WASHINGTON -- A robust, well-documented oversight process by mutual fund boards can help to keep investor lawsuits at bay, but good documentation is not enough. Experts say boards must also stay on top of a wide range of developments in derivative exposure and potentially misleading advertisements, among other things.

The recent, well-publicized Supreme Court decision Jones v. Harris Associates has reaffirmed the crucial role boards play in setting fund fees, and has heaped even more responsibility on directors.

In a unanimous ruling last month, the high court rejected the conclusions of the U.S. Seventh Circuit Court of Appeals and determined that for the time being, the 1982 precedent Gartenberg v. Merrill Lynch Asset Management is sufficient.

"This case underscores how important it is for directors to ask the right questions," said Jameson "Jamie" Baxter, vice chairman of Putnam Investments and chairman of the Mutual Fund Directors Forum, speaking at the forum's 10th annual policy conference.

Investor groups and mutual fund industry leaders both applauded the Court's decision to vacate and remand the more onerous opinion by Seventh Circuit Judge Frank Easterbrook, which would have made it nearly impossible to sue a mutual fund for excessive fees. The vagueness of the Gartenberg standard allows shareholders a small amount of flexibility to sue mutual funds, but the odds of winning a suit against a mutual fund are very slim. So far, few have. One recent, notable case, against construction equipment manufacturer Caterpillar, was settled last November for $16.5 million to 80,000 former and current plan participants.

"I think the Court got it right," Andrew "Buddy" Donohue, director of the Securities and Exchange Commission's Division of Investment Management, told the Forum. "Gartenberg was never an exclusive list of factors. Boards have a responsibility to look at a wide variety of factors."

Donohue said the Court also downplayed the comparability of fees to other funds, particularly institutional funds, and said the fiduciary responsibility of advisors does not require fee parity.

In its decision, the Supreme Court determined that it is not the court's job to decide or set mutual fund fees, but rather the duty of fund boards seated with a majority of independent directors, since they are better suited to make such calculations. To be in violation of Section 36(b) of the Investment Company Act of 1940, "an investment advisor 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," Justice Samuel Alito wrote.

"This is a wake-up call," said Marc Gary, executive vice president and general counsel at Fidelity Investments. "The best protection is to have an extremely robust and well-documented board process."

Although the mutual fund industry has largely remained outside the realm of President Obama's promised financial reform, the Senate version of the financial-overhaul bill currently working its way through Congress calls for a study of mutual fund advertising.

With many mutual fund advertisements now boasting outstanding one-year returns, the widespread practice of using past performance to sell funds is coming under fire.

Mutual funds are always careful to state that "past performance is no guarantee of future results," but that obvious disclaimer doesn't do much to help investors, according to a new study out of Wake Forest University and Arizona State University.

Strong returns are almost always attributable to luck, the study said, and advertisements focused on past performance after the recent bear market are misleading, since almost everything is up from a year ago.

"For most people, past performance is indeed relevant," Gary said. "Before you can render advice, the adviser has to provide you with historical performance data." Past performance also helps funds make sure they are properly classified, he said.

While the disclaimer may be behaviorally ineffective, it is legally vital, experts say. "People are going to want to know what has gone on historically," Baxter said.

This insistence to disregard past performance apparently extends to derivatives, which are growing in popularity among hedge funds-of-funds and even some alternative mutual funds despite having unraveled the global economy just two years ago.

At their basic level, derivative instruments are contracts derived from underlying assets or investments. Creative financial engineers can use derivatives to add exposure or hedge against practically anything, and there is essentially no limit to what these instruments can do.

"Derivatives have enormous benefits to managing portfolios," Donohue said. "They are a marvelous tool. You can change your portfolio without going to the cash markets."

The big problem, however, is that there is an increasing gap between the way the 40 Act deals with portfolios and the way managers are using derivatives, he said.

"Portfolio managers have the ability to totally change what they are invested in through the use of derivatives," Donohue said. "How do we deal with these instruments going forward? How should we fit this in the framework of the 40 Act?"

Just prior to the crash of 2008, the proliferation of derivatives led to an often unintelligible spider web of cross-investment in areas like collateralized debt obligations and credit default swaps, to the point that no one knew what was really in these instruments. When the bottom fell out of the market, these instruments turned into financial toxic waste.

Now that the economy is improving, many mutual funds are taking a fresh look at these instruments, but experts can't stress enough how critically important it is for board directors to understand how these instruments work.

"Derivatives have evolved in their complexity over the last five years" and will only continue to get more complicated, Baxter said. "Boards may not have expert knowledge, but that doesn't exempt you from responsibility. Directors can't stop trying to figure these things out."

"Before you buy derivatives or mortgage-backed securities, you need to get the right people on your audit committee to determine what they're really worth," said John Capone, an audit partner in KPMG's Boston office. "Check your prices and know where they come from. Ask if these are appropriate products for your mutual funds to invest in." If the portfolio manager is the only one who understands the investment, that should be a huge red flag, Capone said.

(c) Copyright 2010 Money Management Executive and SourceMedia Inc. All rights reserved.

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