A New York probate judge has dealt a potentially serious setback to banks that invest common trust fund assets in mutual funds of unaffiliated companies.

In a surprise reversal of a steady easing of restrictions on the investment of common trust assets, Onondaga County Surrogate Court Judge Peter N. Wells held that a bank can only invest the assets in outside mutual funds if it also absorbs the fund management fees.

The ruling, though limited in its reach, alarmed banking executives, who said it was a blow to their efforts to expand investment options for common trusts. If it stands, they warned, the ruling could become a precedent for other jurisdictions.

It would especially hurt smaller banks, they added, which have come to view mutual funds as an important tool in managing common trusts.

"New York is a leading maker of trust law, which other states look to in setting their own," said Sarah A. Miller, senior government relations counsel at the American Bankers Association. "I'm concerned enough that I'm having my trust counsel committee go over it line by line."

"This decision steps back from the direction courts have been going - to provide as many options for trust vehicles as possible," added William J. Bosies, group vice president for government relations at the New York State Bankers Association.

The decision, issued last Friday in a case involving Onbank and Trust Co., a unit of Onbancorp, Syracuse, contradicts the state banking department's interpretation of New York law.

The court ruling bars the bank from passing along outside fund management fees, citing state law barring a bank from charging both trust fees and asset management fees within a common trust fund.

"It is elemental that what cannot be done directly cannot be done indirectly," wrote Judge Wells.

But the bank's attorneys and several outsiders criticized the decision as wrongly applying a law designed to prevent a bank itself from charging multiple fees to manage trust assets.

"If the decision is not reconsidered then the danger is that the banks - because they can't pass on these mutual fund fees - would limit the options for beneficiaries," said Mr. Bosies.

By requiring the bank to cover the management costs of mutual funds not managed by the bank, the judge has "effectively said you can't invest in mutual funds," said Bernard J. Karol, a law partner at Carter Ledyard & Milburn, New York, which will represent Onbank in its appeal.

The bank has used four mutual funds - two from Smith Barney Shearson and one each from Federated Investors and SEI Corp. - to hold cash awaiting distribution or investment within an equity and a fixed-income trust fund.

The equity trust held $7 million and the fixed-income trust had $15 million in 1994, Mr. Karol said, and the mutual funds were unlikely to exceed 5% of the trusts' assets at any time.

"Essentially, this is a piggy bank," he said of the bank's use of the funds. "It's a place to stash cash." He added that the bank hasn't decided whether to make any changes in the wake of the ruling.

Judge Wells' decision calls for a hearing to determine the amount of mutual fund management fees that the bank should reimburse to the common trust fund from 1984 to 1994.

One trust law expert said the ruling is so quirky that it may be short- lived. "It is highly likely to be reversed," declared John H. Langbein, a professor at Yale University. "This is a backwater little probate court in upstate New York, and it's an ignorant opinion."

He also maintained that the judge overreached in rejecting the state regulator's interpretation. "The public interest is most strongly served by encouraging small banks to get out of the money management business, which they're not good at, and to use mutual fund vehicles," Mr. Langbein said.

But a lawyer representing the trust beneficiaries' interests begged to differ.

"The statute itself is very clear on the issues of fees," the lawyer said, who requested anonymity. "I don't think this was a complicated issue at all, and I'd be very surprised if it gets reversed." He said the matter would likely have to be resolved in the state Legislature.

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