American Funds Distributors is the fund company that said no. While in the past few years many funds sued by regulators have been quick to settle, American, the second-largest fund family in the U.S. with $650 billion in assets is fighting back. It says it has only followed longstanding industry practices and refuses to submit to what it calls arbitrary enforcement.
American has even gone on the offense — pre-emptively suing California Attorney General Bill Lockyer, who has countersued the company for securities fraud. And American is also challenging the NASD, which has charged American with violating industry rules involving brokerage commissions. Both cases are pending, with no hearing dates set.
“It is unusual for a fund group to pre-emptively sue a regulator. But this fund group appears to have had enough — I think they decided to send a strong message,” says Jay Baris, a partner with New York-based firm Kramer Levin Naftalis & Frankel.
American declined to comment, but lawyers following the cases believe American, while it is taking a major risk, has a shot at winning, particularly in California. In both cases, there is a lack of legal precedent, giving American leeway to argue that the practices it is accused of, including revenue sharing with broker/dealers, are long-standing fund industry practices not specifically outlawed under current rules.
American also has what some other funds have not — time and money. The fund company is well capitalized to mount a serious legal battle. In 2004 American sold $83.7 billion in mutual fund shares, about a third of the industry's total, and further, American is privately held, which means it does not have to worry about a deteriorating share price if its legal battles drag on. “Because they're a private company, they don't have to worry about shareholder sentiment,” says Geoff Bobroff, head of Bobroff Consulting.
American seems committed to what could be considered a quixotic campaign. The NASD, at least, has a very strong winning record — a survey of NASD cases between 2001 and 2004 by law firm Sutherland Asbill & Brennan found the NASD has had an 89 percent litigation success rate.
An NASD Fight
American's battles began in February, when the NASD charged that American directed about $100 million in commissions to 50 brokerages that were also the top sellers of its mutual fund products. The NASD argued these actions violated its rule designed to prevent quid pro quo arrangements between funds and dealers.
American, however, argues the rule expressly permitted mutual fund sponsors to consider a b/d's volume of fund sales in determining whether to use that firm when buying or selling securities for the fund. The rule set forth several conditions on this practice, the key one being that the funds receive “best execution” in all its portfolio transactions.
In American's official comment on the case, it claims it has “always sought and obtained ‘best execution,’ and notes that the NASD does not allege shareholders incurred any additional costs in any transaction in which fund sales were a consideration. American also claims it never committed in any way to direct “a specific amount or percentage of portfolio transactions to any firm.”
What are American's chances of prevailing? There is little in the way of precedent to go on. “As far as I know there is no legal precedent for the NASD's case. It seems to primarily come down to each party's interpretation of what the law is,” says Brian Rubin, an attorney at Sutherland Asbill & Brennan. American's “core argument appears to be that regulators are trying to prosecute for conduct that has been fairly standard in the industry for a number of years,” he says.
As the NASD suit was getting under way, American faced a second regulatory assault from the State of California, which it decided to try to head off. On March 24, American and its parent, Capital Research and Management, filed a complaint in Los Angeles Superior Court against the state attorney general's investigation into whether American had sufficiently disclosed “revenue-sharing” payments., prompting Attorney General Lockyer promptly countersued.
In California, American's argument is solely one of jurisdiction. Its attorneys cite a 1996 federal law, the National Securities Markets Improvement Act, which makes the federal government the sole regulator of all documents in connection with national securities offerings, to claim that American adequately disclosed its sales practices under this federal law, and further, that this federal law supersedes any securities laws recently passed by California (in particular, the 2003 state law that gives Lockyer prosecuting authority over American), and that the case needs to be moved to the SEC.
By contrast, “California is saying that American Funds is based in L.A., they operate in L.A., that there are laws intended to protect California consumers and that California clearly has jurisdiction,” one securities lawyer says. “American's main argument to Lockyer appears to be that, ‘We don't have to listen to you. Maybe we did what you say we did, maybe we didn't, but we want the SEC to resolve this.’”
Why is American so gung-ho to move the case to the federal level? The company is betting that the SEC will provide a more nuanced understanding of fund industry practices than an ambitious state attorney general, lawyers say. Another plus: The company's case would be handled by a new SEC regime, headed by the recently appointed Christopher Cox, a pro-business former Republican Congressman from Orange County. “The appointment of Cox as the new SEC head will probably cause American Funds to fight this even harder,” says David Nolte, an official at Fulcrum Financial Inquiry, a Los Angeles-based investment advisor.