In a test case that threatens to pull scores of banks into litigation, plaintiffs' lawyers are challenging First National Bank of Chicago's conversion of common trust funds to proprietary mutual funds.
The suit, filed last month in Cook County Circuit Court, charges that First Chicago violated its fiduciary responsibilities because the $1.3 billion conversion benefited the bank at the expense of the beneficiaries.
"The transfer of these assets placed FNBC in a conflict of interest with its trust customers because FNBC profited - and continues to profit - by using funds it held in its capacity as a fiduciary to benefit itself," the suit alleges.
For instance, the lawsuit charges that the conversion provided seed money for First Chicago to create 16 mutual funds, which it is using to attract new customers and build fee income. But the beneficiaries were harmed, according to the lawsuit, because the conversion led to higher charges.
The suit demands damages and fees for lawyers, but it does not specify a dollar amount. It currently names only two victims, although the court is expected to give the lawyers a chance to review the bank's records to find other trust beneficiaries affected by the conversions.
Congress amended the tax laws in 1996 to exempt conversions from capital gains taxes. Since then, nearly half of the 119 banks with trust departments and proprietary mutual funds have conducted conversions. For example, First Union Corp. used $7 billion in common trusts to start 16 Evergreen Select mutual funds.
First Chicago officials as well as the bank's outside lawyers at Mayer, Brown & Platt declined to discuss the case.
The plaintiffs' lawyers warned that more suits are possible.
"This is a problem that extends beyond First Chicago," said Jonah J. Orlofsky, a partner at the Chicago law firm of Plotkin, Jacobs & Orlofsky. "The banks went about doing this for their own benefit because they were interested in establishing mutual fund businesses, rather than for the benefit of their customers. This is the exact opposite of how a fiduciary should do it."
Gene F. Maloney, senior vice president and counsel at Federated Investors Inc. of Pittsburgh, warned that bankers are especially vulnerable because there is little case law on how to properly convert funds.
"These are very novel transactions with novel legal issues," he said. "I just hope the institutions that engaged in these transactions were sufficiently sensitive to trust law issues."
Melanie Fein, a partner at the Washington law firm of Arnold & Porter, said banks must prepare a detailed analysis of whether the new investment is prudent. For instance, the analysis should address how the objectives of the fund and the trusts are similar, she said.
Ms. Fein disputed the plaintiffs' arguments that banks benefit more from conversions than the beneficiaries. She said consumers often fare better with mutual funds because they are priced daily and are covered by strict consumer protections. Common trust funds are priced quarterly and covered by weaker regulations, she said.
Donald Smith, a partner at the Washington office of the Kirkpatrick & Lockhart law firm, predicted First Chicago will win.
To succeed, the plaintiffs would have to show either that First Chicago received unreasonable fees or that the conversion so harmed the beneficiaries that the bank violated its fiduciary duties, he said.
But Mr. Orlofsky, the point man for five law firms involved in the case, warned that many transactions are suspect.
Rather than provide a balanced disclosure of the conversions, banks highlight the advantages of mutual funds and downplay the negatives, he said. "I would be surprised if this were an isolated situation."
