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SEC Prevails in Redemption Fee Dispute

The SEC appears to have succeeded with its appeals to the mutual fund industry to limit redemption fees to two percent.

Fidelity Investments of Boston has dropped the three percent redemption fee it has imposed on its Small Cap Stock Fund, Fidelity said in an SEC filing April 28. Fidelity reduced the fee to two percent for all shareholders redeeming after April 28, according to the SEC filing. The three percent fee had been in effect since the fund was formed in March 1998.

What appears to have been the industry's only other fund with a redemption fee of more than two percent, the Deutsche Preservation Plus Income Fund, also will cut its three percent redemption fee, a spokesperson said last week.

The moves came in response to pressure from the SEC, which has argued since late last year that fund redemption fees of more than two percent in most cases violate the Investment Company Act, the key federal securities law which governs the operations of mutual funds. Many industry lawyers have questioned the SEC's interpretation that the law limits funds to a redemption fee of two percent. Nevertheless, both Fidelity and Deutsche Asset Management of New York have deferred to the SEC on the issue.

"While we believe that the three percent fee is fully justifiable, we decided to decrease the fee to two percent rather than engage in protracted discussions with the SEC," said Jessica Catino, a Fidelity spokesperson.

Redemption fees mean that investors who redeem their fund shares shortly after buying them must pay a percentage of the amount they redeem.

Funds impose redemption fees to compensate long-term investors for costs associated with shareholders that move in and out of a fund quickly. The redemption fees are paid into the fund in an effort to offset increased brokerage commissions and other costs that can be incurred because of investors who redeem on a short-term basis. The fees also are intended to discourage short-term trading.

Cindy Fornelli, an advisor to Paul Roye, the director of the SEC's division of investment management, declined to comment on the Fidelity or Deutsche matters specifically. But, on the issue of redemption fees generally, she said the SEC is sympathetic to funds' efforts to discourage short-term trading. But the Investment Company Act provides that shareholders must receive the approximate net asset value of their fund when they redeem, she said. The SEC will allow funds to exceed the two percent cap only if the funds can show that their expenses associated with short-term trading exceed two percent, she said.

"While we're sympathetic (to concerns about short-term trading), the statute is what the statute is," Fornelli said.

Funds that can show their short-term trading expenses exceed two percent can request a regulatory ruling from the SEC for a special exception from the provisions of the Investment Company, Fornelli said. She said she knew of no pending requests to exceed the two percent limit.

It was unclear when the Deutsche fund will drop its three percent limit. The new rate presumably will be two percent, but that was unclear as well.

"The Deutsche Preservation Plus Income Fund will change its redemption fee to meet SEC concerns," a company spokesperson said in a statement. She declined further comment.

Fidelity said in the April 28 SEC filing that the Small Cap Stock Fund's directors approved the redemption fee reduction at a meeting April 20. Catino declined to say whether the board vote was unanimous or describe what discussions surrounded the matter.

Fidelity's redemption fee applies to shareholders that redeem their holdings within less than three years of the date of purchase. Fidelity believes that the two percent fee and the three-year holding period will discourage investors who might be inclined to redeem quickly from investing in the fund, Catino said.

"The level of the fee and the length of the holding period will send a message that the fund will not tolerate short-term trading," Catino said.

The Fidelity Small Cap Stock Fund, with assets under management of approximately $967 million, was the only fund on which Fidelity was imposing a redemption fee in excess of two percent. Fidelity imposed the fee because the costs associated with short-term trading in small-capitalization stocks are higher than in sectors where stocks trade more frequently, Catino said.