Industry observers are cheering the news that the hugely popular American Funds group stood up to regulators — and won.
California Attorney General Jerry Brown said last month that the state has dropped a long-running lawsuit against the nation's biggest mutual fund group over an alleged failure to adequately disclose revenue-sharing and directed-brokerage agreements, also known as "shelf space" payments.
"John Wayne always wins. That's exactly what [this case] is — it's the good guys winning," said Joseph Hardgrove, owner of Omega Securities Inc. in Fort Worth, Texas. He has nearly $500 million of client assets in American Funds products.
The agreement between the state and Capital Research and Management Co., adviser to the American Funds, and the funds' distributor, American Funds Distributors Inc., both of Los Angeles, ends a three-year standoff.
The state had sought a disgorgement of profits gained from shelf space fees, other fines and improved disclosures.
Although the fund company avoided a fine, it will pay $2.5 million to cover the costs of the investigation.
In October, the Securities and Exchange Commission quietly dropped a parallel investigation of the fund company.
"We were applauding [American Funds]" for fighting the charges, said a brokerage industry executive who asked not to be identified. "Usually, [firms] just roll over and let [regulators] hammer whatever body part they can grab."
In what amounts to a stunning about-face, California's agreement to drop the case actually came with praise for American Funds for improving disclosures, lowering costs and educating investors.
The agreement also noted that the SEC had dropped its case. The state brought the charges in March 2005 with the assistance of SEC enforcers.
In announcing the suit three years ago, then-California Attorney General Bill Lockyer called American Funds' shelf space payments "little more than kickbacks to buy preferential treatment."
Mr. Brown, California's former governor, replaced Mr. Lockyer as attorney general in January 2007.
VICTORY FOR ADVISERS
The decision is "a victory for funds and advisers," said Jay Baris, a partner at Kramer Levin Naftalis & Frankel LLP in New York. "It shows there is some justice when an aggressive prosecutor steps over the line."
Chuck Freadhoff, a spokesman for American Funds, declined to comment.
"Our concerns were resolved," said Gareth Lacy, press secretary for the California attorney general's office in Sacramento. American Funds has "disclosed the most egregious practices," he said.
SEC spokesman John Nester also declined to comment about the case, as did officials in the SEC's Los Angeles office who handled the case.
In 2004, California settled similar cases against Stamford, Conn.-based PA Distributors LLC, distributor of the Pimco Funds, for $9 million; and with Franklin Templeton Distributors Inc. of San Mateo, Calif., for $18 million, $14 million of which was returned to the Franklin fund portfolios.
Both settlements required greater disclosures.
Although the state and SEC have backed off from American Funds, fund companies and brokerage firms could still encounter similar suits, said Mercer Bullard, founder and president of Fund Democracy Inc. of Oxford, Miss., a mutual fund shareholder advocacy group.
Mr. Bullard, who is also an assistant professor of law at the University of Mississippi School of Law in Oxford, was a consultant for the state of California in the American Funds case.
"Nothing has changed. Any other state can bring similar charges," Mr. Bullard said.
"There's always a risk of a lawsuit," Mr. Baris said.
But the fact that the regulators dropped such a prominent case is a good sign for the industry, he said.
Mr. Bullard said that the SEC hasn't been clear about what is required in terms of disclosing shelf space fees.
"I can understand the
Capital Group's frustration," he said. "Why leave the industry hanging out to dry?"
"Commission staff expertise is readily available to registered firms and individuals to promote compliance," Mr. Nester said in a statement.
INADEQUATE DISCLOSURE?
Ironically, American Funds pays the lowest revenue-sharing fee in the industry, Mr. Bullard said.
According to the funds' prospectuses, the company pays its top 75 dealers, in the aggregate, less than 0.02% of assets in revenue sharing.
In 2004, the SEC banned the practice of directing brokerage in exchange for fund sales.
Regardless of the amounts, American Funds "did not make adequate disclosure of [revenue-sharing] payments," which are used to get brokers to recommend the funds, Mr. Bullard said.
The law doesn't require such disclosure, Mr. Baris countered, which was why the California case and others like it were so controversial in the industry.
The "de facto standard" for disclosure came from a 1999 SEC legal brief in which the commission argued that revenue-sharing payments didn't have to be disclosed in detail, he said.
What's more, SEC disclosure rules pre-empt state law, Mr. Baris added. Indeed, that was a legal argument that American Funds made.
Before the suit was dropped, California courts disagreed.
Last year, a court of appeals ruled that the state's case against American Funds could proceed.
Also last year, another California appeals court said a similar state suit against Edward D. Jones & Co. LP of St. Louis could proceed. That case, which is still pending, dates from 2004.
"We still maintain that we have a good case under California securities law to take action against companies that commit fraud or don't provide information to investors," Mr. Lacy said.
"Edward Jones contends that the issues in our case are similar to those involved in the lawsuit the state of California recently settled with American Funds," John Boul, an Edward Jones spokesman, said in a statement.
"We cannot predict whether the settlement of the American Funds suit will have any impact on ours," Mr. Boul said.
Separately, an NASD hearing panel in 2006 fined American Funds Distributors $5 million for violating NASD rules in directing trades to its largest 50 dealers.
NASD is now the Financial Industry Regulatory Authority Inc. of New York and Washington.
The fund group appealed that decision and is awaiting a decision from Finra's appellate body, the National Adjudicatory Council. NAC decisions themselves can be appealed to the SEC.
"I hope [American Funds] hangs in there," Mr. Hardgrove said.
E-mail Dan Jamieson at [email protected].
