Regulator slaps American Funds and upholds previous fine

The giant American Funds mutual fund firm in recent months managed to get two regulators to back off from allegations of questionable sales practices. But the company was tackled today by a third securities-industry cop.

An appeals panel of the Financial Industry Regulatory Authority, the self-policing agency of the securities business, upheld the group’s three-year-old case alleging that the sales arm of L.A.-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. (Read the summary of the decision here.)

The money was awarded through a now-banned industry practice known as directed brokerage. As American Funds bought and sold stocks for its portfolios, it had to decide which brokerages should get the commission-generating trades. Many of those trades, FINRA says, were sent to brokerages that had met pre-arranged sales targets for American Funds -- which amounted to a deal rife with potential conflicts of interest, the agency says.

The group’s appeals panel, known as the National Adjudicatory Council, added a dig at American Funds in the decision it handed down today. The council rejected the 2006 conclusion of a lower hearing panel, which decided that although American Funds’ sales arm broke industry rules governing sales arrangements with brokerages, the firm had been "negligent, not intentional or reckless." Wrong, the council says: In upholding a $5 million fine against the company, it judged the firm’s conduct to be "intentional."

The fine is a pittance for American Funds’ parent, Capital Group Cos. The private firm is the largest U.S. manager of stock and bond mutual funds, with $1.07 trillion in fund assets. Moreover, FINRA didn’t allege that American Funds’ investors were harmed by its practices.

This fight was always about reputation and image. The case marked the first time in Capital Group's 77-year history that it had been censured and financially penalized by a regulator. The firm's blemish-free record has long been a source of great pride to its executives.

Until today, American Funds looked like it was on a roll in terms of escaping censure: Since October, the Securities and Exchange Commission and California regulators have abandoned their own probes into the firm's sales practices and deals with brokerages.

Dozens of other fund companies in recent years were accused by regulators of having similar improper "revenue-sharing" practices with brokerages that sold their funds. Nearly all of the firms settled, often paying large fines, without admitting or denying wrongdoing.

Capital Group 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 group's national council.

The company’s next appeal, if it so chooses, would be to ask the SEC to review the FINRA council’s decision. A spokesman said the firm couldn’t yet say if it would appeal.

Posted April 30, 2008