Court Backs American Funds in Suit

A state court judge Tuesday dealt a blow to Atty. Gen. Bill Lockyer’s efforts to regulate what mutual fund companies tell their shareholders.

Los Angeles Superior Court Judge Carl J. West tentatively ruled that the state did not have jurisdiction to sue industry giant American Funds over its disclosure practices involving marketing deals with the brokerages that sell its funds.

The case against American Funds, the second-largest U.S. fund firm with stock and bond fund assets of $738 billion, has been closely watched because a win for Lockyer could mean new regulatory standards for an industry historically governed by federal rules.

Lockyer’s suit, filed in March, claimed that the company broke state law by failing in its sales prospectuses and other documents to properly tell its 20 million shareholders about certain payments made to brokerages.

The payments, a widespread practice in the industry over the last decade, represented a potential conflict of interest because they raised the risk that brokers would push the funds that paid their firms the most, rather than those most appropriate for clients, Lockyer said.

American Funds, a unit of Los Angeles-based Capital Group Cos., had sought to get the case tossed out, arguing that a 1996 federal law bars states from creating securities-offering disclosure rules that differ from those of the federal Securities and Exchange Commission.

West agreed with that view Tuesday, writing that the state case “seeks to impose disclosure requirements beyond those deemed necessary by the SEC.”

What’s more, he suggested that if the state had a legitimate case to bring regarding insufficient disclosure to investors, it would be against the brokerages that had “direct contact” with fund buyers rather than against American Funds.

The company relies solely on brokers to sell its funds, which have been the nation’s most popular since 2002.

The attorney general’s office immediately vowed to appeal if, as expected, the judge’s ruling becomes final in coming weeks.

American Funds is one of few mutual fund firms that have fought back rather than settle as federal and state regulators have brought a wave of cases in the last two years alleging improper trading and sales practices in the $8-trillion industry.

Lockyer’s suit claimed that the company failed to fully disclose $426 million in brokerage “shelf-space” payments it had made in the last five years. As a result, investors couldn’t know that brokerages had special incentives to sell American funds over rivals, the suit claimed.

American Funds has contended that the payments were permitted under SEC rules to cover costs of educating brokers about the company’s products. The firm also has said it adequately disclosed the payments in fund documents.

Lockyer sued the company under a 2004 state law that gave him greater power to pursue alleged securities fraud.

Last year he used that clout to wrest multimillion-dollar settlements from Franklin Resources Inc. and the marketing arm of Pacific Investment Management Co. over similar fund payments to brokerages.

On Tuesday, West said allowing the state’s action would not only “frustrate the purpose and intent” of federal law but also force fund firms into “the untenable position of having to seek review of their offering statements by regulators in all states in which their shares are sold.”

The state’s legal team expressed confidence that it would prevail in the 2nd District Court of Appeal.

“The legislative history is replete with Congress’ clear intent that states be allowed to enforce their securities fraud laws,” said Tom Dresslar, spokesman for the attorney general’s office.

American Funds spokesman Chuck Freadhoff said the firm was “gratified at the judge’s tentative ruling,” but he declined to comment further.

Paul Herbert, an analyst at investment research firm Morningstar Inc. in Chicago, called the ruling “very favorable” for American Funds.

But the company faces other legal challenges.

NASD, the brokerage industry’s self-regulatory body, brought an enforcement action in February against an American Funds unit over another conflict-of-interest issue. In that pending case, NASD claims the firm improperly steered commission-generating stock trades to brokerages as a reward for selling its funds from 2001 to 2003.

American Funds has denied wrongdoing.

Separately, the SEC has been probing whether the company overpaid brokerages for some trades as a reward for fund sales.