Supreme Court to weigh in on excessive mutual fund fees
The Supreme Court took up a case Monday to determine whether fund fees are being determined correctly and whether investors get enough information to adequately understand the fees they are paying. The case made it to the Supreme Court when U.S. Circuit Judge Frank Easterbrook created a new free market standard for regulating advisory fees. He wrote in his decision in the case Jones v. Harris Associates that, "A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation."
In Jones v. Harris Associates, mutual fund shareholders made the case that Harris' Oakmark Funds charge considerably more to retail mutual fund shareholders than to institutional shareholders. They pointed, for example, to the Oakmark Fund that charges 0.88 percent on assets of $6.3 billion. The fund's shareholders pay $55 million dollars in fees under that arrangement. But for the exact same portfolio, an unnamed institutional investor pays just 0.45 percent on assets of $160 million for a total of $720,000 in fees. Is that fair? Or should fees for retail investors be comparable to those charged to institutional investors? That's the core of the issue to be decided by the Supreme Court.
Easterbrook's decision wiped out practices that have been in place since the Gartenberg case (Gartenberg v. Merrill Lynch Asset Management), which was decided 27 years ago. In Gartenberg, the ruling stated that to win a lawsuit, investors must prove that 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." This standard remains ambiguous because no shareholder has ever won such a lawsuit, so no one knows what "disproportionately large" actually means. Yet it's better than the free-market stance Easterbrook took.
By throwing out the long-time standard and replacing it with a free-market model, Easterbrook assured the decision would be taken to the Supreme Court. A decision is not expected until June, but the court will likely take one of four actions:
• Remand the case back to the First Circuit Court and ask that it determine what is a fair fee structure for mutual fund fees.
• Reinstate Gartenberg as the standard and overturn Easterbrook's ruling
• Create a Gartenberg-plus standard in which mutual funds will need to not only look at how their fees compare to other retail funds, but also to institutional funds
• Uphold Easterbrook's ruling.
So What Do They Mean By "Fair Fee"?
If Chief Justice John Roberts gets his way, it appears the Supreme Court will uphold Easterbrook's free-market standard, based on the questions he asked. Chief Justice Roberts did not appear to understand that mutual fund fees are not determined by performance when he asked numerous questions about how performance fits into pricing. But that could just have been to get the plaintiff on record regarding how he thinks fees should be set. One cannot always determine what's behind a justice's questions. Even so, Roberts seemed to like the idea of a performance-based fee model, which does not currently exist. Under practices in place today, your fund fees stay the same no matter how well or how badly your mutual fund performs. Based on his statements, though, Roberts does believe market forces should prevail. If a person doesn't like a mutual fund's fee structure they should just change funds.
Newly minted Justice Sonia Sotomayor appeared to be on the consumers' side and more supportive of a Gartenberg-plus standard. She asked numerous questions about how to set a "fair fee" and what a "fair fee" really means. She definitely seemed to indicate that in her opinion, standards for mutual fund fees needed to be clearer.
The SEC supported the plaintiff's positions. Chief Justice Roberts asked why, if the SEC had a problem with high mutual fund fees, it hasn't prosecuted a case on fees since 1980? The SEC answered that they had decided to focus on other areas and left it to fund boards to ensure fees were appropriate.
Once Again, Justice Kennedy Will Likely Play King Solomon
When the defendants took the podium, Sotomayor jumped in quickly and questioned how directors can be sued or held liable for their decisions. The defendant's attorney pointed to Section 36(b) of the Investment Company Act, the law that sets mutual fund standards, and said that even if the process in which the fee was established is acceptable, directors might be held liable if a fee was set extremely high. The law also states that even if the fee is not excessive, if the process for setting the fee is flawed, the directors could be held liable. Even the defendants don't appear to buy Easterbrook's ruling on free-market forces.
While it's difficult, if not impossible to judge how a case will be decided from the arguments heard, it did appear that the court will be divided again along conservative versus liberal lines, with the four traditionally conservative judges accepting Easterbrook's free-market ruling and the four more-liberal justices wanting to either reinstate the Gartenberg standard or expand upon it.
As has been the case with such splits in the past, the swing vote of Justice Anthony Kennedy will likely be the deciding factor. Hopefully he will come down on the side of mutual fund shareholders, who desperately need more information on mutual fund fees and their impact on long-term investments. Why should retail mutual fund shareholders pay the lion's share of the costs of managing mutual funds? It's time for this unfair practice to come to light, and for the SEC to require more disclosure about what mutual funds are costing retail shareholders.
Lita Epstein has written 25 books, including The Pocket Idiot's Guide to Mutual Fund Investing and The Complete Idiot's Guide to the Supreme Court.