In a blow to its reputation, Los Angeles-based American Funds on Wednesday was slapped with a $5-million fine for paying improper incentives to brokerages that pushed the company’s mutual funds to their clients.
Along with the fine, an NASD hearing panel rebuked American Funds for what it called the “disingenuous” testimony of employees who asserted that documents describing the sales arrangements with brokerages didn’t mean what they said.
The ruling is a stinging defeat for American Funds and its parent, privately held Capital Group Cos., which is one of the world’s largest money managers. The case marks the first time in the fund giant’s 75-year history that it has been censured and financially penalized by a regulator.
An American Funds spokesman said the company “strongly disagreed” with the panel’s decision and would appeal it.
As authorities have cracked down since 2003 on mutual fund and brokerage practices viewed as potentially harmful to individual investors, every other fund firm and brokerage accused of misconduct has settled the allegations by paying a fine and neither admitting nor denying wrongdoing.
Capital Group chose to fight. Its executives have said that a settlement would, in the firm’s eyes, be an admission of guilt.
The NASD, the brokerage industry’s chief regulatory group formerly known as the National Assn. of Securities Dealers, filed a complaint against American Funds last year, alleging that the company had improper sales agreements with about 50 brokerages from 2001 through 2003.
By meeting certain fund sales targets, the brokerages knew they would share a pool of money that totaled about $100 million in that three-year period, the NASD said.
The money was awarded through a practice known as directed brokerage. As American Funds bought and sold stocks for its fund portfolios, it had to decide which brokerages should get the commission-generating trades. Many of those trades were sent to brokerages that had met sales targets for American Funds, the NASD said.
The agency has long had a rule prohibiting a direct tie between fund sales and the award of stock trades, to guard against the risk that a brokerage would tout funds based on its own financial gain rather than on clients’ needs.
American Funds, which has attracted more new money than any other fund company for the last four years, insisted that sales by brokerages were merely a “consideration” in its directed-brokerage decisions, and that there were no quid pro quos. It demanded an appeal of the NASD complaint, which sent the case to a hearing panel.
The three-member panel, after reviewing American Funds documents and listening to testimony from some of its employees, upheld the agency’s case. The firm’s deals with brokerages were “clearly contrary to the language and purpose” of the NASD rule banning direct tie-ins, the panel wrote.
Moreover, a footnote in the decision questioned the honesty of the American Funds employees who testified before the panel, including the executive who oversaw the firm’s fund sales unit.
Most of the material facts in the case were “undisputed or clearly established” by documents introduced as evidence, the panel wrote. Yet American Funds employees “repeatedly testified that damaging documents they had written, edited or reviewed ... did not really mean what the documents plainly said, did not say what the authors meant to convey or were simply incorrect,” the panel wrote.
The testimony was “disingenuous, to say the least,” according to the footnote.
In the company’s favor, however, the panel noted that American Funds ceased directed brokerage before the Securities and Exchange Commission banned it in 2004, and that the firm discontinued a related practice in 2002, even though competitors did not.
The $5-million fine was a fraction of the $98-million penalty sought by the NASD’s enforcement division. In setting the fine, the panel said it found American Funds’ violations to be “negligent, not intentional or reckless,” and that the firm’s practices were “consistent” with what the rest of the fund industry had been doing for years.
The fine will be paid to the NASD, not to investors. The NASD had not alleged that American Funds’ investors were harmed by its practices.
The fine was smaller than what some other firms have paid in directed-brokerage settlements. Brokerage Morgan Stanley paid $50 million in 2003. Ameriprise Financial Services last year paid $12.3 million.
If American Funds follows through on its pledge to appeal, the case will be heard by a 14-member NASD panel.
American Funds, which has $860 billion in fund assets, also is fighting California Atty. Gen. Bill Lockyer, who has sued the company on fraud charges related to its sales pacts with brokerages.
Petruno reported from Los Angeles and Hamilton reported from New York.