While the Supreme Court's ruling last week on a controversial lawsuit over mutual fund fees was viewed as a huge win by the mutual fund industry, the decision will likely put more pressure on the boards and managements of fund companies to defend their fees and could open the door to even more litigation.
While the Supreme Court's ruling last week on a controversial lawsuit over mutual fund fees was viewed as a huge win by the mutual fund industry, the decision will likely put more pressure on the boards and managements of fund companies to defend their fees and could open the door to even more litigation.
In the 2004 case Jones v. Harris, a group of investors sued Harris Associates LP, adviser to the Oakmark Funds, alleging that Harris breached its fiduciary duty by charging excessive management fees. Specifically, plaintiffs claimed that the fees were double what Harris charged institutional clients for the same services. The case raised concern among fund companies because it could have exposed them to a wave of fee litigation suits.
Last week, the court upheld a standard used by judges to decide if fund fees are too high. Known as the Gartenberg standard (named for the plaintiff in a 1982 court ruling), it basically states that fees should be determined from “arm's-length bargaining” between a fund's adviser and its board of directors.
But while upholding this standard, which favors the fund industry, the court rejected a lower-court ruling that would have seriously restricted investors' ability to sue fund companies over fees. In 2008, the 7th U.S. Circuit Court of Appeals dismissed Jones v. Harris, ruling that a fund provider hasn't breached its fiduciary responsibility so long as there is transparency and no fraud is committed when setting fees.
The Supreme Court said the lower court had gone too far, and instead stressed that the law — and not market forces — should decide mutual fund fees. The court pointed out that under the Investment Company Act of 1940, a fund's board members are charged with acting as the fund's fiduciaries and therefore are responsible for proving that its fees were properly negotiated. This, the court stated, should help keep fund fees from becoming excessive.
This ruling “could give some weight to excessive-fee cases,” said Gregory Ash, chairman of the Employee Retirement Income Security Act litigation group at Spencer Fane Britt & Browne LLP. “The Supreme Court took back the "get out of jail free' card that the 7th U.S. Circuit Court of Appeals had given investment advisers by saying they could just prove that fees were reasonable.”
Indeed, shareholder advocates see the court's decision as a victory. Mercer Bullard, president and founder of Fund Democracy Inc., noted that over the past 10 years, defendants in mutual fund fee cases increasingly have used the argument that market competition determines pricing. But now the court has thrown out that argument, he said.
“This is definitely a win for fund shareholders,” Mr. Bullard said. “They are more likely to win an excessive-fee case now than they were before the 7th Circuit opinion.”
“Now, when these cases are filed, courts are going to have to do a lot more digging to see if the board of directors and fund management fulfilled their fiduciary duties,” Mr. Ash said. “If a plaintiff is able to draft a complaint carefully enough to follow what is essentially a blueprint laid out in this opinion on how to establish a [legally viable] claim, they will at least get to summary judgment.”
Mutual fund industry representatives, however, don't see the court's decision as a win for potential plaintiffs in fund fee cases.
“That's a real stretch,” said Paul Schott Stevens, president and chief executive of the Investment Company Institute. “I think it confirms [that] the standard that we have been using is the appropriate one and is consistent with the text of the statute and the intent of Congress.”
Fund industry officials said the court's decision is a good thing not just for mutual funds but also for financial advisers who sell funds.
“Providing this clarity going forward is very important for everyone involved in fund investing, including someone recommending funds to clients,” Mr. Schott Stevens said.
By endorsing the Gartenberg standard, the court's opinion essentially assures advisers that fund directors are doing their jobs for shareholders, said Carolyn McPhillips, counsel with the Mutual Fund Directors Board. But it remains to be seen whether the decision will result in more fund fee lawsuits, she said.
Even if there aren't more lawsuits per se, the Supreme Court opinion does require that boards and management of fund companies prove that fees are appropriate, said Barry Barbash, a partner in the law firm Willkie Farr & Gallagher LLP and a former director of the Securities and Exchange Commission's Division of Investment Management.
For example, in its opinion, the Supreme Court stated that fund expenses can vary for different kinds of clients, but fund companies have to explain why higher fees for certain types of accounts are warranted. For example, firms should examine a fund's trading activity, services provided to clients and market costs when determining if it is warranted for one account to pay more in fund fees than another.
“Fund companies are going to need to be a lot more analytical with looking at their accounts and fees,” Mr. Barbash said. “A data dump isn't going to work.”
And if shareholders bring on fund fee cases, this kind of analysis could be done in court, Mr. Ash said.
But whether the opinion leads to a jump in shareholder lawsuits will depend largely on what the lower courts decide, now that the Supreme Court has kicked the case back down.
“The key will be to see how the lower court applies the standards,” Mr. Barbash said.
E-mail Jessica Toonkel Marquez at jmarquez@investmentnews.com.
