SEC Eyes Fund Firm’s Trade Costs

Times Staff Writer

The Securities and Exchange Commission has narrowed its probe of Los Angeles-based American Funds to the question of whether the firm overpaid brokerages for trades as a reward for mutual fund sales, according to people familiar with the inquiry.

The fund giant already is fighting two other regulatory agencies over charges of improper practices. The SEC’s case, however, potentially poses a bigger threat to the company because it could include allegations that American Funds’ trading deals penalized its 20 million shareholders.

By contrast, recent cases against American Funds by state Atty. Gen. Bill Lockyer and by the NASD, the securities industry’s self-regulatory agency, did not allege specific instances of investor losses, but focused on technical issues in the company’s practices.


The SEC, by concentrating on the so-called best execution trading rule, could shake the entire fund industry by raising questions about long-standing sales arrangements between many fund companies and brokerages, industry analysts said Wednesday.

American Funds, which has about $650 billion in assets and has been the best-selling fund group for the last three years, has become a key target of regulators as they focus on “revenue sharing” deals that became common between fund companies and brokerages over the last decade.

The company, a unit of Capital Group Cos., has vigorously defended itself against the state and NASD cases over alleged revenue-sharing abuses.

Under the sales arrangements, also known as shelf-space agreements, fund companies have made special marketing-related payments to the brokerages that sell their funds.

One way such payments were made was via “directed brokerage”: A fund company would send commission-generating portfolio trades to certain brokerages in part based on how actively the brokerages sold the company’s funds.

The SEC allowed the practice, but with one overriding caveat: A fund company was always required, on shareholders’ behalf, to get the best possible execution of each trade.

The SEC is examining whether American Funds, in funneling some commission income to brokerages that were major sellers of its funds, failed the best-execution test in some of its trading, according to people with knowledge of the probe who spoke on condition of anonymity.

For example, if American Funds paid a certain brokerage 4 cents a share for a stock trade, and the SEC were to judge that the trade could have been done properly for 2 cents a share, the agency might allege that American Funds overpaid by 2 cents a share solely to reward the brokerage for fund sales.

American Funds sells its funds exclusively through brokers. The company has said that all of its marketing-related payments have been made within SEC guidelines.

The SEC banned the practice of directed brokerage last year, but it has continued to investigate how fund firms conducted such trading in previous years.

Linda Thomsen, deputy enforcement director at the SEC in Washington, declined to comment on the agency’s investigation of American Funds.

Chuck Freadhoff, a spokesman for American Funds, also declined to comment except to say that “we continue to cooperate with the SEC.”

Because trading commissions are paid out of fund assets, they are borne by shareholders. So if a fund firm overpays for trades, it directly reduces shareholders’ returns on the funds.

But a lawsuit alleging failure to get best execution could be difficult for the SEC to prosecute, some experts say, because there is no single, simple definition of best execution in stock trading.

“The swamp is in trying to prove that someone didn’t get best execution,” said Wayne Wagner, chairman of Plexus Group, a trading-cost research firm in Los Angeles.

The SEC, in guidance issued to fund companies and brokerages over the years, has said that best execution doesn’t necessarily mean that a trade is performed at the lowest possible commission rate. Other factors also must be taken into account, including the speed with which a brokerage can buy or sell the shares for a fund company, regulators have said.

In the case of American Funds, the SEC has been focusing specifically on so-called step-out arrangements the company employed in some directed brokerage trades, sources say.

In step-out deals, also banned by the SEC since last year, a mutual fund company sent a stock trade to a single brokerage, while instructing that firm to share the commission with another brokerage as well.

Fund companies have justified step-out deals under the best execution rule: They were sending the trade to the brokerage best able to perform the transaction, but they also were acknowledging services provided by another brokerage by sending some of the commission to that firm.

If a brokerage executing a trade is sharing the commission, however, the actual cost of handling the trade must be lower than the total commission, some securities lawyers say. That could be a violation of the best-execution rule, they said.

“It seems to me that in a step-out, you’re always paying more to execute than you arguably had to,” said Kathryn McGrath, a partner at Crowell & Moring law firm in Washington.

Some industry analysts expect that American Funds could defend step-out arrangements by contending that, to get a particular trade done properly, it would have had to pay, say, 4 cents a share regardless of which firm executed the trade. If that was the price, and some of that money went to another brokerage under a step-out deal, then shareholders still got best execution, the firm could argue.