Lawsuits challenge unequal fund fees

Fidelity Investments charges two-tenths of 1 percent to manage a $484 million stock portfolio for the Massachusetts state pension fund. It charges investors in its flagship Magellan fund seven-tenths -- more than three times as much.

This pricing discrepancy between what individuals and large clients pay for investment services is a bedrock of the business that has rarely been challenged -- until now. In a series of lawsuits filed around the country, attorneys for small investors are accusing fund companies, including Fidelity and Putnam Investments, both Boston companies, of violating their fiduciary duty by making excessive profits through "egregious price-gouging."

"By any stretch of the imagination it would be impossible for Fidelity to show the mutual fund fees are reasonable in light of what it's charging institutional clients in arm's-length transactions," said Harry Miller, an attorney at the Boston firm Perkins Smith & Cohen LLP and co-counsel in the suit against Fidelity.

The fee revolt comes amid a climate of intense scrutiny of fund company practices, particularly trading improprieties that resulted in federal and state fraud actions. New York Attorney General Eliot Spitzer used his office's investigations as leverage to force several major money managers, including the Columbia funds, a unit of the former FleetBoston Financial Corp., to reduce fund fees.

While critics say Spitzer overreached, the fee cuts that he won nonetheless fueled a perception among some investors that fund companies could afford to charge less.

The lawsuits allege that the economies of scale companies enjoy as funds grow, to multibillion-dollar levels, are not passed on to investors, but rather pocketed as additional profits. Institutional clients bargain for better fees, the lawsuits charge, but the trustees who represent individual shareholders fail to negotiate better prices.

Fidelity and Putnam, citing matters under litigation, declined to explain in detail their pricing practices.

"The management fees charged to each and every Fidelity fund are well within the range of fair and reasonable fees," said Fidelity spokeswoman Anne Crowley. "They are also critically reviewed and approved every year by our board of trustees. Our fees are also highly competitive when compared to the rest of the mutual fund industry, and our customers have shown by their investment decisions that we offer attractive pricing and high value in the management of the Fidelity funds."

Putnam spokeswoman Laura McNamara said mutual fund investors require more servicing, such as tax and regulatory reporting matters. Moreover, she said, fees for institutional accounts and mutual funds are set by separate competitive marketplaces.

McNamara noted that Putnam reduced fund fees after being charged with market-timing fraud by regulators. Moreover, Putnam trustees a decade ago instituted "breakpoints," or discounts that lower the overall cost of investing as the funds grow in size.

Roger P. Joseph, leader of the investment management practice at Bingham McCutchen LLP in Boston, said that in addition to having much higher operational costs, a retail mutual fund exposes the money manager to greater "entrepreneurial risk."

"If people are going to take those risks, they want the chance to really hit home runs. And the way you hit a home run is to get a big fund that you manage for a long time. That doesn't mean there aren't pressures" on costs from funds trustees and customers, he said.

But the lawsuits contend the additional administrative and related functions don't explain the size of the gap between retail and institutional fees.

In the Putnam suit, for example, the lawsuit contends the company recovers much of its mutual fund administrative costs through separate fees. And yet Putnam's money management fee is still two to three times higher than what it charges an institutional client for both investment and administrative costs, the suit said.

For example, Putnam charged the Pennsylvania teachers fund a fee of 0.15 percent on a portfolio of $1 billion. Investors in Putnam's Voyager fund paid 0.5 percent on assets of $1 billion, for just money-management services, the suit said. The total expense ratio for the Voyager fund in 2003 was 1.02 percent.

(The Pennsylvania fund fired Putnam as an investor of international equities in December following the market-timing charges.)

The lawsuits are the work of Thomas R. Grady, a Naples, Fla., securities attorney. Grady first began suing fund companies in federal court in Illinois in 2001, and, working with other lawyers, secured settlements in December with Alliance Capital Management and UBS Global Asset Management, he said.

Details of the settlements are confidential, but Grady said, "It was settled favorably." However, it's unclear whether the lawsuits achieved their objective -- to lower fees for shareholders -- or just resulted in settlement payments to the lawyers and their clients.

The Alliance fund cited in the lawsuit, Premier Growth, did see a big drop in fees, from 1.89 percent to 1.58 percent, but that was because of a market-timing fraud settlement the firm reached with Spitzer, a spokeswoman said, declining to comment further.

UBS declined to comment.

Since the settlement, Grady has joined with the Boston law firm Robins, Kaplan, Miller & Ciresi LLP to file the Putnam suit in federal court here in May, and the Fidelity suit with Perkins Smith & Cohen in July.

The latest suits, however, must prove fund fees are unreasonable according to the definition spelled out in a 1982 court decision, said Jeffrey Haas, a professor of mutual fund regulation at New York Law School.

"The test is whether the fee is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been a product of arm's-length bargaining," Haas said. "The way in which the law is interpreted presents a very tall order for the plaintiff's attorneys."

Andrew Caffrey can be reached at caffrey@globe.com.