By Sam Mamudi

The mutual-fund industry is unhappy with elements of the financial overhaul bill passed by the House of Representatives last week, claiming that the proposals would go too far in their reach over funds.

The industry's trade group, the Investment Company Institute, took issue in particular with the part of the bill that would push mutual funds under the scrutiny of the Federal Reserve Board in cases where the funds are thought to pose systemic risk.

"It is wholly inappropriate to impose bank-like prudential standards on a mutual fund," wrote ICI to House leaders in a letter sent after the bill's passage. "We strongly object to granting the Fed sole authority to impose such standards even if...the Fed has discretion not to apply capital requirements--a fundamentally inappropriate construct for mutual funds."

The provision refers to "a financial holding company" and, in essence, states that regulators should keep a close eye on such companies with a view to clamping down on those that pose "a grave threat to the financial stability or economy of the U.S." As worded, the provision would include mutual funds.

This means that Pimco Total Return Fund (PTTAX), which has almost $200 billion in assets under management according to Morningstar Inc., could for example be considered a threat because of its size and thus come under the supervision of the Fed. Under the bill, the Fed could then prevent the fund from offering more shares for sale, or force it to sell some of its portfolio holdings.

Despite ICI's concerns, the bill still leaves it up to regulators to decide what would fall under their oversight.

"The Federal Deposit Insurance Corp. has the discretion to determine what assets a firm has under management that are owned by somebody else," said Steve Adamske, communications director, at the office House Financial Services Committee Chairman Barney Frank (D., Mass.), architect of the bill.

Adamske said that since the House bill was passed last week, any recourse that the fund industry would want would need to be sought in the Senate. The upper chamber has yet to put forward its own version of the bill.

Not everyone is persuaded by ICI's arguments.

"The ICI's position on systemic risk is not credible because of its position on money-market funds," said Mercer Bullard, associate professor at the University of Mississippi School of Law and president of Fund Democracy, an advocacy group for mutual fund shareholders.

"No one could seriously deny that money market funds are subject to "bank-like prudential standards" and that they pose systemic risk," added Bullard. "The ICI is correct that non-money market funds, which have demonstrated extraordinary resilience in the face of extreme volatility, do not pose systemic risk, but ICI's unwillingness to distinguish money market funds undermines their credibility. It suggests that they do not know what systemic risk is and should be ignored on this issue."

ICI wouldn't comment on the issue beyond the letter, saying it continues to work with Members of Congress.

ICI is also critical of other measures in the bill, notably a provision that would require financial companies with more than $50 billion in assets to contribute to a Dissolution Fund that would be used if the government was required to step in to unwind a failing firm.

The industry objects to having to pay for the Dissolution Fund because it says the Fund will never be used to help mutual fund shareholders.

Morningstar data shows that there are 13 mutual funds with more than $50 billion in assets -- seven funds from American Funds, four from Vanguard Group, Fidelity Contrafund (FCNTX) and the Pimco fund. The 13 funds have combined assets of about $1.2 trillion. The industry's view is that the bill is essentially creates a tax on the assets of investors in these funds, and provides nothing in return.

"Mutual funds cannot 'fail' in a manner requiring systemic resolution and their 90 million shareholders should not be at risk of having to foot the bill for those firms that can and do," said ICI's letter.

-By Sam Mamudi, 415-439-6400; AskNewswires@dowjones.com