AFD is the principal underwriter and distributor of American Funds, the third largest mutual fund family in the U.S. with more than $450 billion in assets and approximately 25 million shareholder accounts. The commissions were payments for executing trades for the American Funds' portfolio that were directed to the brokerage firms as additional compensation for past sales of American Funds, and to ensure that American Funds would continue to receive preferential treatment at those firms.
NASD's "Anti-Reciprocal Rule," which first became effective in July 1973, is designed to prevent quid pro quo arrangements in which brokerage commissions, which are assets of the shareholders of the mutual funds, are used to compensate brokerage firms for selling the funds' shares. The rule also is designed to ensure that the execution of portfolio transactions by brokerage firms is guided by the principle of "best execution" and not by other considerations. In addition, the rule is meant to eliminate the danger that a brokerage firm, when recommending mutual funds to customers, will base its recommendations on the additional rewards the firm may receive in portfolio commissions from the funds rather than on the investment needs of the customer.
"Prior cases in this area have focused on retail firms that received directed brokerage payments from mutual fund companies in exchange for giving preferential treatment to their funds," said NASD Vice Chairman Mary L. Schapiro. "Today's action makes clear that it is just as impermissible to offer and make such payments as it is to receive them."
NASD's complaint alleges that, between 2001 and 2003, AFD calculated "target commissions" that it intended to direct to each of the top-selling retailers of American Funds according to a formula that was based upon each of the firms' prior year's sales of American Funds. AFD communicated to each of these retail firms the specific amount of that firm's "target commissions" for the upcoming year and the fact that the amount was a function of the firm's prior year's sales of American Funds, typically 10 or 15 basis points of those sales. At the same time, AFD also discussed with the top-selling retail firms the benefits that AFD expected to receive pursuant to the sponsorship arrangements, such as the inclusion of American Funds on the firms' "preferred fund" or "recommended fund" lists, and enhanced access to the firms' sales forces.
According to NASD's complaint, at the beginning of each year between 2001 and 2003, AFD provided a chart to the trading desk at AFD's parent company, Capital Research and Management Company (CRMC). CRMC is the investment advisor to American Funds. The chart listed each of the top-selling retailers with which AFD had a sponsorship arrangement and the amount of "target commissions" for each firm. The Fund's trading desk directed brokerage commissions on American Funds portfolio transactions to the top-selling retailers on the chart based on the "target commissions" set by AFD for each firm. Throughout the year, the trading desk provided monthly updates to AFD about the amount of brokerage commissions directed to each of the top-selling retail firms. In turn, AFD occasionally provided updates to the top-selling retailers about how much of the target commissions had been directed to them throughout the year.
The trading desk not only directed brokerage commissions to firms that executed American Funds portfolio transactions, but also to retail firms that did not have the capacity to execute securities transactions. Those firms (approximately 30 of the 50 or so) entered into "step out" arrangements with clearing firms in order to receive the directed brokerage commissions.
NASD's investigation found that the clearing firms, which executed the trades, shared the brokerage commission with the retailers even though the retail firms provided no services in connection with the trade. The amount of commission that the retail firms received-typically seventy to ninety percent of the commission-depended upon the agreement between their firm and the clearing firm executing the trades. Twenty-nine million of the $100 million in directed brokerage was paid in this fashion and ranged from a high of approximately $5.4 million to one retailer to a low of approximately $112,855 to another retailer.
Under NASD rules, AFD can file a response and request a hearing before an NASD disciplinary panel. Possible sanctions include a fine, suspension, bar, or expulsion from the NASD.
NASD wishes to acknowledge the substantial assistance of the Pacific Regional Office of the Securities and Exchange Commission in this matter.
Investors can obtain more information about, and the disciplinary record of, any NASD-registered broker or brokerage firm by using NASD's BrokerCheck. NASD makes BrokerCheck available at no charge to the public. In 2004, members of the public used this service to conduct more than 3.8 million searches for existing brokers or firms and requested more than 190,000 reports in cases where disclosable information existed on a broker or firm. Investors can link directly to BrokerCheck at www.nasdbrokercheck.com. Investors can also access this service by calling 1-800-289-9999.
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