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(SACRAMENTO) – Attorney General Bill Lockyer today announced an $18 million settlement with the distributor of Franklin Templeton Investments (FTI) to resolve a lawsuit alleging the distributor violated state securities laws by not adequately informing investors about agreements to pay broker-dealers to recommend and sell FTI mutual funds.
"Most mutual fund investors are families with modest incomes," said Lockyer. "They work hard for their money, and when they invest it they deserve to be told the whole truth so they can make informed decisions. That is what our laws against securities fraud require. Franklin Templeton violated those laws and the trust of small investors."
Along with the complaint itself, Lockyer today filed the settlement with Franklin/Templeton Distributors, Inc. (FTDI) in Sacramento County Superior Court. The court approved the settlement, which takes effect immediately. FTDI is the front-line distributor of FTI Funds, which include the Franklin, Templeton and Mutual Series mutual funds. FTDI is a wholly-owned subsidiary of Franklin Resources, Inc. (FRI), the parent company of San Mateo-based FTI. In 2003, FTI managed more than $300 billion in assets worldwide.
The settlement requires FTDI to pay $18 million. Of that total, $14 million will be disgorged back to the FTI Funds. An independent consultant, agreed to by Lockyer, will develop and implement a plan to allocate the $14 million to the various FTI funds. FTDI also will pay the state $2 million in civil penalties for violating the state Corporate Securities Law (CSL), and another $2 million to cover costs.
Aside from monetary terms, the state's settlement memorializes FTDI's agreement to implement voluntary reforms in response to Lockyer's investigation. FTDI will more fully inform investors about the "shelf space" arrangements it enters with broker-dealers to secure either sales of FTI funds or spots on lists of recommended buys. These procedures will require FTDI to disclose both shelf space payments and the services those payments buy from broker-dealers. Additionally, FTDI will take steps to enter written shelf space agreements that detail the terms.
Pursuant to a ban approved in August 2004 by the U.S. Securities and Exchange Commission, FTDI has ended its practice of directing commission payments for its portfolio transactions to broker-dealers in return for sales of FTI funds. The practice is known as directed brokerage.
Directed brokerage is one of two forms of shelf space compensation provided broker-dealers by mutual funds. The other is cash payment. Regulators and law enforcement officials view directed brokerage as more harmful to investors because, unlike cash payments, commissions come out of mutual funds' assets.
From January 2000 through the present, according to the complaint, FTDI paid broker-dealers a combined $147 million under "shelf space" arrangements. Of the total, about $63 million, or 43 percent, constituted directed brokerage, the complaint alleged.
During the four-year period covered by the lawsuit, FTDI made close to $20 million in shelf space payments to one broker-dealer, according to the complaint. In 2002, the complaint alleged, this broker-dealer notified FTI and other mutual funds of the broker-dealer's plans to slash the number of its shelf space partners from 22 to as few as six. The broker-dealer said those that remained in the program would capture 80 percent of the broker-dealer's non-proprietary mutual fund sales, according to the complaint.
"In other words, this shelf space broker-dealer agreed to preferentially market the mutual funds of as few as six mutual fund complexes out of over 500 mutual fund complexes commercially available and, by limiting the number of shelf-space partners, forecasted an immediate gain in (FTI) funds' market share without regard to the quality or propriety of (FTI) funds," the complaint alleged.
The CSL prohibits fraud in the sale of securities, including mutual funds. Under the CSL, fraud includes failure to disclose material facts that a consumer would consider important to know in deciding whether to make a particular investment. Shelf space arrangements qualify as such material facts, Lockyer's complaint alleged, and the failure to disclose them to investors violated the CSL.
The complaint noted shelf space payments can increase mutual funds' costs by increasing portfolio turnover rates, and can deplete its assets through directed brokerage. Additionally, the complaint alleged the arrangements create a conflict of interest between broker-dealers and investors because they "create an incentive for a broker-dealer to highlight, feature or recommend funds that best compensate the broker-dealer or to meet other promises rather than to recommend investments that meet the customer's personal investment needs."
FTDI did not inform investors about its shelf space deals, according to the complaint, or about the quid pro quo services the payments bought from broker-dealers. "Defendants' failures to disclose to investors and prospective investors the existence, details and significance of defendants' shelf space agreements constitute violations of the CSL ...," the complaint alleged.
The FTDI lawsuit is the second enforcement action against a mutual fund firm taken by Lockyer under a law he sponsored which took effect January 1, 2004. Lockyer on September 15, 2004 settled another shelf space complaint against the distributor of PIMCO mutual funds, PA Distributors. Investigations remain ongoing of California-based American Funds, as well as several broker-dealers.
Employees of mutual funds or broker-dealers who have knowledge of securities law violations by their companies should contact the Attorney General's Whistleblower Hotline at 800-952-5225 (for California residents) or 916-322-3360 (for out-of-state residents).