Will the Supreme Court curb mutual fund fees?

Jones et al. v. Harris Associates is usually one of those legal cases only legal scholars pay any attention to. However, the consequences of the Supreme Court of the United States of America’s decision on this case could have wide ranging implications on the retail investor and may alter how much advisors are paid to sell and manage mutual funds (since I am not an American lawyer, all errors are my own).

Background

Congress passed the Investment Company Act of 1940 which, among other things, prohibited advisory fees which were excessive. Seems simple enough right?

However, what constituted “excessive” was interpreted so narrowly that most plaintiff/investors could not prove that advisors were paid excessive fees. Specifically, the test for excessive advisor compensation is known as the Gartenberg test and it boiled down to whether:

“the fee schedule represents a charge within the range of what would have been negotiated at arm’s-length in the light of all the surrounding circumstances. . .[to] be guilty of a violation of § 36(b) . . . the adviser-manager must charge 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 the abstract, the test is fine but it relies on the notion that arm’s length bargaining which, when the rubber hits the road, may not be a useful guide. Jason Zweig, commenting on the same case, disputed the notion that arm’s length bargaining occurs at all in setting mutual fund fees. The notion of fair value for fees is pretty subjective when the asymmetry of information favors the advisor.

Consequently, given such a high threshold of the definition of excessive compensation, few, if any, litigants have been successfully under the Gartenberg test.

Jones et al. v. Harris Associates

The case is pretty straightforward. Three investors who purchased shares in an open ended mutual fund commenced a lawsuit against Harris Associates alleging that the compensation paid was excessive and there was no arm’s length bargaining. Harris Associates had created the mutual fund in question and managed it.  The fund’s fees were set by the board of directors of the fund. The plaintiff’s lost at both the trial level and on appeal but this is where things get interesting.

On appeal, Chief Justice Easterbrook writing for the majority actually threw out the Gartenberg test and opted for a test that can be best described as “let the market decide and let’s get out of the way.” Chief Justice Easterbrook wrote unless an advisor “pulled the wool over the eyes of disinterested trustees or otherwise hindered their ability to negotiate a favorable price for advisory services” the Court should get out of the way and only step in when fees where unusual for the industry. In other words, short of fraud, there is no such thing as excessive advisory fees- a very high standard indeed.

A member of the Court of Appeal obviously disagreed. After the investors lost their petition to have the Court of Appeal reconsider the case, a judge requested a vote  on the request for the hearing en banc  (what this means is that one of the judges was not happy with the original decision and invoked its right for the entire Court of Appeal to rehear the case. This right is rarely invoked except for cases with large public policy implications). On being rejected on this request, Judge Posner wrote a stinging criticism of Chief Justice Easterbrook’s majority decision.

Specifically, Judge Posner found that a strict reliance on letting the market decide where the industry itself  is, in his opinion, subject to “rampant” abuses on the issue of compensation with “feeble incentives… to police compensation…” was not the right test to apply. Furthermore, permitting the Courts to only step in when compensation was unusual would lead to abuse since: “the governance structure that enables mutual fund advisers to charge exorbitant fees is industry-wide” and all you are doing is allowing the industry to set a high floor. Judge Posner argued, instead, that  the Gartenberg test was the right test to apply.

There are a few observations here that others have made: (1) Judge Posner is a Reagan appointee, fierce supporter of the Chicago School of Economics, noted jurists (you can’t go through law school without reading something written by Judge Posner)- in other words, this is not a battle between the political right and left (you know things are bad when a free-market judge with libertarian tendencies is taking a run at the mutual fund industry); (2) the appeal was heard in 2008 in the midest of the recession; (3) the Supreme Court of the U.S.A. decided to hear the appeal. The Supreme Court only hears approximately 1% of all petitions for appeal, meaning they deem this to be a very important case.

What does this all mean to you and me?

There are several ways the Supreme Court can decide the issue:

Uphold the new “let the market rule” test by Chief Justice Easterbrook in which case the mutual fund industry has scored a huge victory and efforts to curb the excesses of the industry will be focused on regulatory reform. Some have suggested that if the Supreme Court supported this test, it would have simply refused to hear the appeal.

The Supreme Court upholds the Gartenberg test and you end up back at status quo and a loss for the investor, given few have won under this test. However, equally importantly, the question is not whether it upholds the Gartenberg test but why. If, for example, the Court suggests that the Gartenberg tests prevails if there are true independent directors and outlines what a true independent committee looks like, it can be seen as a loss for the mutual fund industry.

Create a whole new test. In which case, it is anyone’s game to win or lose. For the mutual fund industry, the worst thing that the Court could do is to impose a new test that is so uncertain in its application that it may have to drop fees as a litigation prevention strategy (or the Court is radically split like the Court of Appeal which means someone else may take a run on this issue to provide clarity). Given that most mutual funds have thousands of investors, they are class-action lawsuits waiting to happen if the Supreme Court renders a more investor friendly test.

The true reforms on mutual fund fees should not be judicial in nature but regulatory. As the Zweig article rightfully points out, directors set fees but the directors are appointed by the fund shareholders and its hard to tell the person paying you that they should get less.  The regulators tend not to focus on these issues because their prime mandate is to ensure proper disclosure to the general public and not to comment on whether the contents of the disclosure are good or bad.

Regulatory reform to clear up the worst of the conflicts of interest in the industry as well as ensuring mutual fund investors are allotted seats on the board of directors of mutual funds would be a welcome start.  Until then, I will keep you updated when a decision is rendered.