The American Funds mutual fund firm on Wednesday lost its battle to challenge a regulator's 3-year-old allegations of improper sales practices.
An appeals panel of the Financial Industry Regulatory Authority, the securities industry's self-policing agency, upheld the authority's case contending that the sales arm of Los Angeles-based American Funds broke industry rules in rewarding brokerages that sold its funds to investors.
The upshot: About 50 major brokerages got nearly $100 million in improper financial incentives, beyond normal sales fees, to hawk American Funds to clients from 2001 to 2003, according to FINRA .
The money was awarded through a now-banned industry practice known as directed brokerage. As American Funds bought and sold stocks in its portfolios, it had to decide which brokerages should get the commission-generating trades.
Many of those trades, said FINRA, were sent to brokerages that had met prearranged sales targets for American Funds -- which amounted to a deal rife with potential conflicts of interest, the agency said.
Such arrangements could give brokerages a reason to recommend funds based on the extra revenue such sales could generate, as opposed to what would be best for clients.
FINRA's appeals panel, known as the National Adjudicatory Council, added a dig at American Funds in its decision.
The council rejected the 2006 conclusion of a lower hearing panel, which decided that although American Funds' sales arm broke rules on arrangements with brokerages, the firm had been "negligent, not intentional or reckless."
Wrong, the council said: In upholding a $5-million fine against the company, it judged the firm's conduct to be intentional. The panel's report said, "The evidence demonstrates that [American Funds] deliberately formed directed-brokerage arrangements."
Yet the panel did not allege that American Funds' practices hurt its shareholders.
Dozens of other fund companies in recent years were accused by regulators of having similar improper "revenue-sharing" practices with brokerages. Nearly all the firms settled, often paying large fines, without admitting wrongdoing.
American Funds' parent, Capital Group Cos., has refused to settle, insisting it did nothing wrong. It rejected FINRA's initial allegations in February 2005 and demanded a hearing. When the first hearing panel ruled for the agency in August 2006, Capital Group appealed to the national council.
The case focused on whether American Funds merely "considered" a brokerage's fund sales in allocating stock trades -- which regulators allowed -- or whether the firm had quid-pro-quo agreements, which weren't permitted. American Funds said it had no such agreements but FINRA said it did.
Mercer Bullard, a securities-law professor at the University of Mississippi, said the regulations were never clear, creating a trap for the fund industry. He called the FINRA panel's interpretation of the rules in the American Funds case "arbitrary and capricious."
The $5-million fine is a pittance for Capital Group. The private firm is the largest U.S. manager of stock and bond mutual funds, with $1.07 trillion in fund assets.
But the company has long prized its blemish-free track record with regulators. The FINRA case marked the first time in Capital Group's 77-year history that it had been censured and financially penalized by a regulator.
Since October, the Securities and Exchange Commission and California regulators have abandoned their own probes into the firm's sales practices.
The company could ask the SEC to review the FINRA council's decision. A spokesman said the firm couldn't yet say whether it would appeal.