Efforts on the part of the Vanguard Group of Malvern, Pa. to develop an exchange-traded share class may have been defeated last week after a U.S. District Court decision prohibited Vanguard from offering the new share class using its S&P index funds, according to industry observers.
The decision rendered by the U.S. District Court for the Southern District of New York limits Vanguard's options in developing the product and could force Vanguard to scrap its plans before the share class is ever issued, according to Daniel P. Wiener, editor of the monthly newsletter, The Independent Adviser for Vanguard Investors.
"Vanguard doesn't like to lose," Wiener said. "This is an embarrassment, so where they go from here is really unclear. Clearly they didn't introduce VIPER's [Vanguard Index Participation Receipts] in the third quarter of 2000 and unless they can cut a deal with S&P pretty soon, they won't be introducing them in the third quarter of 2001."
The decision upholds claims made by McGraw-Hill Companies of New York that Vanguard's use of the Standard & Poor's trademark and name with its VIPER's violated a 1988 licensing contract between Vanguard and S&P, a subsidiary of McGraw-Hills also based in New York.
McGraw-Hill argued in its complaint that Vanguard's VIPERs are a distinct product separate from conventional mutual funds and therefore not covered under the licensing agreement. It further argued that in the past, Vanguard sought S&P's approval each time it wanted to market a new fund using S&P's trademark. However, it did not seek an amendment nor did it notify McGraw-Hill that it intended to issue the VIPER share class.
"The parties, in considering that they needed a new agreement for each new marketing activity, showed their understanding as to the scope of the 1988 license agreement, limiting the license to Vanguard's then-existing and continuing use," McGraw-Hill's complaint said.
Vanguard has maintained that VIPERs are simply a share class of funds already covered under its existing licensing agreement with S&P. The VIPERs would be Vanguard's first exchange-traded product. But, Judge Alvin Hellerstein ruled in favor of McGraw-Hill.
"The issuance of VIPERs by Vanguard would enlarge the 1988 contract beyond the terms and scope of the McGraw-Hill license, thereby breaching the contract and infringing on McGraw-Hill's trademark rights," said Hellerstein in a memorandum.
Vanguard will appeal Hellerstein's decision, according to Brian Mattes, a company spokesperson. In the meantime, Vanguard's lawyers are considering the fate of Vanguard's VIPERS, he said.
Vanguard is considering adding VIPER share classes on its Small Cap Index Fund and its Total Stock Market Fund which track the Russell 2000 and the Wilshire 5000 indexes respectively, Mattes said. The new share class is covered under existing licensing agreements with both indexes, he said.
Since 1985, Vanguard has added share classes to S&P index funds 16 times, never informing S&P of the change, and there was never a problem, Mattes said.
In fact, McGraw-Hill is unwilling to allow Vanguard to use its indexes in conjunction with its VIPER share class because of agreements with other firms, Mattes said. In fact, Judge Hellerstein wrote in his memorandum, "There is no license agreement between the parties specific to VIPERs, for McGraw-Hill has been unwilling to license Vanguard to use its index data and trademarks in connection with VIPERs. At oral argument, McGraw-Hill represented that it cannot do so because of its other license agreements."
Currently, Barclays Global Investors of San Francisco is the only firm that offers exchange-traded funds based on S&P indexes.
Appealing the court's decision will further delay the issuance of the share class, something Vanguard cannot afford to do, according to Wiener.
"They are losing valuable time and momentum," he said. While Vanguard is spending time and money on the appeals process, other companies are gaining market share and establishing themselves in the exchange-traded fund market, he said.
Moreover, the odds against Vanguard prevailing on appeal are significant, said Mercer Bullard president and founder of Fund Democracy LLC of Chevy Chase, Md. and former assistant chief counsel at the SEC's division of investment management.
"The Second Circuit [New York Court of Appeals] has a lot of experience in analyzing federal securities laws, but very little experience analyzing the nature of a mutual fund," he said. "They may just get it wrong. There's going to be a three-judge panel and it's a toss up. You get the right judges, Vanguard will win. If S&P gets the right judges, S&P will win."
Reorganizing the VIPER share class as a separate offering of exchange-traded funds based on other indexes is another option, said Wiener. However, that would destroy the economies of scale provided by a share class of existing funds, according to Wiener.
"The problem is if they don't have the backing of that $100 billion-worth of assets in their 500 fund and the tens of billions in the other funds, they lose the tail wind of the ultra-low operating expense ratio that they can leverage off of those assets," he said.
Negotiating a new licensing deal for VIPER's with S&P is another option, but it is likely that S&P will drive a hard bargain in the negotiations, Wiener said. Vanguard's existing licensing agreement with S&P caps fees at a paltry $50,000 a year, according to Wiener.
"The way their contract is set up, had they not had a cap, they might be paying closer to $10 million a year," Wiener said.
Further complicating the matter is Vanguard's reputation for providing low cost index funds, he said. Paying S&P a bigger licensing fee would raise the cost of its VIPERs and compromise that reputation, Wiener said.
"If Vanguard can't provide value-added in having the lowest cost VIPER or ETF, then they become a me-too product," he said. "It's questionable then if they would even need to get into that business."
McGraw-Hill is more than willing to renegotiate its contract with Vanguard in order to include VIPERs in the licensing agreement, according to Steven Weiss, a company spokesperson.
"We would like to have a very good relationship with them and we are disappointed that they didn't come to us in the first place," said Weiss. "We would be open to discussing a variety of alternatives and options with them but they obviously have to approach us to do so, which, to this point, they have not done."
