American Funds in a fix: Fight or settle?
The American Funds mutual fund group has gone 77 years without a significant whack from financial regulators, a track record that is a true rarity in the investment business.
Now the firm’s parent, Los Angeles money-management giant Capital Group Cos., has to decide whether to wave the white flag in a three-year legal battle, ending the company’s blemish-free streak.
American Funds is well known on Wall Street for its conservative investment style, low fund management fees, strong long-term returns -- and for being unapologetically aggressive in protecting its franchise. It now has taken that hard-edged approach to extremes with one of its regulators, in a case that may finally be coming to a head.
The company has been accused of making improper payments to about 50 brokerages from 2001 through 2003 as an incentive to get them to pitch its funds to investors.
If a broker sold you shares in one of the company’s funds in that period -- say, the popular Growth Fund of America -- the broker’s firm might have gotten a little extra reward, beyond normal sales fees.
The case, brought by the Financial Industry Regulatory Authority, the securities industry’s self-policing agency, was announced in February 2005 as part of a crackdown on so-called shelf-space arrangements between fund companies and brokerages.
Regulators decided the arrangements were getting too cozy, raising the potential for a broker to favor certain funds over others solely because it was in his firm’s financial interest.
Dozens of other fund companies have faced similar allegations in recent years, and nearly all of them have done what financial firms normally do when their watchdogs allege wrongdoing: quickly settle by paying a fine, without admitting the charges.
But if the regulators thought Capital Group would roll over, they underestimated how far the generally secretive company -- which manages more than $1 trillion in assets -- would go to protect its clean-living image.
American Funds immediately appealed the case in 2005 to a FINRA hearings panel. That panel ruled against the company in August 2006, triggering another appeal.
This week, FINRA’s national hearings panel also ruled against the firm.
Enough, already? Maybe. Embarrassed though American Funds may be to cave in to the charges, they amount to violations of an arguably hazy rule governing fund firms’ relationships with brokerages.
Important for American Funds, FINRA doesn’t allege that any of the firm’s millions of investors were harmed by its sales practices. So in the annals of financial scandals, this one lacks victims.
The penalty if American Funds settles the case isn’t much of a grabber, either. The fine would be $5 million, a veritable dust speck for privately held Capital Group, which is believed to be enormously profitable.
The allegations in the case center on payments American Funds made via a now-banned industry practice known as directed brokerage.
How it worked: 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, FINRA said, were sent to brokerages that had met prearranged sales targets for the firm’s funds.
Regulators had for decades allowed fund companies to “consider” a brokerage’s fund sales when deciding where to send trades. But they didn’t allow quid-pro-quo deals.
FINRA, the successor to the National Assn. of Securities Dealers, argued from the get-go in the case that American Funds had quid-pro-quo arrangements. The company vehemently denied that. And around and around the two sides have gone for three years.
The arguments in this case have begun to sound like the semantics exercise in President Clinton’s defense of himself before the grand jury in the Monica Lewinsky scandal. For American Funds, the issue has been the precise meaning of “consider” . . . and “arranged” . . . and “conditioned upon.”
Many industry veterans give American Funds credit for standing up for itself. And they say the company had to be emboldened in recent months as the Securities and Exchange Commission and California Atty. Gen. Jerry Brown dropped separate probes into the firm’s sales practices.
“I have a tremendous amount of respect for them because they fought this as a matter of principle,” said Don Phillips, managing director of strategy at investment research firm Morningstar Inc.
Fund industry regulators, he said, could have raised objections years earlier about such marketing deals, instead of allowing the industry to, in effect, dig itself into a trap.
Still, there is a risk that American Funds could push back too hard, making matters worse for itself.
Mercer Bullard, a law professor at the University of Mississippi and an expert on mutual fund regulation, also lauds American Funds for going to the mat with regulators. But he said the company’s defense efforts were “overly legalistic and probably annoyed FINRA.”
There were signs of that in this week’s affirmation of FINRA’s case by its national hearings panel.
The first hearings panel, in 2006, decided that American Funds was merely “negligent” in breaking the rules on sales deals with brokerages. The national panel said it was worse than that, accusing the firm of “intentional” conduct.
What’s more, the national panel almost seemed to be looking for victims in the case. It said the company’s practices “potentially injured the customers” of its brokerage partners by giving the brokerages a reason to favor American Funds’ products over other firms’ funds, regardless of whether they were the right choice for the investors.
American Funds, which has contended all along that its sales practices did not harm its investors, declined to discuss the national panel’s ruling.
The company also said it hadn’t decided whether it would appeal its case to the SEC.
Do you fight on in what looks like a losing battle -- or move on, and hope your investors will allow you one infraction in nearly 80 years?
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