NASD Charges American Funds with Directed Brokerage Violation

Saying it’s just as impermissible to make directed-brokerage payments as it is to receive them, the NASD charged American Funds—one of the country’s most reputable asset managers—with paying kickbacks to brokerages for selling its funds. The NASD says the popular fund firm violated securities rules by directing $100 million in commissions to the top 50 retailers of its 29 different funds. American Funds denies the charges.

Saying it’s just as impermissible to make directed brokerage payments as it is to receive them, the NASD charged American Funds—one of the country’s most reputable asset managers—with paying kickbacks to brokerages for selling its funds. The NASD says the popular fund firm violated securities rules by directing $100 million in commissions to the top 50 retailers of its 29 different funds. American Funds denies the charges.

Specifically, the NASD says American Funds Distributors, distribution arm of American Funds’ parent company, Capital Group Companies, violated the “Anti-Reciprocal Rule” of 1973. That rule seeks to prevent quid pro quo arrangements between brokerage firms and fund managers in which commissions are used to compensate brokers for selling the fund’s shares—otherwise known as directed brokerage.

Until the SEC banned the practice outright in 2003, directed brokerage was legal as long as all parties complied with certain provisions. Among other things, NASD Conduct Rule 2830 (k) requires that:

  • the policy must be described in the fund’s prospectus;
  • no broker may favor or disfavor the sale of fund shares based on the commissions it receives;
  • no broker may demand commissions as a condition for selling shares of a fund; and,
  • the broker must provide best execution.
  • The complaint alleges that between 2001 and 2003, American Funds calculated “target commissions” for the top-selling retailers of its funds, and that sum was based on the brokerage’s previous year’s sales. American Funds communicated this number to the firms and made clear what benefits American Funds expected to receive in return for the commissions, such as inclusion of the funds on brokerages’ “preferred” or “recommended” list and enhanced access to the firm’s sales force.

    “The rule is pretty cut and dried,” says Jeff Keil, a mutual fund analyst at Lipper. “If brokerage is directed in direct correlation to sales results, well, that’s a violation,” he says. But according to Keil and several other observers, many firms practice a squishy version of directed brokerage, and proving that there was a genuine contract or arrangement between the firms may be tricky.

    In its own release, American Funds says it “strongly disagrees” with the entire NASD complaint and that it will seek to defend itself in front of an NASD panel. It says that it has “complied fully with both the spirit and the letter of the rule.” And in response to the “target commissions” charge, the firm says, “there are no facts that support this allegation.” American Funds also stressed that the NASD had not charged it with failing to provide best execution or with passing additional costs on to shareholders.

    The NASD’s complaint does not break down which retailers got how much of the alleged $100 million in commissions, but does say the firm paid $29 million to smaller firms that lacked the ability to execute transactions. Approximately 30 of the 50 retailers were involved through these “step out” arrangements, whereby the firms received the brokerage commissions through a clearing firm. According to the investigation, the clearing firms executing the trades gave the retail firm—which had no hand in the transaction—70 percent to 90 percent of the commission, depending on the particular agreement. The commissions ranged from $5.4 million for one retailer to $112,855 for another.

    What’s different with this case is that an asset manager, not a brokerage firm, has been charged. Most recent examples of those violating the rule, according to NASD enforcement attorneys, have been Morgan Stanley, fined $50 million in November 2003, and Edward Jones, fined $75 million last December.

    “Prior cases have focused on retail firms that receive directed brokerage payments from mutual fund companies in exchange for giving preferential treatment to their funds,” said NASD Vice Chairman Mary Schapiro in the release. “Today’s action makes clear that it is impermissible to offer and make such payments as it is to receive them.”

    NASD enforcement attorneys said, “There are a number of investigations like this one under review, both of asset managers and broker dealers.” American Funds acknowledges that it is also under investigation for revenue sharing, and is cooperating with separate investigations by the SEC and the California Attorney General.

    One independent broker and ardent American Funds loyalist received a phone call from the firm soon after hearing the news, assuring him they were fighting the charges and that investors had not been harmed. He says he’s convinced the state and federal authorities are on a witch hunt. “We’ll see more of this—charging people, extracting quick settlements, taking advantage of a firm’s fear of bad publicity. They’ve taken what used to be normal business conduct and criminalized it,” he says. He says the firm has told him of more than 40 subpoenas from the state and the feds, but says of the $300 million his firm has with American Funds: “I’m not moving a dime.”

    Known for its low expenses and standout performance, assets under management at American Funds reached $656 billion last year. Additionally, the firm brought in nearly $84 billion in new money in 2004 (tops in the industry), which accounted for more than a third of all new fund investments, according to Boston-based Financial Research Corp.

    Will its asset gathering be hampered by the charges? Obviously, it's too soon to say, but Janus and Putnam, two asset managers that were implicated in the fund scandals in 2003, had net outflows of $18.5 billion and $26.8 billion for 2004, according to FRC.

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