served Friday with subpoenas seeking trading records, the sources said.

The civil probe focuses on what is known as paying for shelf space, in which fund companies pay brokerage firms to push their funds to individual investors. This is done either through outright cash payments, known as hard money payments, or by steering lucrative stock and bond trading business to the firms, which is known as directed brokerage.

Though such payments have received less attention than the market-timing and late-trading abuses at the core of the 4-month-old fund industry scandal, experts say they could be far more harmful and costly to small investors.

The central issue, Lockyer said, is whether the fund companies should have disclosed the existence of the payments to investors because doing so could have affected their decisions about which funds to buy.

At worst, the covert payments could give brokers a financial incentive to recommend inferior funds, critics say.

And investors suffer further once they buy the funds, according to experts, because the fund companies willingly pay extra large trading commissions to compensate the brokerages.

“It’s not illegal, but it does sound immoral,” said Wayne Wagner, chief executive of Plexus Group, a Los Angeles consulting firm that analyzes stock-trading costs. “The broker should be saying, ‘What’s in the best interests of my client,’ not ‘Who’s paying me the most.’ ”

The issue gained notoriety in November when brokerage giant Morgan Stanley agreed to pay $50 million to settle allegations by federal regulators that it received improper payments from 14 fund companies for promoting their funds.

The Securities and Exchange Commission and the National Assn. of Securities Dealers also are studying directed brokerage and are looking into sales practices by Pimco, American and several other fund firms.

Representatives of American Funds and Franklin Templeton confirmed Friday that those firms had received subpoenas and were cooperating with Lockyer’s office. Calls to Pimco seeking comment were not returned.

American Funds spokesman Chuck Freadhoff said the firm had followed “all existing rules and regulations” in its relationships with brokers, and had done nothing improper.

“Gaining access to a broker-dealer in order to explain our product is in everybody’s interest,” Freadhoff said. At Franklin Templeton, spokeswoman Stacey Johnson said, “A subpoena is a request for information and does not imply any wrongdoing.”

In a statement on its website, Franklin said it believed its directed brokerage deals “were consistent with existing regulatory guidelines,” but added that the firm had decided, as of Nov. 28, “not to direct any further brokerage ... based on sale of fund shares or to satisfy preferred list or other shelf space arrangements.”

Lockyer’s announcement came a day after a state law he sponsored took effect that significantly expanded his authority to pursue securities fraud. The examination of the three companies is the first step toward stepped-up scrutiny of the financial-services industry, including investment banks and hedge funds, Lockyer said.

The team that led the investigation of energy trading companies after California’s energy crisis will handle the “corporate responsibility” effort, he said.

“I suspect this will be the beginning of a much broader inquiry into illegal financial practices,” he said.

The issue of securities regulation in California grew thorny last year when Lockyer clashed with Demetrios A. Boutris, then head of the state Department of Corporations, which had main responsibility for such issues.

Lockyer criticized Boutris for not referring any criminal cases to his office. The new law gives Lockyer equal power to investigate such violations.

Historically, securities matters have been the bailiwick of the SEC, with states often receding into the background. But New York’s aggressive attorney general, Eliot Spitzer, who was the driving force behind last year’s stock analyst scandal as well as the mutual fund furor, has demonstrated the power -- and political capital -- that state officials can wield in high-profile securities investigations.

New York’s Martin Act gives Spitzer far-ranging authority to pursue securities violators. The fund scandal began in September, when a probe by his office turned up rampant wrongdoing in the industry.

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Times staff writer Josh Friedman contributed to this report.