The U.S. Supreme Court's recent rejection of the fund fee case Jones v. Harris Associates will make it easier for shareholders to sue mutual funds for excessive fees, but it won't make it easier for them to take an excessive fee case to trial, let alone win.
In a unanimous ruling March 30, 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 was sufficient. The court sent the case back to the Seventh Circuit to try again. Interestingly, both sides hailed the ruling as a victory.
The 17-page decision, written by Justice Samuel Alito, determined that it is not the court's job to decide or set mutual fund fees, but rather the duty of independent fund boards, since they are better suited to make such calculations.
The core issue of whether funds can charge retail investors differently than institutional investors should be determined by Congress, not the courts, Alito said.
Courts may consider comparisons of fees charged to different types of clients, "but courts must be wary of inapt comparisons," he wrote, such as comparing fees of pension funds to money market funds. "If the services rendered are sufficiently different that a comparison is not probative, then courts must reject such a comparison."
"The Gartenbergstandard, which the [Seventh Circuit] panel rejected, may lack sharp analytical clarity, but we believe that it accurately reflects the compromise that is embodied in Section 36(b) [of the Investment Company Act of 1940], and it has provided a workable standard for nearly three decades," Alito said.
By sending the case back to the Seventh Circuit, the high court ignored the scholarly debate on economic theory between Seventh Circuit Judges Frank Easterbrook and Richard Posner, both appointed in the 1980s by Ronald Reagan and former colleagues at the University of Chicago Law School. Easterbrook and Posner have frequently collaborated on the economic analysis of law over the years.
"The Court essentially ruled in favor of shareholder plaintiffs against business in a case that could lead to more litigation," William Birdthistle, an assistant professor of law at the Chicago-Kent College of Law, wrote on the law blog Conglomerate. "Of course, had the Court ruled the other way, it would have been hard to imagine any plaintiff ever prevailing in these cases, and the judiciary would have read Section 36(b) out of the Investment Company Act."
Case History
Investors Jerry Jones, Mary Jones and Arline Winerman, filed suit against Harris Associates, their mutual fund's investment advisor, alleging a breach of fiduciary duty under Section 36(b), which was created to limit excessive investment advisor fees.
When the case was first heard in a Chicago district court in 2004, its focus was on whether it was unfair that Harris Associates charged retail investors nearly twice what it charged institutional investors and pension funds.
The defendants argued that their fees were unremarkable compared to similar funds, and added that 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.
The district court ruled in favor of Harris Associates, citing Gartenberg. The plaintiffs appealed to the Seventh Circuit, where their case took an unusual turn.
Scholarly Debate
In an article titled "Investment Indiscipline," recently published in the University of Illinois Law Review, Birdthistle detailed how the Seventh Circuit put the $10 trillion mutual fund industry on edge by challenging the way it charges fees.
"In his Seventh Circuit panel opinion, Easterbrook offered an alternative formulation of the Section 36(b) standard that effectively removes the fiduciary duty from the regulatory edifice," Birdthistle said.
Easterbrook's neoclassical decision replaced Gartenberg with a far more hostile standard, making excessive fee cases virtually impossible to win, Birdthistle said. Easterbrook decided that market competition is enough to keep fees down, and mutual funds should be allowed to charge whatever fees they want, provided they "play no tricks."
"[Easterbrook] presumed a well-functioning market for investment advice, discounted possibly irrational investor behavior, and concluded with a call for greater deregulation of the industry," Birdthistle wrote. "He concludes that the duty requires nothing more than that advisors refrain from defrauding their investors, notwithstanding that such prohibition was already imposed by the existing securities regulations."
In a dissent, fellow Seventh Circuit Judge Posner vigorously rebutted Easterbrook's arguments, instead taking a more behavioralist approach, Birdthistle said. Posner suggested the investment industry is not competitive, and that all investors might be overcharged for services.
"The governance structure that enables mutual fund advisers to charge exorbitant fees is industry-wide, so the panel's comparability approach would if widely followed allow those fees to become the industry's floor," Posner wrote.
Posner's dissent was sufficient to get the attention of the Supreme Court, who heard arguments forJones v. Harris Associateson November 2, 2009. After nearly five months of deliberation, the court decided that the Seventh Circuit just confused the matter and misinterpreted Gartenberg. The case was vacated and remanded in a 9-0 decision.
"We conclude thatGartenberg was correct in its basic formulation of what Section 36(b) requires: To face liability under 36(b), 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," Alito wrote.
In a separate but concurring opinion, Justice Clarence Thomas noted that while the court's decision acknowledged the Gartenberg precedent continued to hold up, "I would not say that in doing so we endorse the 'Gartenberg standard.'"
The mutual fund industry and independent directors applauded the decision following Tuesday's ruling.
"We are pleased that the Court's opinion confirms the central role of independent directors in the governance of mutual funds and gives deference to the conclusions of informed, engaged boards," said Carolyn McPhillips, counsel at the Mutual Fund Directors Forum.
"The Supreme Court's unanimous decision brings stability and certainty for mutual funds, their directors and almost 90 million investors," said Paul Schott Stevens, president and CEO of the Investment Company Institute.
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