Could the Supreme Court Boost Mutual Fund Fees?
Investors in mutual funds may need to brace themselves for higher fees in the future if a case under review by the U.S. Supreme Court results in a substantially different legal standard for judging whether or not fund advisory fees are excessive. On Nov. 2, the Supreme Court heard oral arguments in Jones v. Harris Associates LP, in which the plaintiffs—individual shareholders in the Oakmark Funds—claim the mutual fund adviser, Harris Associates, violated its fiduciary duty by charging them fees that were double those the adviser charged institutional investors.
What complicates the case is the fact that Chief Judge Frank Easterbrook of the Seventh Circuit Court of Appeals, in ruling for the defendants, rejected Gartenberg v. Merrill Lynch Asset Management, a decision by the Second Circuit Court of Appeals in New York in 1982 that has served as the legal standard by which all excessive-fees cases have been evaluated for nearly 30 years.
The plaintiffs took the case to the Supreme Court claiming Easterbrook’s ruling requires plaintiffs to prove that the fund advisers “played tricks” on the fund’s board by withholding information in order to qualify as an excessive compensation claim under Section 36(b) of the Investment Company Act of 1940. The plaintiffs also urged the Supreme Court to take the case to resolve the split between circuit courts created when the Seventh Circuit Court rejected Gartenberg in May, 2008.
Oakmark Funds Had Higher Returns
The ramifications of the case are important for investors because of the extent to which higher fees can eat into their returns over time, even under normal market conditions. Standard & Poor’s considers expense ratios important enough to include as a key cost factor in ranking mutual funds on its MarketScope Advisor platform that launched in September. Over the past five years, for the large-cap growth funds S&P covers, the average return was 0.91%, while the average expense ratio was 1.4%, meaning investors were actually losing money. Compare that to one of the top-ranked funds in that group, which had a 4.1% return and a 1.3% expense ratio.
“Performance is important, but the expense ratio has to be lower for it to add value, otherwise you’re paying [into a fund] with limited benefit,” says Todd Rosenbluth, an equity analyst who helps S&P rank mutual funds.
In his ruling, Judge Easterbrook cited the fact that the Oakmark Funds had posted higher returns than the norm for comparable funds, “which implies that Harris Associates has delivered value for money.” In many cases investors would be willing to pay higher fees if the net performance result is superior, says Pearl Meyer, senior managing director at Steven Hall & Partners, which provides independent outside advisers to board compensation committees. “If you’re not getting incremental gains from the firm with high fees, then … go somewhere else,” she says.
A New Standard?
Recently, there’s been pressure on fees across the board, not surprising given the events in the financial markets, says Susan Ferris Wyderko, executive director of the Mutual Fund Directors Forum (MFDF), which provides education and other services to independent directors. And the Supreme Court’s review of Section 36(b) of the 1940 Act is occurring amid a much broader push to better scrutinize executive compensation as a result of the financial crisis.
A key question is whether the nation’s highest court will simply reaffirm the Gartenberg standard or feel compelled to come up with its own. There’s no consensus among legal or industry experts about whether a new standard would necessarily result in higher fees for mutual fund investors. But the fear is that a new standard would invite a wave of litigation to test its limits. Given the estimated millions of dollars it costs defendants to get a victory at the summary judgment stage of a case, it’s likely those costs would be passed on to investors, says Ferris Wyderko.
In a brief filed on behalf of the defendant with the Seventh Circuit Court, the Investment Company Institute (ICI), a trade association of mutual funds, characterized the case as “an attempt by trial lawyers to subject yet another industry to perpetual lawsuits by establishing a new and unworkable legal standard for evaluating excessive-fee claims against mutual fund advisers.” The ICI specifically objects to any outcome that would allow the court to consider advisory fees without giving appropriate weight to the annual evaluation and approval process by a fund’s independent directors.
