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WHY FUND FEES ARE SO HIGH

A series of lawsuits points a finger at ''co-opted'' directors

High mutual-fund expenses can eat away at shareholder profits, and numerous lawsuits have tried in vain to force fund companies to lower their fees. But a series of suits filed in recent weeks attacks the fee issue in an unusual way--by challenging the independence of fund directors. The shareholder suits against Fidelity, Prudential, T. Rowe Price, BlackRock, and BEA Associates claim directors consented to high fees only after being ''co-opted'' by fund-management companies through high compensation and appointments to multiple fund boards within the same fund company. Directors ''are no longer independent watchdogs,'' the suits contend.

Securities lawyers say the suits are a long shot. But they spotlight a highly charged issue that may prompt regulators and legislators in Washington to take action. The Securities & Exchange Commission recently launched a review of how directors set fees. And the chairman of the House Commerce Committee is considering proposing legislation next year that would require more detailed fee disclosure.

''BAD JOKE.'' Fund fees have come to the forefront because critics believe that even though fund assets have quadrupled, to $5 trillion, in the 1990s, the companies are not sharing the benefits of economies of scale with investors. After all, it doesn't take twice as many people, computers, or offices to run a $2 billion fund instead of a $1 billion fund. So as a percentage of the fund assets, management fees should fall as the assets increase. Instead, the average expense ratio for an equity fund is 1.53%, or $1.53 per $100, vs. 1.25% in 1985, according to Morningstar Inc.

Independent directors, by law, are supposed to represent shareholders. But critics say they do a poor job when they allow fees to rise. ''Fund directors are, to a very major extent, sort of a bad joke,'' says John C. Bogle, founder of Vanguard Group, which has the industry's lowest fees.

The recent suits follow a surprising court decision in May that opened the door for a legal assault on independent directors. In a suit in federal court in Maryland, Robert Strougo, a shareholder in Scudder Kemper Investments Inc.'s Brazil Fund, charged that a cozy relationship between independent directors and Scudder management led to the directors approving a rights offering that can dilute the value of the shares. At the Brazil Fund, four of the seven independent directors serve on other Scudder fund boards. Scudder moved to dismiss the case, but the judge allowed it to proceed, citing a Maryland law that restricted directors from sitting on multiple boards. The case is still pending.

The decision prompted the attorneys who brought the Strougo case to apply that ruling to bring five new suits challenging fund fees. The suits claim that the fees that were approved by these directors are invalid because the directors serve on multiple boards within the same fund complex and are thus not truly independent.

LONG ODDS. The suit against Fidelity Investments contends that ''the fee-gouging by Fidelity has been especially dramatic.'' Fidelity assets under management jumped from $36 billion, to $373 billion from 1985 to 1995, and management fees were increased from 1.085% of assets under management to 1.146% of assets. The higher fees resulted in an extra $288 million in revenue for Fidelity, the suit claims. Fidelity has one board of directors representing all its 263 funds, and 9 of the 12 directors are independent. Fidelity's independent directors are paid in excess of $200,000 a year. ''Our shareholders are well-represented by talented and knowledgeable directors,'' says a Fidelity spokeswoman. ''We are in full compliance with the Investment Company Act of 1940 and we will defend ourselves vigorously.'' Representatives of T. Rowe Price Associates, Prudential, and BlackRock say the suits are without merit. BEA Associates could not be reached for comment.

Barry Barbash, former director of mutual-fund regulation at the SEC, says the suits have a slim chance if they zero in on the issue of directors serving on multiple boards. The SEC has allowed the practice since at least 1970. Even so, Barbash, an attorney with Shearman & Sterling in Washington, believes independent directors might not be in the clear. ''You might have a case if you can show that independent directors are not in fact independent,'' he says.

The betting is that the latest legal attack on fees will fail. But the shareholders can still win if regulators begin to champion the cause of lower fees.

By Geoffrey Smith in Boston

To read a letter to the editor about this story, click here.


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Updated Nov. 19, 1998 by bwwebmaster
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