Upcoming Supreme Court Ruling Could Impact The Mutual Fund Industry … But Probably Will Not
Section 36(b) of the Investment Company Act establishes a fiduciary duty. Since a 1982 industry-favorable ruling, there has not been a single successful lawsuit against a mutual fund over management fees. The U.S. Supreme Court now is considering this issue. Mutual fund management fees may need to be reworked, or at least rigorously justified through analysis based on the costs of servicing the different classes of investors.
Section 36(b) of the Investment Company Act states:
"the investment adviser of a registered investment company shall be deemed to be a fiduciary with respect to the receipt of compensation for services."
The word “fiduciary” is not defined in the statute. Consequently, one would initially state that Congress was relying on the common law definition to explain this fiduciary duty. In Jones et al. vs. Harris Associates (Supreme Court Case 08-586), individual investors sued an investment advisor (who runs the Oakmont mutual funds) because the fees charged to individual investors were approximately double the fees charged to pension funds and institutional investors in the same fund. The individual investors claimed that fees twice that charged to others could only occur if the required fiduciary duty was being violated.
Last week, the U.S. Supreme Court heard oral argument in Jones vs. Harris. This case could be a big deal for the mutual fund industry. Separate classes for shares in the same mutual fund (and the related differences in fees charged) are quite common. The Street.com compiled data indicating that individual investors are charged double or more in around a third of the mutual funds with multiple share classes.
In 1982, the Second Circuit defined what a fiduciary duty meant in the context of mutual fund fees. The standard was set quite low, resulting in not a single successful lawsuit against a mutual fund over fees in the 27 years that followed this ruling. In Gartenberg v. Merrill Lynch Asset Management, 694 F.2d 923 (2nd Cir. 1982), the Court held that the Section 36(b) fiduciary duty is violated if the adviser charges a fee that is:
" so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining."
In evaluating this, the Gartenberg Court set forth the following factors:
1. The nature, extent and quality of services provided to fund shareholders
2. The profitability of the fund’s fees to the adviser
3. Fallout benefits to the adviser
4. Whether fee levels reflect economies of scale as the fund grows
5. The fee structure of comparative funds
6. The independence and conscientiousness of the trustees
Since 1982, most mutual fund boards of directors conduct an annual review of advisory contracts following these Gartenberg factors. However, the analysis is performed by boards of directors hired by the advisor whose fees the board is supposed to be negotiating. Despite the good wishes of any such board of directors, the conflict of interest is obvious. With this in mind, it is surprising that challenges to mutual fund fees have not been more successful, particularly with the large fee differences charged to different shareholders, as described above.
In Jones vs. Harris, 527 F.3d 627, 632 (7th Cir. 2008), the Court revisited the Gartenberg analysis. The Seventh Circuit loosened the Gartenberg decision, making it even more difficult to sue a mutual fund advisor. Because there had never been a successful suit regarding mutual fund fees since 1982, one must wonder how much of a better result the mutual fund industry could actually desire. Nevertheless, Judge Easterbrook rejected the Gartenberg analysis “because it relies too little on markets". Depending upon your perspective, Judge Easterbrook either (i) created a new free market standard that provides an even easier-to-meet standard, or (ii) eliminated the fiduciary standard altogether since any investor concerned with whatever is happening should have already sold the security and gone elsewhere. According to Judge Easterbrook:
"A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth."
A lack of fraudulent “play no tricks” certainly does not define a fiduciary duty in other contexts. Congress’s imposition of a “fiduciary duty” must mean something. In a sharply-worded dissent, Judge Posner, joined by Circuit Judges Rovner, Woo, Williams, and Tinder, explained the need for en banc review of the underlying panel decision. The dissent noted conflicts and abuses in the mutual fund industry that were ignored by the Jones vs. Harris decision. In the words of the dissent:
“Competition in product and capital markets can’t be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds. Mutual funds are a component of the financial services industry, where abuses have been rampant. … [C]onnections among agents in [the mutual fund industry] foster favoritism, to the detriment of investors. Fund directors and advisory firms that manage the funds hire each other preferentially based on past interactions. When directors and the management are more connected, advisors capture more rents and are monitored by the board less intensely. …
“A particular concern in this case is the adviser’s charging its captive funds more than twice what it charges independent funds. According to the figures in the panel opinion, the captives are charged one percent of the first $2 billion in assets while the independents are charged roughly one-half of one percent for the first $500 million and roughly one-third of one percent for everything above. The panel opinion throws out some suggestions on why this difference may be justified, but the suggestions are offered purely as speculation, rather than anything having an evidentiary or empirical basis.
