PALM DESERT, Calif. - Having exhausted their multimillion-dollar, class-action claims against big tobacco companies, the nation's top trial lawyers are now turning their attention to the mutual fund industry.
According to an expert panel gathered at the Investment Company Institute's Mutual Funds and Investment Management Conference here, these lawyers are using their old tricks-such as direct mailings and newspaper advertisements-to gather shareholders large and small to sue any mutual fund with deep pockets.
"These lawyers are essentially entrepreneurs," said Sean Murphy, a partner at the New York-based law firm Milbank, Tweed, Hadley & McCloy LLP. "When traditional claims dried up, they turned to mutual funds. Often, these lawsuits are not shareholder driven. These lawyers come up with a theory and find a way to make it work."
Fortunately for the mutual fund industry, courts have systematically narrowed the avenues of litigation to Section 36(b) of the Investment Company Act of 1940, regarding breaches of fiduciary duty.
Prior to 2002, plaintiffs were able to sue under many sections in addition to 36(b), but since then, dozens of courts have rejected private rights of action lawsuits, Murphy said.
"After the rejection of applied rights of action, plaintiff counsels turned their attention to 36(b)," said Charles Etherington, general counsel at American Century Investments. "They will try to shoehorn claims of a broad range into 36(b) claims and connect any wrongdoing to a fee."
"These lawyers are looking for things that are misleading that they can tie to underperforming funds," said Robert Skinner, a partner at the global law firm Ropes & Gray. "These are sophisticated, class-action suits. They are tracking down pension funds and big, institutional investors."
A common tactic in class-action claims is to gather as many plaintiffs as possible, he said. This is often done through direct mailings and newspaper advertisements that invite investors to join a class-action lawsuit and list a phone number to their law firm.
"A shareholder who owns $5 in a fund can bring a 36(b) claim," Skinner said. "These law firms want to generate a large enough settlement that will generate a large enough attorney's fee."
"Happily for the advisor industry, courts have been pretty clear that you must be a fund holder of the security in question to bring a claim," Skinner added. "Why would a shareholder in claim A want to sue in other funds she doesn't own? She wouldn't."
Shareholders have the right to sue for a breach of fiduciary duty, but fortunately for mutual fund companies, Section 36(b) puts the burden on the plaintiffs, which is the exact opposite of common law, Murphy said.
"Oftentimes these claims are untrue, and you're stuck with what they allege," he said. "The goal in a securities case is to win early and get a motion to dismiss."
This high burden of proof has protected funds from frivolous lawsuits, but many financial experts have argued that courts need a better precedent to protect investors from widespread industry price gouging.
The Gartenberg Standard
In the 1982 case Gartenberg v. Merrill Lynch Asset Management Trust, the Second Circuit stated that for an investment advisor to be guilty of violating Section 36(b), its fee must be so disproportionately large that it is not reasonably related to the services provided and could not have resulted from arm's-length bargaining between the advisor and the mutual fund.
The Gartenberg case stood as the standard for more than 25 years, until the Seventh Circuit Court of Appeals determined that the Gartenberg standard needed revisiting.
In the case Jones v. Harris Associates, investors Jerry N. Jones, Mary F. Jones and Arline Winerman claimed their fund company Oakmark Funds, owned by Harris Associates, was charging regular mutual fund investors higher fees than it charges third-party clients like pension funds. Furthermore, they argued that Harris' fees are so high, they violate 36(b), which was created to limit excessive investment advisor fees.
When they set out to sue Harris, the plaintiffs had no intention of challenging Gartenberg, said Skinner, who worked on the Harris case.
Skinner said the plaintiffs initially built their entire case around the Gartenberg standard, but in the end, the judge ruled that even though there were factual disputes, the fees were not disproportionally large compared to other fund companies.
The plaintiffs appealed, this time arguing that the Gartenberg standard was inappropriate, relied too heavily on the marketplace and argued that most mutual fund fees are too high, he said.
The plaintiffs' attorneys appealed to the U.S. Supreme Court to take up the case, saying the case "presents a recurring question of exceptional importance warranting the court's immediate resolution." Furthermore, the standard for claims of breach of fiduciary duty under the law affects "millions of shareholders who have trillions of dollars invested in mutual funds."
The Supreme Court agreed on March 16 to take up the case, and will likely see it sometime in the first two or three weeks of October, though the actual date could be anytime before June 2010.
"Whenever it happens, it will probably be right smack in the middle of your 15(c) process," Skinner joked.
Mutual fund boards can take evasive action to make sure they are prepared and protected against 36(b) lawsuits, such as making sure their 15(c) processes are as robust as possible, Etherington said.
Section 15(c) of the '40 Act requires independent board approval of the investment advisor contract and fees, so it's critical boards review these contracts with special care. "Don't avoid the difficult issues and be very aware of conflicts of interest," Etherington said. "Document that you've handled these problems and that you've resolved them. It's important to sit down and make sure you understand the process. Make sure you're plugged into the right venues for information flow, and have your chief information officer sign off on any disclosures."
"It's harder to prove a prospectus was misleading," Skinner said. "If you just got it wrong, it will be tough to claim that you were misleading clients."
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