FINRA's National Adjudicatory Council Affirms $5 Million Fine Against American Funds Distributors for Violating FINRA's Anti-Reciprocal Rule
Washington, DC — A $5 million fine imposed against American Fund Distributors (AFD) for directed brokerage in 2006 will stand, according to a ruling issued today by the National Adjudicatory Council (NAC), the appeals body of the Financial Industry Regulatory Authority (FINRA).
The NAC upheld a FINRA Hearing Panel decision finding that AFD violated FINRA's Anti-Reciprocal Rule when it directed more than $98 million in brokerage commissions between 2001 and 2003 to the 46 retail securities firms that were the top sellers of its mutual funds.
AFD is the principal underwriter and distributor of American Funds, a family of 29 mutual funds. In ruling on AFD's appeal of the Hearing Panel decision, the NAC concluded that AFD arranged for the direction of a specific amount or percentage of brokerage commissions to other securities firms conditioned upon those firms' sales of American Funds shares, an "outright" violation of FINRA's Anti-Reciprocal Rule.
The NAC also concluded that AFD's requests and arrangements for the direction of brokerage, conditioned upon sales, was directly at odds with the goal of the Anti-Reciprocal Rule, which is "to curb conflicts of interest that might cause retail firms to recommend investment company shares based upon the receipt of commissions from that investment company."
In the decision released today, the NAC emphasized that AFD tracked, monitored, and facilitated the directed brokerage payments by identifying the top-selling retail firms of American Funds, providing its investment adviser with the amount of commissions to be sent, and monitoring its investment adviser's trading with, and the payment of commissions to, the selected retail firms throughout the year. The NAC also highlighted the fact that AFD directed commissions to "step-out firms" - retail firms that had no capability to execute portfolio trades for American Funds, but nevertheless obtained commissions indirectly from clearing firms that did execute the trades.
In assessing sanctions, the NAC articulated its concern that directed brokerage arrangements, like those employed by AFD "tended to undermine the rules of fair competition envisioned by the rule." The NAC explained that "AFD's target commission payments amounted to undisclosed additional sales commissions that would harm other mutual funds families' ability to compete in the market to sell their mutual funds to the investing public" and "triggered the potential for preferential treatment for American Funds' mutual funds to the disadvantage of other mutual funds in the industry."
The NAC also found that AFD's conduct was intentional, not negligent as the Hearing Panel had concluded. "The evidence demonstrates that AFD deliberately formed directed brokerage arrangements with the top-selling retailers of American Funds' mutual funds," the NAC's decision says. "AFD tracked (its investment adviser's) trading activity with the retail firms and monitored the execution of these arrangements to ensure proper crediting of the targeted commission payments. AFD also ceased payments to step-out firms, and modified its calculation of target commissions, as regulators began to question the use of directed brokerage in the mutual fund industry. There is no evidence in the record to support a finding that AFD's conduct was negligent."
Although the NAC emphasized these and other aggravating factors, it noted that there was no evidence that AFD was unjustly enriched, that American Funds' shareholders were harmed, or that AFD placed unwarranted trades or paid excessive commissions. The NAC concluded that AFD's violations, while "not egregious, were quite serious" and that a "substantial" fine of $5 million was appropriate based on the facts and circumstances of the case.
The NAC is a 14-person committee composed of seven industry and seven non-industry members that decides appeals from disciplinary, membership, and exemptions decisions, and rules on statutory disqualification applications. The NAC decision is the final decision of FINRA. The Securities and Exchange Commission (SEC) may review and modify FINRA's findings and sanctions. The parties have 30 days from receipt of the decision to file an appeal with the SEC.
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