In a unanimous ruling penned by Justice Samuel Alito, The Supreme Court has upheld a several decade long standard by which investment companies are expected to conduct its business. The term of art that’s used is “fiduciary duty.”
The decision affirms a standard that says to face liability “an investment adviser must charge 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.”
But the Court is very wishy-washy on drawing any hard and fast rules about how to make a liability determination. A key area of dispute is the comparison of fees charged to mutual fund clients (higher) than those to institutional clients (lower) like pension funds. The Court’s ruling says the discrepancy may be used as part of a court’s analysis in determining if fees charged to mutual fund shareholders are too high. “We do not think that there can be any categorical rule regarding the comparisons of the fees charged different types of clients,” Alito wrote.
Even in upholding the standard the Court acknowledges it lacks “sharp analytical clarity, but it accurately reflects the compromise embodied in [the Investment Company Act of 1940] as to the appropriate method of testing investment adviser compensation, and it has provided a workable standard for nearly three decades.”
Today’s ruling vacates the decision of the lower court and remands the case for further consideration thus making it a minor victory for the investors who sued.
Here is my backgrounder on the case: Nearly 1/3 of all Americans own mutual funds which are the favored investment vehicle for 401k retirement plans. There are about 8,000 of these funds totaling $10 trillion in assets. The managers of these funds also pocket about $100 million annually for their services but some groups including the Obama Administration feel that amount is too high and that current industry practices violate federal law regulating the mutual fund industry.
The question presented to the Court in this case is if fund advisors breech a legally required “fiduciary duty” when they charge fees that are deemed to be disproportionate. A lower appellate court didn’t think so when it ruled last year that Harris Associates management of Oakmark mutual funds were within federal law. But the judge who spearheaded that ruling went even further when he wrote “a fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.”
The suggestion that barring any malfeasance on the part of the advisor, market forces were sufficient to determine fees–no matter how large– rankled other members of the Seventh Circuit Court of Appeals who were unable to muster the votes to rehear the case. “Mutual funds are a component of the financial services industry, where abuses have been rampant,” Judge Richard Posner declared.
It doesn’t appear that fees charged by Harris Associates were out of bounds relative to other mutual fund advisors. In fact, given the outstanding performance of the Oakleaf funds it could be argued shareholders were getting tremendous value from Harris’ management. The objection rests in the suggestion that Harris’ fees when compared to the fees it charged for funds it did not manage was disproportionate. By and large, Harris’ fee schedule was in bounds compared to industry norms.
For that reason, a ruling in this case could have a huge impact on mutual fund managers. The AARP and a number of consumer groups have submitted briefs to the Court decrying the Seventh Circuit’s ruling and call for stricter controls on fund managers. The AARP brief argues the “imposition of excessive mutual fund investment fees jeopardizes the ability of countless current workers to become financially self-sufficient in retirement.”
On the other side of the argument are various financial groups who contend the mutual fund marketplace is working properly. They point to principles of supply and demand that show investors are loath to put their money in funds where managers charge above average fees. They further argue that a ruling against Harris will invariably lead to increased litigation and inconsistent rulings from judges who are not fully capable of determining fair compensation. They also see the lawsuit as nothing more than an attempt to jump on a bandwagon of popular opinion against high executive salaries. “This Court’s task is interpreting statutes, not ‘sending messages,’” says Richard Bernstein, lawyer for the U.S. Chamber of Commerce. He says it would be a “radical departure” for the federal government–especially judges–to get involved in regulating executive compensation.