High Court’s Fund-Fees Ruling Opens New Door

April 03, 2010

The U.S. Supreme Court sent a longstanding fight over mutual fund fees back to lower courts, and also served up what amounts to a glimmer of hope for any Davids with the stomach to take on Goliath.

The Supreme Court ruled last week to send a longstanding dispute on mutual fund fees back to lower courts and, by adding a subtle twist to its decision, all but assured that Jones v. Harris and other cases like it will be wending their way through the
U.S.
legal system for years to come.

In a 17-page ruling, Justice Samuel Alito wrote that courts, given the right suspicions, can now demand to learn why investment advisers typically charge mutual fund companies more for their services than they do big individual clients, such as pension funds. That possibility for extra judicial scrutiny never existed before, and marks a new way for shareholders to be heard, according to some legal scholars.

“When it goes back to the trial judge, he’ll have a new equation,” Professor William Birdthistle of the Chicago-Kent College of Law said in a telephone interview. “We’re looking at a test that’s still hard for plaintiffs, but it’s a test that’s easier than before.”

The case began in 2004 when investors in the Oakmark Funds sued the funds’ investment adviser, Harris Associates LP, charging that the fees they had to pay were twice what institutional clients were paying Harris. They argued that that constituted a violation of a section of the Investment Company Act of 1940 that imposes a fiduciary standard on investment advisers when they negotiate their pay. The plaintiffs lost that initial federal case in Chicago in 2007, as well as a subsequent federal appeal, also in
Chicago
.

In its decision, the High Court reaffirmed the validity of the so-called Gartenberg standard used to measure investment advisers’ fiduciary responsibility in the 1940 Act. The standard holds that fees are reasonable as long as negotiations are conducted by an impartial mutual fund board “at arm’s length” and weigh “all of the surrounding circumstances.” Fiduciary duty is breached when advisers’ fees are “so disproportionately large” that they “bear no reasonable relationship to the services rendered.”

The Investment Company Institute, the mutual fund industry’s trade group, applauded the Supreme Court’s emphasis on Gartenberg.

“The Supreme Court’s unanimous decision brings stability and certainty for mutual funds, their directors, and almost 90 million investors, by endorsing the Gartenberg standard under which courts have long considered claims of excessive fund advisory fees,” ICI President and Chief Executive Officer Paul Schott Stevens said in a press release.

In the earlier cases, the U.S. District Court ruled that the plaintiffs failed to prove Harris Associates had flunked the Gartenberg test, while the Seventh Circuit federal appeals court dispensed with Gartenberg completely, establishing outright fraud by the investment adviser as the true measure of a breach of fiduciary duty. The High Court specifically noted in its ruling that the appeals court had erred in relying on the investment adviser’s honest disclosure rather than on Gartenberg.

‘Gartenberg-Plus’

Much of the motivation behind the passage of the Investment Company Act of 1940 was to protect mutual fund shareholders from pricing abuses. Such concern only grew as the fund industry blossomed in the 1950s and 1960s, Alito wrote in the decision. The fiduciary standard that’s at the center of Jones v. Harris—so-called Section 36(b)—addressed those growing concerns when it was added in 1970 as an amendment to the Investment Company Act, Alito said.

The Supreme Court Justice called Section 36(b) a “delicate compromise” between the insufficient remedies that existed for shareholders before and the explicit control over investment adviser fees the Securities and Exchange Commission was pushing for at the time.

Since Congress amended the Investment Company Act in 1970, the mutual fund industry has grown exponentially, Alito wrote. Assets under management increased from $38.2 billion in 1966 to over $9.6 trillion in 2008. The number of mutual fund investors grew from 3.5 million in 1965 to 92 million in 2008, and now more than 9,000 open- and closed-end funds compete for investor business, the decision said.

Courts have long grappled with the balance that Section 36(b) tried to strike, and the Gartenberg standard, which came out of Gartenberg v. Merrill Lynch Asset Management, Inc. in 1982, has since been embraced as the most tangible guide to determining appropriate fees without dictating them.

“This standard has well served the interests of funds and fund shareholders, who have seen their cost of investing fall by half in the last 20 years,” Schott Stevens said in the ICI’s prepared statement.

But the standard is now a bit different, argued Professor Birdthistle, who summed up the carefully couched wording of the pivotal passage in Justice Alito’s decision as “Gartenberg-Plus.”

In that critical passage, Alito wrote: “[S]ince the Act requires consideration of all relevant factors … we do not think that there can be any categorical rule regarding the comparisons of the fees charged different types of clients. … Instead, courts may give such comparisons the weight that they merit in light of the similarities and differences between the services that the clients in question require, but courts must be wary of inapt comparisons.”

What this means in practice is that if it’s clearly established that a mutual fund’s board has decided on the investment adviser’s compensation through a rigorous and impartial process, the courts have no business meddling in the fund’s affairs. But if there’s any sense that the fee seems high and the compensation-negotiation process hasn’t met the Gartenberg “arm’s length” standard, it may be time to subpoena documents to shed light on who got paid what, and why.

Reading The Tea Leaves

Birdthistle said that the fund industry has long defended its fees with conjecture, and has failed to produce any empirical evidence definitively establishing that, say, the cost of servicing 10,000 investors in a mutual fund is more than the red-carpet treatment a single institutional client such as an endowment often gets.

“My sense is that if the answer were clear-cut, then the industry would have long ago presented a lot of data that showed exactly why these rates are twice what the individual rates are. But they haven’t done that,” said Birdthistle, who was the counsel of record for the amicus curiae brief more than 25 legal scholars filed in support of the petitioner in Jones v. Harris.

He said getting to the bottom of the fee question will take years in the courts as Jones v. Harris plays out and other shareholders file similar actions. Also, because Gartenberg puts the burden of proof on plaintiffs seeking remedies, small shareholders who sue will still have a tough row to hoe.

He suggested more efficient ways of gauging the effects of the Supreme Court’s decision. For example, a rising number of cases filed would probably suggest shareholders think they now have a better shot at making their cases. And if the number of out-of-court settlements of any new cases is high, that would probably mean the mutual fund industry is on the defensive.

Finally, Birdthistle asked, why not monitor fees themselves starting right now to take measure of whether the decision really changed anything?

“Certainly if you’re Morningstar or Lipper, you could run metrics and see if the discrepancy between individual and institutional rates starts to close. If it does, that suggests something happened on Tuesday.”

 

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