Low-profile capital gets high scrutiny.

For the first time in its 74-year history, Capital Group Cos. finds itself in an unusual position--defending itself to regulators while trying to hold onto its pristine reputation.

The question being raised is how mutual funds market themselves and whether there are conflicts of interest inherent in the payments funds make to brokers.

Some brokers believe the NASD complaint against Capital's American Funds Distributors Inc. unit, which gave $100 million in commissions to brokerage firms that aggressively sold its mutual funds from 2001 to 2003, reflect widespread industry practices. Others say the charges are overblown and won't sully Capital Group's reputation for high ethical standards.

"They have always been considered a white-shoe company," said Joe Bogdahn, who runs Bogdahn Consulting LLC in Winter Haven, Fla., a fiduciary advisor to municipal pension plans. "But the SEC is going after the biggest dogs in the pack and they're the barn with the biggest bull's eye painted on it."

Probes by the Securities and Exchange Commission and the NASD (formerly the National Association of Securities Dealers) come at an inopportune time for Capital Group, which is structured as a private stock company owned by its 350 senior partners. The company, based in downtown Los Angeles, has always maintained an aura of secrecy unmatched by any other entity its size.

In the past two years, Capital has been the biggest beneficiary of massive inflows as investors fled scandal-plagued mutual funds such as Putnam Investments, which paid $110 million to settle a 2003 probe by New York Attorney General Eliot Spitzer into late-trading and market timing.

American Funds recorded one of its strongest sales years in 2003, when the first round of mutual fund scandals led to outflows at Putnam, Strong Investments and Janus Capital Group. Of the $183 billion in net inflows in 2003, 26 percent, or $48 billion went to American Funds, according to Financial Research Corp. in Boston.

American now ranks as the third-largest mutual fund company, behind Fidelity Investments and Vanguard Group. Its assets have ballooned to nearly $900 billion, from $200 billion in 1995 and $25 billion in 1985.

Capital Group's chief operating unit, Capital Research and Management, has a contract with American Funds to serve as its financial advisor, a fiduciary responsibility that is regulated by the SEC. Capital Research spends lavishly on investment publications and research to educate its clients--the brokers that sell mutual funds directly to consumers.

American Funds sells its investment products only through middlemen such as those stock brokerages--unlike Vanguard and Fidelity, which use direct sales as well as other methods of distribution.

Client brokers are so loyal that several in Los Angeles said they consider the NASD probe a non-event. One local independent broker said Capital's research was so superior to that of other mutual funds that he routinely used its literature in financial planning sessions, even if he sold a competing fund from Fidelity or Merrill Lynch & Co.

'No stars'

Capital Group was founded in 1931 by Jonathan Bell Lovelace, who cashed out his 10 percent stake in a Detroit brokerage firm months before the 1929 stock market crash.

Group executives rarely make comments to the media and decline most requests for interviews or profiles. Part of the reason is the company's structure, which dictates that decision-making be made by consensus.

Capital Group has a management committee with a rotating, non-executive chairman who holds the top title for just two years. Each of its five subsidiaries--American Funds, its marketing arm; Capital Research; Capital Guardian, which advises large institution funds; and Capital Bank and Trust, a trust company; and Capital International, its overseas arm--operate in a similar way.

Chuck Freadhoff, a Capital Group spokesman, said the company "does not have any stars." Its current chairman, R. Michael Shanahan, is a portfolio counselor at Capital Research. The firm's most well-known executive is Paul G. Haaga Jr., an executive vice president and former chairman, who is also chairman of the powerful Investment Company Institute, the mutual fund industry's main lobbying arm in Washington. Gordon Crawford, an executive vice president and the group's chief money media stock picker, is a powerful voice among media investors. Investment strategist Michael J. Johnston, another executive vice president, occasionally speaks to the press and at events such as the World Economic Forum in Davos, Switzerland.

Last year, the SEC launched a wide, ongoing probe into a dozen mutual fund companies, including Capital Group, by requesting information about payments that constitute conflicts of interest. Such deals typically have been disclosed in the fine print of mutual fund prospectuses, but rarely are detailed to the average investor.

The SEC and NASD are investigating two longstanding practices--directed brokerage and revenue sharing.

The 13-page NASD complaint against American Funds claims it directed the trading desk of its investment advisor, Capital Research, to execute stock trades and give brokerage commissions based on a list of brokerages that were top sellers of American Funds' 29 mutual funds.

American Funds "directly or indirectly offered or promised brokerage commissions to other firms as a condition to the sale or distribution of shares of American Funds," the NASD complaint states.

The practice of directed brokerage violates the "anti-reciprocal rule" which first became effective in 1973, though many industry experts say the rule has rarely been enforced.

"The industry practices are so ingrained that if a fund stopped paying a brokerage firm, the brokerages would stop selling those mutual funds," said Edward A.H. Siedle, president of the Center for Investment Management Investigations, a unit of Benchmark Companies. "Billions of dollars that belong to investors are being siphoned out of their savings to assist money managers in building their business."

Revenue sharing, as defined by the SEC, involves a payment from a mutual fund investment advisor--in this case, Capital Research--to a brokerage firm. The issue often is referred to as "soft dollar" payments because it essentially gives an incentive to brokers to sell shares of a specific mutual fund, in much the way that supermarkets get paid by manufacturers for the best "shelf space" in supermarket aisles.

Such marketing fees and payments are passed along to clients, and can dramatically impact the long-term performance of a retirement plan. Capital Group denies that any fees and commissions paid to brokerage firms constitute kickbacks.

"We never made any commitment of any kind to do a specific amount of brokerage business," said Freadhoff. "We have a responsibility to manage the assets in the best possible way, in the shareholders' best interest, including doing thorough research and getting the best possible execution on trades."

Brewing clash

The issue could blow up into a major fight because the SEC is considering stiffening disclosure rules on revenue-sharing agreements. Requiring more disclosure has sparked opposition from financial advisors who complain that brokers are not held to the same strict fiduciary standards as financial advisors and financial planners under the 1940 Investment Advisors Act.

(Capital Research is governed by the 1940 Act, which is enforced by the SEC. The self-regulatory NASD has the lead role in monitoring broker-dealers such as American Funds, along with the SEC.)

Last year, the Financial Planning Association, an industry trade group, sued the SEC to force brokers to strike down a proposed exemption to the 1940 Act for broker-dealers. They argued that the exemption is a de facto rule because the SEC was allowing it to take effect before its final approval.

Four consumer groups--Consumers Union, Consumer Federation of America, Consumer Action and FundDemocracy--support the FPA suit that seeks to overturn the exemption, which has been dubbed the "Merrill Lynch rule."

Steve Lansing, president of Sentinel Fiduciary Services in Orlando, Fla., which advises retirement plans, said companies such as Capital Group should be passing cost savings onto consumers, not using the money to pay brokers to sell its mutual funds.

"If a mutual fund family goes to a broker and says, if you get your brokers to sell our funds we'll give you extra money, then that absolutely taints the entire process," said Lansing, a member of the Revere Coalition, a consortium of independent retirement plan consulting firms advocating for "best practices" in the financial planning industry.

"This is not like selling coffee machines," he said. "These people are stewards of employee and investor retirement money and must treat these transactions in an ethical and un-partisan way."