Lockyer Settles Franklin Directed Brokerage Case

November 17, 2004 (PLANSPONSOR.com) - California Attorney General Bill Lockyer said his office has hammered out an $18 million settlement with Franklin Resources covering charges the company paid broker-dealers to recommend and sell Franklin Templeton mutual funds.

In a  Web site statement ,   Lockyer said the settlement with Franklin Templeton Distributors (FTDI) called for $14 million in disgorgement to shareholders in Franklin, Templeton and Mutual Series funds. The pact also calls for the company to pay $2 million in civil penalties and another $2 million in costs.

Lockyer said the company was charged with not adequately informing investors about the broker-dealer setup (See  CA Attorney General Probing Fund Sales Misdeeds ). “Most mutual fund investors are families with modest incomes,” Lockyer asserted in the statement. “They work hard for their money, and when they invest it they deserve to be told the whole truth so they can make informed decisions. That is what our laws against securities fraud require. Franklin Templeton violated those laws and the trust of small investors.”

Shelf Space

Also as part of the deal, FTDI agreed to a series of procedural reforms such as more fully informing investors about the “shelf space” arrangements it enters with broker-dealers to secure either sales of its funds or spots on lists of recommended buys. These procedures will require FTDI to disclose both shelf space payments and the services those payments buy from broker-dealers, according to the statement.

Pursuant to a ban approved in August 2004 by the US Securities and Exchange Commission, FTDI has ended its practice of directing commission payments for its portfolio transactions to broker-dealers in return for sales of FTI funds – a practice known as directed brokerage, the statement said.

Directed brokerage is one of two forms of shelf space compensation provided broker-dealers by mutual funds. The other is cash payment. Regulators and law enforcement officials view directed brokerage as more harmful to investors because, unlike cash payments, commissions come out of mutual funds’ assets, Lockyer said.

From January 2000 through the present, according to the complaint, FTDI paid broker-dealers a combined $147 million under “shelf space” arrangements. Of the total, about $63 million, or 43 percent, constituted directed brokerage, the complaint alleged.

During the four-year period covered by the lawsuit, FTDI made close to $20 million in shelf space payments to one broker-dealer, according to the complaint. In 2002, the complaint alleged, this broker-dealer notified FTI and other mutual funds of the broker-dealer’s plans to slash the number of its shelf space partners from 22 to as few as six. The broker-dealer said those that remained in the program would capture 80 percent of the broker-dealer’s non-proprietary mutual fund sales, according to the complaint.

Turnover Rates

The complaint said setups like those at FTDI can increase mutual funds’ costs by increasing portfolio turnover rates, and can deplete its assets through directed brokerage. Additionally, the complaint alleged the arrangements create a conflict of interest between broker-dealers and investors because they “create an incentive for a broker-dealer to highlight, feature or recommend funds that best compensate the broker-dealer or to meet other promises rather than to recommend investments that meet the customer’s personal investment needs.”

FTDI is a wholly-owned subsidiary of Franklin Resources, Inc. (FRI), the parent company of San Mateo-based FTI. In 2003, FTI managed more than $300 billion in assets worldwide.