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(LOS ANGELES) – Attorney General Bill Lockyer today filed a securities fraud lawsuit against American Funds’ Los Angeles-based distributor and investment manager, alleging the defendants failed to adequately inform investors about $426 million in "shelf space" payments made to dozens of broker-dealers to sell and recommend American Funds.
"American Funds dressed up these arrangements with fancy names like ‘execution revenue,’ ‘target commissions’ or ‘Broker Partnership Payments,’ " said Lockyer. "But when you look beneath the cloak of legitimacy, the payments are little more than kickbacks to buy preferential treatment. Investors deserve to know that. The law American Funds violated is based on that simple principle."
The defendants in the lawsuit filed in Los Angeles County Superior Court are American Funds Distributors, Inc. (AFD) and Capital Research and Management Company (Capital), the investment manager for American Funds. The complaint seeks disgorgement of all profits the defendants obtained as a result of violating provisions of the state’s Corporate Securities Law (CSL) that prohibit fraud in the sale or offering of securities. Additionally, the complaint seeks restitution for investors, civil penalties of up to $25,000 per CSL violation and an injunction prohibiting future violations.
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 alleges. Such payments – made in cash or "directed brokerage" commissions on mutual funds’ portfolio transactions – create conflicts of interest, increase mutual funds’ expenses and decrease consumers’ investment choices, the complaint notes. The defendants violated the CSL by failing to adequately inform investors about the significance of the shelf space payments and potential problems, and about the preferential treatment the defendants received in return for the payments.
The American Funds complex includes about 29 mutual funds with 20 million shareholders and more than $600 billion in combined assets. From January 1, 2000 through the present, AFD maintained an annual average of about 100 shelf space arrangements with broker-dealers, the complaint alleges. Until 2004, when the U.S. Securities and Exchange Commission (SEC) banned directed brokerage, the defendants paid the top 47 AFD shelf space partners portfolio transaction commissions, as well as cash. From 2000 through the end of 2004, the defendants’ shelf space payments totaled at least $426 million, including $294 million in cash and $132 million in directed brokerage, the complaint alleges.
AFD’s shelf space brokers included Edward D. Jones & Co. (Jones), Morgan Stanley Dean Witter and Piper Jaffray. To increase sales of American Funds, all three of these partners used shelf space payments to provide bonuses, cash rewards and/or resort travel assistance to local sales representatives. These incentives were not disclosed to investors.
To show the defendants knew they were not informing investors about how the shelf space arrangements worked in practice, the complaint cites a January 9, 2004 "global" voice mail message from AFD’s co-CEO Kevin Clifford to all sales representatives. After offering the argument the payments actually help investors, Clifford states, "I think it’s important that you be on message because this is the message that we have been using with regulators ... This will be the story that we use with regulators going forward, and I think you’ll see it in time incorporated in our disclosure."
The defendants also misled independent directors on the boards of various American Funds, according to the complaint. Executives of Capital – which occasionally subsidized AFD’s cash payments to broker-dealers– falsely told independent directors AFD did not maintain shelf space arrangements, did not use directed brokerage to purchase shelf space and did not provide portfolio transaction targets to broker-dealers, the complaint alleges.
Jones ranked as AFD’s top shelf space partner. From 2000 through 2004, AFD paid Jones more than $106.5 million in cash and directed brokerage. After the defendants ended directed brokerage for Jones in January 2002, they replaced it with cash to maintain their preferential treatment. As a result, the cash payments jumped from $10.7 million in 2001 to $20.7 million in 2002. Meanwhile, from 2000 through 2003, Jones sold more than $45 billion in American Funds shares.
Some of AFD’s shelf space partners, such as Jones, did not have the capacity to perform securities trades. In those cases, at least until 2002, Capital would trade directly with the shelf space partner’s "clearing broker." The clearing broker would keep a portion of the directed brokerage commission and pass on the remainder to the AFD shelf space partner.
Lockyer’s office has been working closely with the SEC on the American Funds case, and Lockyer acknowledged the SEC’s substantial assistance and cooperation.
The American Funds lawsuit is the fourth brought by Lockyer under a law he sponsored which took effect January 1, 2004. The statute gave his office authority to file civil enforcement actions under the CSL. Lockyer settled shelf space complaints against the distributor of PIMCO funds, PA Distributors (on September 15, 2004) and Franklin Templeton Distributors, Inc. (on November 17, 2004). Both settlements ensured greater disclosure to investors of the shelf space payments. The Franklin Templeton settlement also disgorged $14 million back to its various mutual funds. Lockyer on December 20, 2004 sued Jones, alleging the broker-dealer failed to adequately disclose about $300 million in shelf space payments it received from seven preferred mutual funds, including American. That case remains pending.
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).