Industry Defends Gartenberg Fee Ruling
Changes to Decades-Old Standard Could Rattle Firms
September 14, 2009
Mutual fund advocates are rallying together in preparation for a key Supreme Court battle this fall that could drastically change the way fund companies structure their fees.
The Investment Company Institute, the Mutual Fund Directors Forum, the Independent Directors Council and the U.S. Chamber of Commerce have all filed amicus "friend-of-the-court" briefs in the case of Jerry N. Jones et al. v. Harris Associates LP, scheduled to be heard by the U.S. Supreme Court in early November.
During its climb up the legal system, the case has morphed from its original goal of gaining fee equality for retail and institutional investors to its new attempt to reverse an appeals judge's controversial ruling, throw out 27 years of legal precedent that favors fund companies and call out the Goliath, $10 trillion mutual fund industry and the way it charges fees.
In its brief, the Chamber of Commerce said the high court would set a dangerous precedent that could reverse decades of reliance on independent board directors and market forces that have driven costs down over time.
"Litigation like this isn't about protecting investors from poor investment advice" on the part of boards selecting advisors, said Robin Conrad, executive vice president of the Chamber's policy law center. "The plaintiffs' bar is targeting the well-performing mutual funds because they hope to extract huge settlements."
No one is sure what will happen to fee governance if the plaintiffs win, but most experts anticipate a tidal wave of fee-related lawsuits with fees skyrocketing as a result.
"Extensive litigation over mutual fund fees would only serve to increase those fees, as the costs of litigation will be borne by the very investors on whose behalf it is ostensibly brought," said the Independent Directors Council in its brief. "Extensive litigation would also deter highly qualified individuals from serving as independent directors, undermining the governance scheme established by Congress and ultimately harming investors."
When Jones v. Harris Associates first began in a Chicago district court in 2004, its focus was on whether it was unfair that Harris Associates' Oakmark Funds charged retail investors more than institutional investors, and thereby violated Section 36(b) of the Investment Company Act of 1940, created to limit excessive investment advisor fees.
Individual accounts are almost always more expensive to manage than institutional accounts due to the customer service required to support retail clients through phone support and the mandatory mailing of prospectus information.
The court found the Oakmark fees to be in line with its competitors and ruled that the market, not the judiciary, should determine manager fees.
Investors Jerry N. Jones, Mary F. Jones and Arline Winerman took their case to the U.S. Court of Appeals for the 7th Circuit in Chicago, which affirmed the lower court's order.
Chief Judge Frank Easterbrook said that different clients call for different time commitments. Additionally, he said if the investors were so dissatisfied with the fees, they could have asked for lower fees or simply taken their business elsewhere.
He noted the 1982 landmark decision Gartenberg v. Merrill Lynch Asset Management, which determined that "to be found excessive, the trustee's fee must be so disproportionally large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining."
Easterbrook then went further and said investment advisors can charge whatever fees they like as long as they aren't excessive and don't involve fraud. This new precedent goes way beyond Gartenberg and makes it all but impossible for investors to challenge high fees.
Lawyers for the plaintiffs then shifted tactics and appealed to the high court to reverse the 7th Circuit's decision. They are arguing that the Gartenberg standard is inappropriate, relies too heavily on the marketplace and that most mutual fund fees are too high.
"For nearly three decades, the Gartenberg framework has provided fund boards and advisors with useful guidance, ensured investor protection, and served judicial economy by not embroiling the courts in technical disputes over business judgment," the Investment Company Institute wrote in its brief. "The improvements Congress made to fund governance are robust, and they operate to ensure that directors carefully and objectively scrutinize advisory fees."
The vast majority of the boards of fund companies have at least 75% independent directors, in addition to an independent chair or independent lead director. Thanks to market efficiencies and competition, the cost of investing in both stock and bond mutual funds has dropped by approximately 60% since 1980, the ICI said.
Big Role for Independents
"One of the independent directors' most important responsibilities is to annually evaluate and approve the advisory contract, including the amount of compensation provided to the advisor," a brief by the Independent Directors Council said.
The process has worked well for decades, and changes should not be considered lightly.
Absent a fundamental deficiency in the approval process, the IDC said courts should defer to the business judgment of the fund directors, but added that if fundamental deficiencies are found, a court should review the advisory fees applying to the Gartenberg standard.
The Securities and Exchange Commission has spent the last 15 years strengthening boards, emphasizing their independence and giving them the necessary tools to represent the interest of fund shareholders, said the Mutual Fund Directors Forum.
"The statutory regime relies upon an independent, engaged and able board," the Forum said. "Boards effectively use a Gartenberg-like approach to determine whether a contract is appropriate from the shareholder's perspective, and courts should ordinarily give deference to the conclusions reached by an informed, engaged board. Failing to give deference to a responsible board determination would, in effect, undermine the existing regulatory regime."
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