A recent court ruling makes it harder for investors who want to sue mutual fund advisers over "excessive fees," but the case may be headed to the U.S. Supreme Court.
A recent court ruling makes it harder for investors who want to sue mutual fund advisers over "excessive fees," but the case may be headed to the U.S. Supreme Court.
If allowed to stand, the ruling could also mean that fund boards may eventually decide to relax the process by which they determine whether fees are excessive, industry experts said.
"I think [fund directors] will be acutely aware of all the implications of this," said Jeff Keil, president of Keil Fiduciary Strategies LLC, an industry consulting firm in Littleton, Colo.
LET THE MARKET DECIDE
The 7th U.S. Circuit Court of Appeals in Chicago ruled May 19 that it is inappropriate for it to get caught up in an analysis of the "reasonableness" of fees charged by Harris Associates LP, the Chicago-based adviser to The Oakmark Funds in Kansas City, Mo.
The market does a much better job than judges at determining whether fees are excessive, wrote Chief Judge Frank H. Easterbrook.
"Investors can and do protect their interests by shopping," he wrote, citing a study partly financed by the Investment Company Institute, the Washington-based mutual fund industry trade group.
Plaintiff's attorneys disagree, saying that they would ask for a new hearing.
Failing that, they are prepared to take the case all the way to the U.S. Supreme Court, said James C. Bradley, an attorney with Richardson Patrick Westbrook & Brickman LLC of Charleston, S.C.
"Our position is, [the ruling] was wrongly decided and conflicts with precedent," he said.
There is no doubt that it breaks new ground.
Since a 1982 ruling by the 2nd U.S. Circuit Court of Appeals in New York, courts have applied the Gartenberg standard — named for a plaintiff in that case — to excessive-fee claims.
That standard holds that for a fee to be excessive, the mutual fund 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."
SIX FACTORS
Courts typically consider six factors in applying the standard.
These are: the nature and quality of services provided to fund shareholders, the profitability of the fund to the adviser-manager, benefits other than the advisory fees that flow to the adviser or its affiliates as a result of the adviser's relationship with the fund, economies of scale, comparative fee structures and the independence and conscientiousness of the trustees.
The Gartenberg standard, however, "relies too little on markets" as a factor in determining the validity of excessive-fee claims, Mr. Easterbrook wrote. It requires that judges be "rate regulators," and that isn't a role they should play, he wrote.
Mr. Easterbrook's ruling seems to ignore the intent of Congress when in 1970 it passed a law — Section 36(b) of the Investment Company Act of 1940 — giving investors the ability to sue fund companies over excessive fees, said one prominent Boston-based fund attorney, who asked not to be identified, as her firm may be involved in similar future cases.
The mutual fund industry, however, is very different today than it was in 1970, he wrote.
There is much more competition, Mr. Easterbrook wrote.
As a result, it makes more sense to follow the text of the law, and that "does not create a rate regulation mechanism," he wrote.
Attorneys at fund companies praised the decision.
"I think the case is extremely significant and a very positive development for the industry," said James N. Benedict, chairman of the litigation department of Milbank Tweed Hadley & McCloy LLP of New York.
A look at the number of cases that cite Gartenberg explains why.
There have been 150 reported cases citing Gartenberg since 1982, according to an article in the March 1 issue of the Vanderbilt Law Review, published by the Vanderbilt University Law School in Nashville, Tenn.
None has succeeded at trial, but it has still cost fund advisers plenty.
"There [have] been loads of settlements," said John Donovan, an attorney with Boston-based Ropes & Grey LLP, which is representing Harris Associates.
Fund companies settle for various reasons, including the fact that it may cost them more to fight a claim of excessive fees than to settle, industry experts said.
DIFFERENT IMPLICATIONS
If the Seventh Circuit's decision sticks, however, that may change, Mr. Donovan said. "Defendants are going to be less inclined to settle," he said.
And plaintiff's attorneys will be less inclined to bring excessive-fee cases, Mr. Donovan added.
Those are the short-term implications.
Over the long term, fund boards may "change their negotiating dynamic" with fund advisers, Mr. Donovan said.
Fund boards follow the Gartenberg standard when determining whether fees are excessive, but they may decide that that is no longer necessary if the Seventh Circuit's decision is upheld, he said.
That is a big "if," some industry experts said.
"There are 11 courts of appeal," Mr. Benedict said.
"Each one has the ability to develop its own standard," he said. "To the extent there is a conflict, the Supreme Court is potentially in a position to resolve it."
The Seventh Circuit is alone in its interpretation of the law.
But a decision from the 8th U.S. Circuit Court of Appeals in Minneapolis in an excessive-fee case argued by the same attorneys who appeared before Mr. Easterbrook concerning Ameriprise Financial Inc. of Minneapolis is expected soon.
If that court agrees with his interpretation of the law, it will give fund attorneys a full head of steam heading into a possible showdown before the Supreme Court.
E-mail David Hoffman at dhoffman@investmentnews.com.
