SEC, Fund Firm May Face Off
No mutual fund company has been more successful than the Los Angeles-based American Funds group over the last three years, at least as measured by the money investors have poured into its portfolios.
But the Securities and Exchange Commission may be set to write the next chapter in the story of American Funds and its parent, Capital Group Cos. The agency is considering charges that essentially would accuse the firm of misusing shareholders’ money by overpaying for certain stock trades within some of its funds to satisfy brokerage marketing arrangements.
The focus of the SEC’s investigation of American Funds has been known for the last eight months or so, after the agency formally told the firm that it may be charged with wrongdoing.
It isn’t known how close the SEC may be to filing any charges. Some securities lawyers have postulated that the agency’s enforcement unit has held back to give new SEC Chairman Christopher Cox time to ease into the job before facing a case that could divide the five-member commission.
It’s also possible the case could be dropped.
Randall Lee, head of the SEC’s Los Angeles office, declined to comment on the status of the investigation.
The stakes are high for all concerned. For American Funds, now the second-largest U.S. stock and bond fund manager, with more than $730 billion in assets, an SEC lawsuit could be one of the most severe image blows the firm has suffered in its 75-year history, which has been remarkably free of controversy.
Although the company already is battling two regulators -- the NASD (formerly the National Assn. of Securities Dealers) and California Atty. Gen. Bill Lockyer -- on allegations related to the SEC case, neither the NASD nor the state alleged a specific dollar amount of damage to shareholders. The SEC is expected to name a number.
For the SEC, the risk of bringing the case is that it could be hard to prove the allegations in court, should American Funds fight them. Unlike the “market timing” fund industry abuses that were revealed two years ago -- cases in which many fund companies were caught red-handed ripping off shareholders -- the American Funds probe involves an arguably gray area of securities law: determining whether a stock trading commission was fair or not.
Millions of individual investors in American Funds portfolios could face their own gray zone in this case. No doubt weary of fund industry scandals, they would have to decide whether any SEC charges were serious enough to merit taking their money elsewhere. That could be expensive if a sale means a hefty capital-gains tax bill.
The SEC’s investigation has centered on the issue of “best execution” in stock trading. Mutual funds are required by law to get the best possible deal when buying or selling stocks for their portfolios. That makes sense because trading costs are deducted from fund assets, which means shareholders bear the expense.
But the SEC has been quite clear over the years that best execution doesn’t necessarily entail getting the lowest commission rate. There are many factors that a fund’s managers must consider in deciding what constitutes best execution.
Jonathan Macey, a securities law professor at Yale Law School, once framed the issue this way in a report on best execution: “Unlike pornography, which while difficult to define is known when seen, best execution is easily defined but is often unrecognizable.”
For example, one broker might have the lowest commission, but another with a higher rate might be a savvier trader, able to secure a better share price in buying or selling for a fund client. So paying 4 cents a share to the savvier trader might make far more sense than paying 2 cents to a rival.
For its part, American Funds says it has always satisfied the best-execution rule. “We have always sought and achieved best execution,” said spokesman Chuck Freadhoff.
The SEC, however, apparently suspects otherwise, at least regarding trades American Funds executed via a practice known as directed brokerage.
Directed brokerage was common in the fund industry over the last decade until the SEC banned it in 2004. Under the practice, a fund company would send commission-generating portfolio trades to certain brokerages in part based on how actively the brokerages pitched the company’s funds to investors.
The fund and brokerage industries called this “revenue sharing.” Critics of both industries say the payments were barely disguised bribes or kickbacks for fund sales. Nonetheless, the SEC was OK with it -- as long as a fund company could show it was getting best execution wherever it sent a trade.
In the case of American Funds, the SEC has focused on so-called step-out arrangements the company used in some directed brokerage trades.
In step-out deals, also banned by the SEC since last year, a fund company sent a stock trade to a single brokerage, while instructing that firm to share the commission with another brokerage.
Fund companies justified step-out deals under the best-execution rule, and the SEC appeared to agree, based on this passage from a 1998 agency report on industry practices:
“By telling a broker executing a trade to step-out a portion of the commission to another broker, an advisor can use the broker that provides best execution to execute the trade, and can pay commissions on the trade to other brokers from which it receives research or other services, even if those brokers have inferior execution capability,” the report said.
But that may not provide much of a shield for American Funds, or any other company, to hide behind, securities lawyers caution. The specific facts involved in American Funds’ step-out arrangements, and the firm’s idea of best execution, could be vastly different from how other funds operated -- and from what the SEC considered legitimate.
Disclosure also could be an issue. Did American Funds directors know enough about the practices to police them?
“It’s going to depend on a very detailed look at the facts and the record,” said Barry Barbash, who was head of the SEC’s mutual-fund oversight division from 1993 to 1998 and now is a private attorney in Washington.
Nonetheless, he said, if forced into court, the SEC could have its hands full. “Trying to prove a best-execution case is a difficult endeavor,” Barbash said.
Before SEC staff could file the case, they would need the approval of the agency’s commissioners, led by Cox, who is a former Republican congressman from Orange County. A key question is whether the Republican majority on the commission would consider this a solid case, or an example of what some SEC critics label “regulation by enforcement” -- rewriting industry rules by suing a particular party instead of simply ordering changes for all players.
What’s more, in this case the rules already have been rewritten, because there is no more directed brokerage.
It would be easy for the SEC if American Funds were to agree to settle the case. But the company has shown no sign of being willing to take that route.
For now, that sits well with many financial advisors who have been longtime investors in American Funds portfolios.
“They are fighting for what they believe is right,” said Richard Ferree, a Santa Ana financial planner.
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Tom Petruno can be reached at tom.petruno@latimes.com.
