American Funds' spotless reputation at risk

The American Funds mutual fund group has gone 77 years without a significant whack from financial regulators, a track record that is a true rarity in the investment business.

Now the firm's parent, Los Angeles money-management giant Capital Group Cos., has to decide whether to wave the white flag in a three-year legal battle, ending the company's blemish-free streak.

American Funds is well known on Wall Street for its conservative investment style, low fund management fees, strong long-term returns -- and for being unapologetically aggressive in protecting its franchise. It now has taken that hard-edged approach to extremes with one of its regulators, in a case that may finally be coming to a head.

The company has been accused of making improper payments to about 50 brokerages from 2001 through 2003 as an incentive to get them to pitch its funds to investors.

If a broker sold you shares in one of the company's funds in that period -- say, the popular Growth Fund of America -- the broker's firm might have gotten a little extra reward, beyond normal sales fees.

The case, brought by the Financial Industry Regulatory Authority, the securities industry's self-policing agency, was announced in February 2005 as part of a crackdown on so-called shelf-space arrangements between fund companies and brokerages.

Regulators decided the arrangements were getting too cozy, raising the potential for a broker to favor certain funds over others solely because it was in his firm's financial interest.

Dozens of other fund companies have faced similar allegations in recent years, and nearly all of them have done what financial firms normally do when their watchdogs allege wrongdoing: quickly settle by paying a fine, without admitting the charges.

But if the regulators thought Capital Group would roll over, they underestimated how far the generally secretive company -- which manages more than $1 trillion in assets -- would go to protect its clean-living image.

American Funds immediately appealed the case in 2005 to a FINRA hearings panel. That panel ruled against the company in August 2006, triggering another appeal.

This week, FINRA's national hearings panel also ruled against the firm.

Enough, already? Maybe. Embarrassed though American Funds may be to cave in to the charges, they amount to violations of an arguably hazy rule governing fund firms' relationships with brokerages.

Important for American Funds, FINRA doesn't allege that any of the firm's millions of investors were harmed by its sales practices. So in the annals of financial scandals, this one lacks victims.

The penalty if American Funds settles the case isn't much of a grabber, either. The fine would be $5 million, a veritable dust speck for privately held Capital Group, which is believed to be enormously profitable.

The allegations in the case center on payments American Funds made via a now-banned industry practice known as directed brokerage.