Mutual fund investors may have a new hero. His name is Judge Richard Posner, and largely because of him, the Supreme Court will examine how mutual funds set their fees.
This past summer, Posner wrote a strong dissent in the Jones v. Harris Associates case, roundly criticizing the majority decision by the U.S. Court of Appeals for the Seventh Circuit, which said that mutual fund directors should have final say in setting mutual fund advisory fees. Posner disagreed, writing that relying upon mutual fund directors to set fees has been about as successful as relying upon corporate directors to set executive compensation. In other words, futile.
The case was brought by three investors in the Oakmark mutual funds, which are run by Harris Associates. At issue are the advisory fees Oakmark Fund investors pay Harris Associates, which are much higher than the fees paid by Harris Associates’ pension fund clients. Harris Associates is hardly the only mutual fund manager with such an arrangement, and academics who have studied the issue have a logical explanation: when searching for an asset manager, pension funds negotiate fees vigorously and at arm’s-length; mutual fund investors, on the other hand, are represented in those negotiations by the fund’s board of directors. The problem is that the board is almost always chaired by a representative of the mutual fund advisor, creating a bargaining position that’s more head lock than arm’s-length.
The Harris Associates case was brought under a law passed in 1970, which gave shareholders the right to go to court if they believed their fund’s advisory fees were excessive.
What’s excessive? Good question. The legal precedent in determining that had been what’s known as the Gartenberg decision, named after the plaintiff in a 1982 case against Merrill Lynch. Unfortunately for mutual fund investors, the Gartenberg decision turned the 1970 law into a toothless tiger, ruling that in order to be considered excessive the fee must be “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 other words, absent clear evidence of fraud in setting fees, mutual fund directors were given a great deal of discretion.
The problem is that when outsiders look at asset management fees, they often don’t seem disproportionately large because they’re looking at percentage points. Does an extra 0.3 percentage points seem disproportionately large for a money market fund? Well, probably not. After all, 0.3 percent is a small number.
But if you manage a money market fund with $20 billion in assets, that seemingly small difference of 0.3 percent provides an extra $6,000,000 in fees.
As a result of Gartenberg’s absurdly high threshold, mutual fund investors have never won an excessive-fee lawsuit.
Curiously, the Seventh Circuit’s majority opinion rejected Gartenberg, finding that it relied too much on judicial oversight, and too little on the wisdom of both fund trustees and the markets. “Judges would not dream of regulating the price of automobiles, which are produced by roughly a dozen large firms,” wrote Judge Frank Easterbrook in the majority decision. “Why then should 8,000 mutual funds seem ‘too few’ to put competitive pressure on advisory fees?”
But Judge Posner was having none of it. Refuting the notion that we should rely on mutual fund directors to police fees, he drew an analogy to the field of executive compensation, which he noted “often is excessive because of the feeble incentives of boards of directors….” And in response to the idea of relying upon the marketplace to keep fees in check, he said the marketplace “can’t be counted on to solve the problem because the same structure of incentives operates on all large corporations … including mutual funds. Mutual funds are a component of the financial services industry, where abuses have been rampant….” And in case the reader missed his point, Posner added that the majority decision “misses the point, which is that unreasonable compensation can be evidence of a breach of fiduciary duty.” (Emphasis added.)
The plaintiff’s attorney, armed with Judge Posner’s dissent, petitioned the Supreme Court to hear the case, which it agreed to do last week, placing it on the court’s fall docket.
It’s impossible to predict the outcome, of course, but there are a few undeniable reasons for mutual fund investors to be hopeful. First, the majority opinion is a decidedly pro-business ruling, which is a tough sell in the midst of a once-in-a-generation economic meltdown brought on by lightly regulated players in the financial markets. Second, as William Birdthistle, assistant professor at Chicago-Kent College of Law, recently pointed out, the Supreme Court accepts less than one percent of all cases they’re presented, so it would seem unlikely that they’d allocate a highly sought spot on their docket simply to maintain the status quo.
If the case in fact results in a re-examination of how much mutual fund advisors set their fees, it will be a great day indeed for fund investors everywhere, and they’ll owe a large debt to Judge Richard Posner.