Judge Focused on Market Forces
The mutual fund industry has long embraced the Gartenberg standard and it was Judge Easterbrook, who’s known in legal circles for his strong personality, who went beyond what the defendants were seeking by emphasizing the role of market forces in constraining fees over that of independent trustees’ fiduciary duty, according to Lynn Stout, Paul Hastings Professor of Corporate and Securities Law at the University of California at Los Angeles.
The powers of those trustees have been strengthened over the years through amendments to the 1940 Act “to give them the tools they need to fairly and adequately represent shareholders in the [fee] negotiations,” says Ferris Wyderko at MFDF. The result of that, plus extensive education programs offered by the MFDF and other groups, has been “a sea change since the beginning of this decade in the caliber of reviews given by independent directors of the determinations of fund fees,” she says.
Even if the Supreme Court devises a new mechanism that doesn’t meaningfully depart from reliance on independent directors’ assessments, it will probably result in higher fees for mutual fund investors, says Mercer Bullard, assistant professor at the University of Mississippi’s School of Law, who was deposed as an expert witness for the plaintiffs when the case was heard by the Seventh Circuit Court. He didn’t testify because the court ruled at the summary judgment stage before the case went to trial.
The Supreme Court should “simply adopt the Gartenberg standard and save everybody a lot of pain and money,” says Bullard. But he doubts the court will be modest enough to do that. The Court’s fairly pro-business stance suggests that any new standard could well raise the hurdle that plaintiffs would have to satisfy in order to win excessive-fee claim cases, he says. An opinion by the Court is expected by June 2010.
Retail Accounts Are Less Profitable
For all the drama around the implications of rejecting a longtime legal standard, the case’s central question is whether charging retail investors substantially more than institutional clients constitutes a breach of fiduciary duty by investment advisers, according to Stout at UCLA.
It makes sense for institutional accounts’ total fees to be cheaper than those for retail accounts, since the cost of phone calls, prospectus mailings, and other services to many small accounts makes those accounts less profitable for a fund adviser. The catch is that there are a lot of components in the retail fund management fee that make it hard to do an apples-to-apples comparison between the two kinds of accounts, says Russ Kinnel, director of mutual fund research at Morningstar (MORN).
The lack of transparency as to how fees translate into actual dollar costs for individual investors is the core issue that the Harris case doesn’t get at, says Rick Miller, founder of Sensible Financial Planning in Cambridge, Mass. Considering that mutual fund companies can provide your individualized performance, he finds it hard to believe they can’t tell you what it costs, at least approximately.
Aiming for Up-Front Disclosure
While it can be difficult to break out exact costs for different business models, it’s important that mutual funds disclose up front the fees investors pay, since investors are sensitive to fees and gravitate toward lower-cost mutual funds, says Karrie McMillan, ICI’s general counsel. “Overall, if you look at the bottom line in comparing fees, you’ll be comparing apples to apples. Investors tend to look at a fund’s past performance when deciding whether to invest in that fund, despite warnings that past performance isn’t a predictor of future performance. Since performance is net of fees—higher fees reduce performance—the investor is taking fees into account.”
The investment adviser and the fund’s trustees are, to a certain extent, wedded together by market forces since investors tend to buy into an individual fund because they like a portfolio manager and “neither know nor care about the fund trustees,” says Stout at UCLA. If the investment adviser decides to walk away from a certain fund because of disagreement with trustees over fees, investors would view that as “an extremely negative development” and probably follow the adviser, she says. That relationship gives both trustees and fund advisers limited room to bargain when it comes to setting and approving fees, she adds.
The Supreme Court ruling will ultimately decide who gets to determine what is an appropriate fee to be paid to investment advisers—the fund’s trustees or the court. “I would hope and I would expect that the Supreme Court, if it does tinker with the Gartenberg standard, does so in a way that recognizes that it isn’t in the interests of investors themselves to invite constant judicial review to this process,” says Stout.
Source:businessweek.com
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