Updated from 1:38 p.m.

McGraw-Hill, on behalf of its Standard & Poor's unit, filed a suit against Vanguard Group funds today that could stall Vanguard's planned launch of its exchange-traded index funds or ETFs.

The suit alleges that the index-fund titan's use of the S&P's stock indices in its planned ETFs, including the S&P 500, isn't covered by the licensing agreement the two firms signed in 1985. The suit charges Vanguard with breach of contract, trademark infringement and unfair competition and seeks a halt to the new shares' launch.

"They [Vanguard] are using our intellectual property in an unauthorized fashion," says McGraw-Hill spokesman Steven Weiss. The firm hopes to settle the issue prior to the fund's launch to save prospective investors any inconvenience or expense if the issue can't be settled.

Vanguard refutes the allegations, saying the new ETF shares don't require another licensing agreement since they are new classes of shares, not new funds. In a statement, the firm says it intends to "vigorously defend" itself against the allegation, which it calls "baseless and without merit."

On May 12, Vanguard announced plans to launch its exchange-traded shares -- called Vanguard Index Participation Equity Receipts or VIPERs -- as new share classes of nine of the firm's index funds. Vanguard hoped to launch the first five ETFs, including shares tracking the S&P 500 index, in the third quarter. The funds are intended to trade on the American Stock Exchange.

Vanguard's push into the burgeoning ETF market was seen by many as a necessity, since ETFs pose a direct threat to its core indexing business. The legal action, if not quickly resolved, could seriously hinder its efforts to establish a beachhead in this potentially lucrative market.

Unlike traditional mutual funds, exchange-traded funds price throughout the trading day and trade like stocks. Their popularity is a potent threat to traditional index mutual funds. Some $245 billion is invested in traditional S&P 500 mutual funds, according to Lipper; $104.8 billion alone is invested in the Vanguard 500 Index fund, the nation's largest mutual fund. Some $38 billion is currently invested in exchange-traded index funds.

McGraw-Hill's Weiss says Vanguard didn't attempt to discuss any licensing issues with McGraw-Hill prior to the May 12 announcement, adding that his firm is willing to discuss a licensing agreement that covers the VIPERs. McGraw-Hill has similar agreements with other firms that have launched similar products pegged to S&P indices, he says.

"We're still willing to speak with them about this. But we're not willing to let them launch investment products based on our intellectual property without our permission," he says.

Beyond legal allegations, the financial stakes are high for both S&P and Vanguard. The race for supremacy in the ETF market is expected to be won by the company offering the shares with the lowest annual expenses, setting the stage for a price war where additional licensing fees could be a real liability. Other funds are already paying the fees, according to Weiss, and Vanguard certainly would like to retain its advantage on this front.

In anticipation of a cheap S&P 500 ETF from Barclays Global Investors, State Street Bank & Trust dropped the expenses on its Standard & Poor's Depositary Receipts (SPY:Amex - news), commonly known as Spiders, to a maximum of 0.12% from 0.18%. On May 19, Barclays rolled out its iShares S&P 500 (IVV:Amex - news) with 0.09% annual expenses.

The annual expenses on Vanguard's 500 Index fund are 0.18%, the lowest among open-end index mutual funds. But its S&P 500 VIPER could be a tough sell if it doesn't beat Barclays' expenses.