Last week, an NASD Hearing Panel censured and fined American Funds Distributors $5 million for allegedly using directed brokerage practices to sell its funds, in violation of the regulator’s Anti-Reciprocal Rule.

From 2001 through 2003, the regulator charges that American Funds directed more than $98 million in brokerage commissions to securities firms who were top sellers of the company’s 29 mutual funds. Those commissions were a reward for past sales of American’s funds and to encourage future sales of its funds.

The NASD Department of Enforcement first brought its action against the firm in February 2005. American Funds, the second largest mutual fund family in the U.S., has vigorously fought the NASD’s charges since then.

The mutual fund giant plans to appeal this latest ruling to the NASD’s National Adjudicatory Council.

The NASD's Anti-Reciprocal Rule prohibits fund firms from using brokerage commissions to compensate securities firms for selling the funds' shares. The rule seeks to ensure that securities firms make portfolio transactions to serve the investment needs of the fund shareholder, and not to pursue further fund sales.

In February 2005, the regulator claimed that American Funds calculated how much in commissions it would direct to the top-selling retailers of its mutual funds based upon how much the retailers sold the previous year. The fund firm then discussed those "target commissions" for the upcoming year with the retailers. In those discussions, it made it clear that the amount was a function of the firm's prior year's sales of American Funds, typically .10% or .15% of those sales. At the same time, it also told broker-dealers what benefits it expected to receive from the arrangement, such as the inclusion of American Funds on the retailers’ "preferred fund" or "recommended fund" lists, and enhanced access to the firms' sales forces.

At the beginning of each year between 2001 and 2003, American Funds provided a chart to the trading desk of its parent company and investment advisor, Capital Research and Management Company. According to the NASD’s complaint, the chart listed each of the top-selling retailers that American Funds had an arrangement with and the amount of their target commissions.

The firm’s trading desk then directed brokerage commissions on American Funds portfolio transactions according to the chart. Throughout the year, the trading desk provided monthly updates to American Funds about the amount of brokerage commissions it had directed. In turn, American Funds occasionally provided updates to its top-selling retailers about how much of the target commissions had been directed to them throughout the year, the regulator claims.

While the NASD Hearing Panel described American Funds’ use of brokerage commissions to reward top-selling firms “precisely what the [Anti-Reciprocal Rule] was intended to proscribe,” it rejected Enforcement’s argument that the mutual fund firm engaged in an intentional, or at least reckless, pattern of misconduct over a period of years.

The Panel noted that American Funds’ use of directed brokerage was consistent with practices that had arisen in the mutual fund industry over a number of years. It also recognized that regulators did not express concern about those common practices until 2001, and that, unlike its competitors, American Funds acted voluntarily to change those practices when regulators began expressing concern.

The panel also rejected Enforcement's call for sanctions in the amount of the total directed brokerage payments, noting that the trades were placed and the commissions actually paid by Capital Research. Capital Research is not subject to NASD regulation.

American Funds Distributors was also the subject of a complaint filed in state court by the California Attorney General in 2005. That complaint questioned the sufficiency of disclosure of additional payments American Funds made to broker-dealer firms in exchange for “educating” financial advisers about American Funds.

The Superior Court of California dismissed the complaint in November, 2005. In February of this year the California Attorney General appealed that dismissal. The appeal is now pending.

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