Thanks to their robust disclosure policies, mutual fund companies are generally well-protected against investor lawsuits, but that won't stop lawyers from trying anyway.
Allegations of mismanagement, conflicts of interest and excessive or illegal fees can have severe financial and/or reputational risks on a fund company, and addressing these issues swiftly and seriously as soon as they crop up can make a tremendous difference in a firm's legal costs.
"Outside of the mutual fund area, there has been an explosion of litigation against securities firms," said Jonathan Eisenberg, of counsel for Skadden, Arps, Slate, Meagher & Flom LLP. Mutual fund cases, on the other hand, are almost never resolved through trial, he said.
"All these TV shows are a total lie," Eisenberg said. "There is a 99.75% chance that if you get sued in a securities act transaction, it won't go to trial."
Mutual funds tend to win far more often on motions to dismiss than companies outside the investment management field, Eisenberg said, but 'it is extraordinary the lengths" to which some law firms "will go to to find plaintiff cases."
Getting that motion to dismiss is critical for keeping litigation costs down, he said.
Defense costs can skyrocket if a case goes to discovery, said Mark Perry, a partner at Gibson, Dunn & Crutcher LLP.
"Discovery is the lion's share of litigation costs," Eisenberg said. "You should devote the absolute best job you can do to get that motion to dismiss."
Even if the lawsuit appears frivolous or unsubstantiated, when a fund company does get sued, there are several key steps that legal departments can take early on to strengthen their case.
"In the first few days after you receive a lawsuit, you have to have in place a standard document-retention notice," said Dana Pescosolido, vice president and deputy general counsel of litigation at Legg Mason. "Give your departments a document-preservation notice and sensitize them to the fact that they can't destroy these documents. But don't rely on that document-preservation notice alone. Go out and grab those documents before people thin out their files."
Jones v Harris
It is even rarer to see an attack on a mutual fund firm's fee structure, as these kinds of claims address the structural foundation of the entire mutual fund industry, Perry said.
Last November, the U.S. Supreme Court heard the fund fee case Jones v. Harris Associates, which challenges the 1982 precedent Gartenberg v. Merrill Lynch Asset Management. The Supreme Court is expected to issue its decision this spring.
"There is no news on Jones v. Harris until the Supreme Court makes a decision," Eisenberg said. "When they do, you can expect to get e-mails from at least 10 legal firms offering their opinions."
During its climb up the legal system, Jones v. Harris Associates 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 28 years of legal precedent that favors fund companies and challenge the way the $10 trillion mutual fund industry charges fees.
When the case was first heard in a Chicago district court in 2004, its focus was on whether it was unfair that Oakmark Funds' investment advisor, Harris Associates, charged retail investors nearly twice what it charged institutional investors and pension funds, thereby violating Section 36(b) of the Investment Company Act of 1940, which was 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 banks and the mandatory mailing of prospectus information.
Summary Prospectus
Most of the cases against mutual funds tend to be related to prospectuses, Eisenberg said.
"The plaintiff tries to prove there is a material error, such as a misrepresentation or an omission," he said. "But you guys generally write good prospectuses."
Mutual fund prospectuses are so thorough they can run hundreds of pages, including every possible bit of risk information. The prospectuses, including the statements of additional information, are full of legal disclaimers warning investors that their investments are not insured and can lose value. Most investors are overwhelmed by these giant mounds of paper and end up throwing them away-unread. In addition to the terrible waste of paper, regulators have long been concerned that investors aren't getting the information they need in a way they could use, leading to the plain English rule and eXtensible Business Reporting Language.
In November 2008, the Securities and Exchange Commission passed a new rule mandating a short-form, summary prospectus, written in plain English. The summary prospectus is to refer to the full prospectus, which is available online or by mail upon request.
The rule initially had firms worried that a shortened prospectus would make the industry more vulnerable to lawsuits, but these concerns were considered when crafting the new rule.
"There was an enormous amount of work done by the industry to make sure the summary prospectus wouldn't change the liability," said Daniel Steiner, executive vice president and general counsel of ICI Mutual Insurance Company.
The summary prospectus rule takes effect at the end of 2010.
Even if their prospectuses are water-tight, fund companies still need general liability insurance to cover lawsuits against directors and officers, shareholder derivative suits and other regulatory proceedings, said Ty Sagalow, chief innovation officer at Zurich Financial Services.
"A general liability insurance policy does not cover your liabilities," Sagalow said. "The vast majority of [financial industry] lawsuits fall into specialized areas. Every carrier has its own policy and the differences can be significant."
Coverage should include the funds themselves, general partners and asset managers, liability insurance for directors and officers, employment practices liability and ERISA liability.
"A financial institution under distress is a prime target for a number of claims that seem to come out of the woodwork," Sagalow said. "Whenever you have layoffs, you have unhappy workers. This leads to allegations of unlawful terminations and sexual harassment claims. When you have unhappy customers, you have an increase in limited liability claims."
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