“The governance structure that enables mutual fund advisers to charge exorbitant fees is industry-wide, so the panel’s comparability approach would, if widely followed, allow those fees to become the industry’s floor. And in this case there was an alternative comparison, rejected by the panel on the basis of airy speculation—comparison of the fees that Harris charges independent funds with the much higher fees that it charges the funds it controls.”
Had the Seventh Circuit simply left the Gartenberg decision alone, the U.S. Supreme Court would have had no reason to accept the case. With the benefit of hindsight, the mutual fund industry wishes that Judge Easterbrook would have left a good thing alone. Nothing demonstrates this more plainly than the mutual fund industry (now before the Supreme Court) supporting a return to the 1982 Gartenberg stand, and a rejection of their “success” at the Seventh Circuit. However, once the Seventh Circuit left the genie our of the bottle, the U.S. Supreme Court is now being encouraged by the Obama administration and a host of investor groups to change the Gartenberg standard to something that more closely resembles what the rest of the world considers a fiduciary duty.
As with many decisions in front of the current Supreme Court, Justice Kennedy will likely be the tie breaker. The four traditionally-conservative judges will likely accept the mutual fund industry’s position, and the four traditionally-liberal justices will want to at least reinstate the Gartenberg standard or perhaps expand upon it. During oral arguments, Justice Kennedy gave no indication as to how he would decide.
Although likely to side with the mutual fund industry, Chief Justice Roberts asked a number of questions that highlight the challenge raised by the Seventh Circuit standard before the Supreme Court in the current case, as well as in the long-standing Gartenberg standard from the Second Circuit. After asking multiple questions about what it means to be a fiduciary, Justice Roberts stated:
“I will just tell you the problem I'm having with the case. If I look at a standard that the fees must be reasonable and I compare that with what a fiduciary would do, I thought a fiduciary has the highest possible duty. But apparently the submission is the fiduciary has a lower duty, a lesser duty than to charge a reasonable fee. I just find that quite a puzzling use of the word "fiduciary”.... I don't know why Congress didn't use some other word."
Somewhat similar issues are at play in the current high-profile debate regarding the government’s role in establishing executive pay. If the U.S Supreme Court writes its majority opinion using broad language that decisions by the board of directors must be “fair” or “reasonable”, then the Jones vs. Harris case might be used as precedent involving a board of director’s obligations for publicly-traded companies in establishing executive pay. Most observers believe that the U.S. Supreme Court will fashion its ruling more narrowly, so that executive pay questions will not be meaningfully clarified.
Practically all commentators state that, should the U.S. Supreme Court alter the Gartenberg standard, mutual funds will need to decrease the fees charged to individual investors. But this may not be the case. One outcome of Jones vs. Harris is that boards of directors will simply need to be more analytical in their fees and cost analysis. Institutional investors deposit significantly larger amounts than the typical individual investor. Fixed costs of dealing with each investor are meaningful, so there is a sound economic basis for charging large investors less as a percentage of assets under management. But mutual fund advisors and their boards of directors rarely perform a rigorous analysis of these costs. Instead, advisors rely on competitive information about what charges the marketplace will bear. It may be that a doubling of charges for individual investors is sensible based on the costs of servicing each type of investor, but this requires a critique that the Gartenberg case does not currently require.
In other legal circumstances, a detailed analysis of fixed and variable costs is required. Our firm regularly performs such work for financial institutions and others in these other circumstances. In the case of many mutual funds, as is often the case in other situations, the analysis is complicated because additional fees exist that address overlapping situations. For example, load-fee mutual funds obtain additional compensation in certain situations when the shares are sold, and certain other fees might be charged to only smaller accounts. Regardless of these complications, even if the U.S. Supreme Court changes the Gartenberg standard, it does not necessarily follow that fees paid by individual investors would need to decrease.
A final decision in the case is expected by June 2010. If the U.S. Supreme Court decision goes back to the industry-friendly Gartenberg standard, then little/no change will result from the status quo. However, the Court could restore some form of fiduciary liability as it exists in the common law. This would mandate additional financial analysis to support the fees that are being charged to individual investors.
ABOUT THE AUTHOR: David Nolte
Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.