American Funds Battle Heats Up

State Atty. Gen. Bill Lockyer on Thursday sued the Los Angeles-based mutual fund company that has been the nation’s most popular for the last three years, alleging that giant American Funds failed to properly tell its 20 million shareholders how it paid brokerages to pitch its products.

In a rare act of defiance for a fund company, the firm beat Lockyer to court, filing its own suit against him and contending that its financial disclosures have been accurate and that Lockyer was encroaching on the authority of federal regulators.

The legal war marks a new chapter in the series of scandals that have rocked the $8-trillion fund industry since 2003.

Until now, almost every fund company charged with abuses by federal and state authorities has agreed to settle the allegations, pay significant fines and change some practices.

American Funds, a $650-billion-asset fund firm that is the nation’s third-largest, has in effect thrown down the gauntlet, insisting that it broke no laws and that it wouldn’t settle with regulators simply to make them go away.

“This fund company has said, ‘Enough,’ ” said Jay Baris, an attorney at Kramer Levin Naftalis & Frankel in New York. In the fund industry, which has a long history of respectful relations with its regulators, such an aggressive response may be unprecedented, Baris and other attorneys said.

American Funds and other mutual fund firms have for years made special marketing-related payments to brokerages that sell their products. Lockyer’s suit, filed in Los Angeles County Superior Court, alleged that American Funds failed to fully disclose $426 million in such “shelf-space” payments over the last five years. As a result, investors couldn’t know that brokerages had incentives to sell American funds over others, the suit said.

“American Funds dressed up these arrangements with fancy names like ‘execution revenue,’ ‘target commissions’ or ‘broker partnership payments,’ ” Lockyer said. “But when you look beneath the cloak of legitimacy, the payments are little more than kickbacks to buy preferential treatment.”

The suit claimed that three of American Funds’ biggest brokerage partners -- Edward Jones, Morgan Stanley and Piper Jaffray Cos. -- sought to “induce” sales of American Funds by passing shelf-space payments through to individual brokers in the form of “heightened bonuses, cash payments and/or credits toward an award of travel to resort destinations.”

Lockyer also alleged that an American Funds executive, Kevin Clifford, in January 2004 sent a voicemail message to the company’s sales team exhorting it to stay “on message” about the brokerage payments, which the firm has long said were made to cover the costs of educating brokers about its funds.

“This will be the story that we use with regulators going forward,” Clifford’s message said, according to the suit.

Lockyer is asking for disgorgement of ill-gotten profit, and restitution.

In an interview, Lockyer said it was too early to determine how much the state would seek in total, but that it could be in the “tens of millions.”

American Funds is a unit of Los Angeles-based Capital Group Cos., a partner-owned firm. The suit said the company’s fund management businesses, including Capital Research & Management Co., earned profit exceeding $1.4 billion in the 2000-2003 fiscal years.

The attorney general said he decided to file the suit after talks between his staff and American Funds’ attorneys broke down.

“Their view was basically, ‘We won’t pay anything. We’ll talk about disclosure improvements,’ ” Lockyer said. “My lawyers are a bit upset.”

Paul Haaga, executive vice president of Capital Research, denied that the company had been discussing a deal to end Lockyer’s investigation.

“We weren’t engaged in any settlement talks,” Haaga said.

In its lawsuit against Lockyer on Thursday, also filed in Los Angeles County Superior Court, American Funds sought an injunction against Lockyer, and said its disclosures about shelf-space arrangements “have always fully satisfied existing disclosure requirements under federal securities laws.”

The firm also said that a 1996 federal law forbids states from regulating fund disclosure documents, such as prospectuses.

Securities lawyers said the law did generally preempt state regulation of fund documents, but permitted states some exceptions in bringing fraud cases.

The legal battle has high stakes for both sides. By balking at a settlement, American Funds risks far greater financial penalties and damage to its reputation if the courts side with the authorities, legal experts said.

For Lockyer, a defeat in the courts could undermine the new securities fraud-fighting powers he has claimed under a state law that took effect last year.

The battle also raises the ante in American Funds’ apparent standoff with the Securities and Exchange Commission. The SEC, working with Lockyer, has been investigating American Funds for the last year, but hasn’t filed a case against the company.

Lockyer’s suit targeting sales practices is part of the second wave of regulatory actions against the fund industry. The first wave, which began in 2003, exposed trading abuses that benefited favored clients.

The second wave focuses on allegations of wrongdoing that may be harder to prove, legal experts say.

American Funds already is fighting the NASD, the securities industry’s self-regulatory agency, which filed a complaint against the firm in February, alleging that it improperly steered commission-generating stock trades to brokerages as a reward for selling its funds.

The NASD said American Funds from 2001 through 2003 guaranteed a certain level of brokerage trades in return for fund sales. Such a quid pro quo was specifically prohibited, the regulator said.

American Funds denied that it had quid pro quo agreements with brokerages that sold its shares, and is demanding a hearing before an NASD panel to defend itself.

Although battling regulators is a risk for 75-year-old American Funds, industry analysts say the company is dealing from a position of strength in one sense: Its funds have a reputation for conservative management, low fees and solid long-term returns. They have been the industry’s bestselling portfolios since 2002.

What’s more, although both Lockyer and the NASD say investors could have been harmed by the company’s payment agreements with brokerages, neither regulator alleged specific instances of investor losses.

Haaga insisted there were no such instances. “We don’t think there was any harm done to our investors because of these payments,” he said.