L.A. Mutual Fund Firm Accused of Misconduct

Los Angeles-based American Funds, the nation’s biggest seller of mutual funds for the last three years, violated securities rules by steering stock trading business to brokerages that pushed its funds to their clients, regulators said Wednesday.

The NASD, the securities industry’s self-regulatory body, alleged that American Funds paid $100 million in commissions to about 50 brokerages from 2001 through 2003 for executing stock trades, both “to reward past sales and to encourage future sales” of funds.

American Funds broke rules designed to bar incentives for brokerages to pitch mutual funds to clients in order to reap lucrative fees from a fund company, the NASD said. Its complaint seeks to force American Funds to return “any and all ill-gotten gains.”

Capital Group Cos., the mutual fund firm’s parent company, denied any wrongdoing and said it would seek to block the action by the NASD, formerly known as the National Assn. of Securities Dealers.

“We have complied fully with both the spirit and the letter of the rule, and we intend to request a hearing before an NASD panel to defend ourselves against these allegations,” the company said in a statement.

The NASD’s complaint is the first formal action by regulators against American Funds, whose reputation for conservative management, solid investment returns and low fees has helped make it the No. 1 destination for mutual fund money since 2002. With $657 billion in stock and bond assets, American is the third-largest U.S. mutual fund manager, after Fidelity Investments and Vanguard Group.

The $8-trillion mutual fund industry has been under heavy scrutiny by the NASD, the Securities and Exchange Commission and state regulators since New York Atty. Gen. Eliot Spitzer in September 2003 alleged widespread wrongdoing involving often-secret trading deals between fund companies and favored big-money clients.

But the new NASD complaint is a gamble for regulators, some analysts said, because the alleged violations don’t involve blatantly illegal practices.

Rather, the charges center on what could come down to technical interpretations of rules governing long-standing practices and relationships in the fund and brokerage businesses.

Some critics say regulators increasingly are telling fund companies that past behavior was improper, even though for years regulators failed to raise objections to the conduct.

“We are living in a revisionist environment, and in my opinion that’s not the right way to deal with regulation,” said Geoff Bobroff, a fund industry consultant in East Greenwich, R.I., and a former SEC enforcement attorney.

“I hope American Funds has the gumption to fight it,” Bobroff said of the NASD case.

The NASD cited a 32-year-old rule prohibiting quid pro quo arrangements between brokerages and mutual fund companies that guarantee payments from fund assets to brokerages in return for sales efforts.

“You have a practice where the retailers are receiving something of value,” said Barry Goldsmith, the NASD’s enforcement chief. “There could be a conflict.”

The NASD complaint focuses on a practice known as directed brokerage that was banned by the SEC last year and abandoned by the fund industry. Under the practice, a fund company would send trades to a specific brokerage for execution -- thus generating a commission for the brokerage -- based at least in part on fund sales considerations.

Because trading commissions are paid from fund assets, shareholders bear the costs.

According to the NASD, an American Funds unit called American Funds Distributors Inc. had “sponsorship arrangements” with the top-selling retailers of its 29 mutual funds from 2001 through 2003, under which the firm calculated the amount of “target commissions” that it intended to direct to each of them at the start of each year.

American Funds typically told the brokerages how much commission business to expect, and specified the benefits it anticipated in return, such as inclusion on brokerages’ “preferred fund” lists and enhanced access to the firms’ sales forces, the NASD said.

The case may hinge on whether American Funds’ sponsorship arrangements with brokerages were quid pro quo deals, as the NASD alleges, or simply a nonbinding factor in determining where its portfolio trades would be sent, as the fund giant contends.

“Those were internal, informal targets,” Capital Group spokesman Chuck Freadhoff said. “We never made a formal commitment to do a certain amount of brokerage with anyone.”

In its complaint, the NASD cited its so-called anti-reciprocal rule, which states that no NASD member “shall, directly or indirectly, offer or promise to another member, brokerage commissions from any source as a condition to the sale or distribution of shares of an investment company.”

A mutual fund is technically an investment company and American Funds Distributors is a member of the NASD.

“The rule is a flat-out prohibition on these types of quid pro quo arrangements,” Goldsmith said.

American Funds has a starkly different interpretation. Freadhoff pointed to another section of the same rule, which says in part that “nothing herein shall be deemed to prohibit” members from “considering sales of shares of the investment company as a factor in the selection of broker/dealers to execute” stock trades.

The NASD complaint said American Funds had specific formulas for determining how much commission income should go to brokerages based on fund sales. The president of American Funds Distributors, Kevin Clifford, “directly handled” sales deals with the top five brokerages, the NASD said.

The firm also had a plan for rewarding smaller brokerages that might have been unable to properly execute trades for American Funds, NASD said: For 30 of the 50 brokerages covered by the payment arrangements, American would send stock trades to third-party brokerages and direct them to share 70% to 90% of the commission payments with the smaller firms, the complaint said.

Those firms received commission income even though they “provided no services in connection with the trade,” the NASD said.

The complaint said American Funds discontinued that practice as of July 1, 2002.

Some securities law experts said the NASD case raised the risk that all mutual fund companies could face similar charges because directed brokerage had been so widespread.

“This is clearly breaking new ground,” said Mercer Bullard, a securities law professor at the University of Mississippi. “What it’s saying is that the industry as a whole got it wrong as far as directed brokerage goes. This is an industrywide indictment.”

Over the last year, the SEC and some state regulators have pursued other cases involving allegedly improper sales agreements between brokerages and fund companies. Both the SEC and California Atty. Gen. Bill Lockyer have been investigating certain American Funds practices, but neither has brought charges against the firm.

In filing a case against American Funds, NASD is taking on a 74-year-old, privately held company that has long prided itself on maintaining a sterling reputation with regulators and with investors.

Last year, a book published about American Funds’ parent, Capital Group, asserted that “no investment organization in the world has ever done so well for so long, for so many clients.”

The preservation of that legacy is a cornerstone of Capital Group’s culture -- and also is a key reason that many fund industry analysts say they believe the company is serious when it says it will fight the NASD.

Although virtually all of the dozens of mutual fund firms that have been accused of improper practices over the last 17 months have settled their cases without admitting or denying wrongdoing, Capital Group executives have privately made clear that they consider such settlements tacit admissions of guilt.

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Bestselling funds

Los Angeles-based American Funds had the biggest net cash inflows to stock and bond mutual funds in 2003 and 2004 combined.

2003-04 net cash inflow (in billions)

American Funds: $148.20

Vanguard Group: $85.30

Barclays Global: $60.10

Fidelity Investments: $48.60

Pimco: $34.90

Dodge & Cox: $32.70

T. Rowe Price: $21.20

Franklin Templeton: $20.10

Dimensional Fund Adv.: $11.60

Calamos Asst. Mgmt.: $11.60

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Data exclude money market funds.

Source: Financial Research Corp.