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Imagine 50 Eliot Spitzers

When are mutual fund companies charging too much in advisory fees? What constitutes proper disclosure of, say, revenue sharing? And which governmental authority has jurisdiction over these issues?

When are mutual fund companies charging too much in advisory fees? What constitutes proper disclosure of, say, revenue sharing? And which governmental authority has jurisdiction over these issues?

The short answer, according to fund companies (at least the couple that are not settling with regulators): Congress, which has invested the SEC with that responsibility. These companies think New York Attorney General Eliot Spitzer and other states’ regulators should butt out.

Well, that’s the upshot of J. & W. Seligman’s lawsuit filed this week with the Southern District of New York. J. & W. Seligman sued the New York attorney general, claiming that the state AG has no authority to supervise fund fees, as he demanded in settling a market-timing case earlier this year. If the court allowed Spitzer to continue to regulate fees, it “would open the door to 50 different state attorneys general doing the same thing, thus defeating the carefully conceived and comprehensive federal regulatory scheme enacted by Congress.”

The attorney general contends that under New York State’s Martin Act, he has the right to address business wrongs. In a series of settlements with fund companies, Spitzer has won fee cuts and the right to oversee future expense ratios. Has the state attorney general overstepped his bounds? So far, no court has ruled on the issue. But there are reasons to think that Seligman could prevail. Under the Investment Company Act of 1940, which established mutual funds, fund managers must set responsible fees. Shareholders and the SEC can sue when they believe that a company is violating its responsibilities. No laws give any role to states in setting fees.

Despite legal obstacles, Spitzer can be persistent, as court documents reveal. After announcing that speculators had engaged in frequent trading in three of its funds, Seligman agreed in August to pay $2 million in a tentative settlement with the SEC and Spitzer. The SEC didn’t push for additional fee reductions, but Spitzer clung like a bulldog, demanding more documents and pressuring the company. Eventually, Seligman decided to contest the fee question.

If Spitzer wins in court, the fee issue could be far from resolved. The New York attorney general would control fees on national funds. But an ambitious attorney general from another state might demand even lower fees, setting off a scramble to determine who is in charge.

Meanwhile, American Funds Distributors is squaring off against California Attorney General Bill Lockyer, who has been on a roll lately, having won settlements from Franklin Templeton and PIMCO in cases involving revenue sharing. American faces similar charges.

In typical revenue-sharing arrangements, a fund company pays brokerages to help cover marketing costs and education of financial advisors. Revenue sharing is legal, but a fund must disclose the practice. In its prospectus, American noted that it made payments to 100 dealers. The California attorney general contends that the disclosure was too vague.

So what should be disclosed? That is hard to say. The SEC hasn’t issued clear guidelines. The question is particularly murky for fund companies. In its enforcement actions, the SEC has targeted brokers and insisted that they tell clients the basis for fund recommendations. But no one knows whether funds should compare themselves to each other or disclose information on brokers.

“There is no way that we are going to settle when we didn’t do anything wrong,” says Chuck Freadhoff, spokesman for American Funds, which has been accused of insufficient disclosures by the California attorney general. “We have been in business for almost 75 years and have never had an enforcement action against us.”

Don’t expect that the California attorney general’s legal arguments will shed much light on the question. The state has no plans to issue guidelines on disclosure any time soon. “We are not talking about exactly what should be in disclosure,” says Tom Dresslar, spokesman for the California attorney general’s office. “It is clear, based on the evidence, that the fund company wasn’t giving investors the information that they needed.”

In any case, the achievements of prosecutors are likely to be dwarfed by the actions of the market place. During the first seven months of 2005, more than $100 billion in assets flowed into low-fee fund companies, including Vanguard, American Funds and Barclays Global Investors. At the same time, investors have been fleeing expensive portfolios. If that trend continues, the markets will reduce fees much faster than any regulators can.

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