Supreme Court Cautious in Question of Regulating Mutual Fund Fees

• Tony Mauro , The National Law Journal
• On 3:03 am EST, Tuesday November 3, 2009

The U.S. Supreme Court appeared wary Monday of second-guessing the fees that mutual funds pay to the investment advisers who run them. The Court heard oral arguments in Jones v. Harris Associates, a closely watched case that could have major impact on the fee structure in the nation's $10 trillion mutual fund industry.

At issue is whether and when, under the Investment Company Act of 1970, shareholders in mutual funds can challenge what they view as excessive fees paid to investment advisers by the funds. Business groups urged the Court to stick with a 27-year-old standard that gives substantial deference to the funds, but investor groups said runaway fees have resulted from the overly close relationship between fund boards of directors and investment advisers.

Several justices appeared sympathetic to the business position, reluctant to involve judges in possibly vetoing marketplace decisions about fees. "It makes a lot more sense to have the SEC regulate rates than to have courts do it," Chief Justice John Roberts Jr. said at one point. An assistant to the solicitor general, Curtis Gannon, said that was right "in the abstract," but pointed out that the SEC had not filed a suit over mutual fund fees since 1980.

Later, Justice Antonin Scalia said the standard that the law would force courts to apply in assessing whether fees are excessive is "utterly meaningless," giving judges free rein to consider whatever factors they would like.

Susan Ferris Wyderko of the Mutual Fund Directors Forum, who attended the argument, came away optimistic that the justices would embrace the traditional standard for evaluating mutual fund fees established in Gartenberg v. Merrill Lynch Asset Management Inc., a 1982 decision by the 2nd U.S. Circuit Court of Appeals. Under that ruling, fees are left alone unless they are "so disproportionately large" that they could not have been the product of "arm's length bargaining."

That standard gives "an engaged, conscientious board" the independence necessary to determine if a fee is too high, said Wyderko.

But in a brief before the Court, John Bogle, an early mutual fund pioneer who has since become a leading advocate for fund investors, said many fund boards of directors are "captive" to the investment adviser who appoints them, giving them little power or incentive to "negotiate a hard bargain on behalf of fund shareholders."

The suit was brought by a group of shareholders in the Oakmark family of mutual funds, for which Harris Associates is the investment adviser. They claimed Harris charged the funds fees that, in percentage terms, were twice what Harris charged nonfund clients for similar services. The fund would have saved between $37 million and $56 million a year if they had been charged the same rate as other Harris clients.

David Frederick of Kellogg, Huber, Hansen, Todd, Evans & Figel, who represented the fund shareholders, told the justices, "the directors can't fire and walk away from the adviser. In any arm's-length transaction, if I sell you a car and you don't like the price, you can walk away."

Scalia countered that a fund board of directors could cut an adviser's fee in half. "He will pack up and leave and the fund will get a new adviser," Scalia said. "Doesn't that work?" Frederick replied that there is no "record I am aware of where that has actually happened. The directors have no leverage."

John Donovan Jr. of Ropes & Gray in Boston, representing Harris Associates, said a shareholder suit could still be possible if the process for arriving at a fee is flawed and has an impact on the fee, placing it outside the range of what could have been negotiated at arm's length with "other funds of a similar stripe."

The case arrives at the Court against a backdrop of public concern about excessive salaries and bonuses on Wall Street. "Some have suggested that the Court use this case to send a message regarding excessive compensation in corporate America," said a brief from the U.S. Chamber of Commerce. "This Court's task is interpreting statutes, not sending messages." The brief added that if government is to regulate compensation throughout the economy, "that kind of radical departure (which the Chamber would vigorously oppose) must come from the elected legislative branch, not the judiciary."

During Monday's argument, Roberts suggested that advances in technology are giving investors the information they need to decide if the fees are so excessive that they might want to take their business elsewhere.

"I mean, you can just look it up on Morningstar and it's right there," Roberts said. "And as an investor you can make whatever determination you'd like, including to take your money out."

Roberts' shout-out to Morningstar, an investment research firm, was notable, because Morningstar in 2007 analyzed Roberts' own investment portfolio -- which included 31 mutual funds -- as an example of what happens when "diversification runs amok."

In the case before the Court, the district court for the Northern District of Illinois dismissed the shareholder suit. Judge Charles Kocoras found that the fees were comparable to those paid by other mutual funds and that the amounts could have been agreed to after good-faith, arm's-length bargaining, as the Gartenberg standard requires.

On appeal, the 7th Circuit upheld the dismissal of the shareholders' suit, but rejected the Gartenberg standard. It said that courts should not disturb fee arrangements unless deceit is involved. "However weak competition may be at weeding out errors, the judicial process is worse -- for judges can't be turned out of office or have their salaries cut if they display poor business judgment," wrote Judge Frank Easterbrook.

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