Commentary

It's crunch time for a key legal case that could have broad ramifications for mutual fund fees and governance.

On Monday, the Supreme Court will hear oral arguments in Jones v. Harris Associates. On one side will be mutual fund shareholders (Jones) arguing that Oakmark Funds violated its fiduciary duty and federal law by charging unreasonable fees. On the other, Harris Associates, Oakmark's advisor, will contend the fees were permissible and fair.

Monday's disputations and the court's ultimate ruling, which won't be rendered until next year, matter to more than just Oakmark shareholders. They will throw a spotlight on fund fees and on the debate over whether market competition--if it truly exists in the fund industry--is enough to regulate retail fund fees. They will also draw attention to fund boards and their effectiveness in policing fees.

Fiduciaries or Finaglers?
Some may wonder how the case got this far. If Jones and fellow shareholders were so concerned about Harris' fees, why didn't they just cash out and move their money to Vanguard or buy exchange-traded funds, like many investors and advisors have done in recent years? This issue is important, though, because investment advisors have a "fiduciary duty with respect to the receipt of compensation" from mutual funds, according to the Investment Company Act of 1940, as amended in 1970. Furthermore, the act says investors can sue if they think their advisors aren't living up to that duty.

There have been dozens of fund fee lawsuits over the years, but none of them has been successful because the burden of proof is heavy. The precedent that has set the standard for such cases for the last 27 years, a case known as Gartenberg, says investors have to prove that the advisor charges "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." The Gartenberg standard, however, has been ambiguous. Because no shareholder has ever won a lawsuit, no one knows what qualifies as a "disproportionately large" fee.

Jones v. Harris was on its way to becoming another inconsequential, defeated mutual fund fee lawsuit until a dispute over the case erupted on the Seventh Circuit Court of Appeals last year. First U.S. Circuit Judge Frank Easterbrook not only supported a lower court's decision to toss the suit out without a trial, he created a new standard. Easterbrook said the free market is the best regulator of advisory fees unless the charges are so out of line that a court could infer that they're the result of deceit. "A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation," Easterbrook wrote.

Mind the Institutional Gap
When the full seventh circuit later refused to hear the case, however, five justices signed a dissent by Judge Richard Posner who contended that in this case the free market might not be doing its job because of the "feeble incentives of boards of directors to police compensation." Posner said when trying to discern if mutual fund fees are excessive courts should be able to compare fees to those of institutional clients who usually pay considerably less.

The plaintiffs in the Jones case contend the difference between the management fees for the retail mutual funds involved-- Oakmark I, Oakmark Equity & Income, and Oakmark Global--and similar institutional and private accounts was significant. For example, Harris' management fee for the Oakmark Fund was 0.88% on assets of $6.3 billion at the time of the original lawsuit, according to court filings. The firm's management fee for providing the same services to an independent client was 0.45% on assets of $160 million. So, the Oakmark Fund paid approximately $55 million in fees, while the independent client paid only $720,000 for essentially the same investment portfolio.

The lower courts' decision didn't dwell on the difference between mutual fund and institutional client fees because Harris' contention that it wasn't an apples-to-apples comparison carried the day. Posner's dissent, however, revived the institutional/retail fee comparison. He pointed out that Easterbrook's market-based standard works only if fund boards are doing their jobs, negotiating competitive fees for fund owners. Posner had his doubts that this was the case. In his opinion comparing one mutual fund's fees with those of other mutual funds is of little use if all mutual fund fees are too high. "The governance structure that enables mutual fund advisers to charge exorbitant fees is industry-wide," he wrote, "so the panel's comparability approach would if widely followed allow those fees to become the industry's floor."

Is the fund industry's fee floor too high? Investors have favored lower-cost fund families in recent years. Low-cost leaders like Vanguard have garnered most of the traditional mutual fund inflows and low-cost ETFs have continued to grab market share. Yet publicly traded asset managers' operating margins remain the envy of other industries. You can also find big fee discrepancies between similar funds.

Who's Watching the Watchdogs?
Furthermore, fund directors have not earned renown as watchdogs. They often have no meaningful investments in the funds they oversee, and plaintiffs in other fee cases pending in federal court against other advisors, such as Ameriprise and Capital Research, accuse directors of not taking their responsibilities seriously. As Warren Buffett has written, "If directors were promised a portion of any fee savings they realized, the skies would be filled with falling fees. Under the current system, though, reductions mean nothing to 'independent' directors while meaning everything to managers. So guess who wins? When the manager cares deeply and the directors don't, what's needed is a powerful countervailing force--and that's the missing element in today's corporate governance."

So the question before the Supreme Court boils down to this: Do shareholders have to show that an investment advisor played tricks or otherwise misled mutual fund directors to prove a fund's fees are excessive and contrary to fiduciary duty? Or is a new standard, perhaps based on the gap between retail mutual fund and institutional fees, needed?

There are many ways the court could come down on these questions. It could rule that advisors just need to be honest with mutual fund boards during fee negotiations. Or the court could set a different standard, such as requiring that to meet their fiduciary duty, advisors should have similar net fees, or operating margins, for serving institutional and mutual fund clients. If that happens, the new standard could put downward pressure on fund fees where there is a big disparity between retail and institutional fees. That could take a long time, however, as lawsuits work their way through the system.

The Best Disinfectant
Regardless of what the court decides, the case pleads for more transparent fee disclosure. Investors should be able to see on their individual statements what mutual funds deducted from their accounts every quarter or year in dollars and cents, as well as a breakdown of how much money is going to investment management, administration, marketing, and other services. Then they'd be better able to recognize unreasonable fees and might even put more pressure on directors to do their jobs. That could be a countervailing force.
Ryan Leggio does not own shares in any of the securities mentioned above.