The mutual fund industry is eager to hear the outcome of a U.S. Supreme Court case that could determine the fate of the Gartenberg standard, an old legal precedent used to determine whether mutual fund fees are too high that has set a high burden of proof for investors and spared the industry from lawsuits.
A district court in Chicago rejected an excessive-fee claim by three investors against Harris Associates' Oakmark Funds, maintaining that the market, not the judiciary, should determine manager fees. The plaintiffs took their case to the U.S. Court of Appeals for the 7th Circuit in Chicago, which affirmed the lower court's order.
More importantly, the 7th Circuit took issue with the Gartenberg standard itself, effectively setting a new precedent that goes beyond that standard to make it all but impossible to challenge high fees.
"The 7th Circuit found that even if a plan sponsor knowingly chooses funds with high fees, they are not in violation of their fiduciary duty," explained Mercer Bullard, founder and president of Fund Democracy.
The protection of the industry may now backfire; the plaintiffs appealed to the Supreme Court, which agreed on March 16 to take up Jones v. Harris Associates. The court will hear the case sometime this fall.
Investors Jerry N. Jones, Mary F. Jones and Arline Winerman own shares in several Oakmark funds. The investors claim the fund company was charging regular mutual fund investors higher fees than it charges third-party clients like pension funds, and said Harris' fees are so high they violate Section 36(b) of the Investment Company Act of 1940, which was created to limit excessive investment adviser fees.
Harris Associates has argued that it discloses all the fees it charges and considers them to be "unremarkable." Additionally, the three mutual funds in question had superior performance during the lawsuit's time period, the company said.
But the plaintiffs argued that Oakmark's average fees rose from 1993 to 2003, even as assets under management continued to soar to more than $11.7 billion and economies of scale should have been passed along to investors. The plaintiffs said Oakmark should charge retail investors the same low fees it charges institutional investors, arguing that it provides the same services to both investor classes. Oakmark countered that retail investors demand more services than institutional investors, and the court agreed.
Critics of mutual funds have long argued that fund companies incur few costs when adding new clients, and high, ongoing fees charged to investors represent almost pure profit to fund managers.
According to Morningstar, average mutual fund fees have gradually declined over the last decade.
"Harris Associates charges a lower percentage of assets to other clients, but this does not imply that it must be charging too much to the Oakmark fund," Chief Judge Frank Easterbrook of the 7th Circuit wrote in the May 19, 2008 decision. "Different clients call for different commitments of time. Plaintiffs do not contend that Harris Associates pulled the wool over the eyes of the disinterested trustees or otherwise hindered their ability to negotiate a favorable price for advisory services," Easterbrook added, implying that if the investors were so dissatisfied with the fees, they could have asked for lower fees or simply taken their business elsewhere.
Attorneys for the shareholders asked the Supreme Court to review 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," they said.
The outcome of the case "is very significant because mutual funds are now the investment vehicle of choice for most American investors," commented James Cox, a law professor at Duke University, last week. "They're the vehicle for planning for our retirements." Certainly, investors have been paying particular attention to fees lately as markets continue to drop.
The appeals court ruling concluded that the fund industry is a competitive business and dissatisfied investors can choose to move to lower-cost funds, Cox said.
The notion that mutual fund investors can switch to lower-cost fund firms is true up to a point, because investors in defined contribution plans-in which half the nation's retirement savings is held-typically don't have that flexibility.
"Many 401(k) investors are stuck in a high-cost fund, and many funds don't disclose their fees," Bullard said. Also, it's easier to overlook high fees when funds produce 20% annual returns, but fees really stand out during periods of average or poor performance, he said.
Setting a Precedent
"There has never been a case decided in favor of plaintiffs, although there have been lots of fairly sizable settlements," said Bullard, who served as an expert witness on the Jones case last year.
The 1982 landmark decision Gartenberg v. Merrill Lynch Asset Management determined that "to be found excessive, the trustee's fee must be 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."
The Gartenberg standard had flaws, Bullard said, but at least there was the possibility of bringing an ERISA claim against a fund company. Last year's ruling makes it even more difficult for individual investors to challenge high fees.
While plan sponsors and other fiduciaries could be held liable under Gartenberg, the 7th Circuit's decision said that plan sponsors can choose high-priced funds without violating their fiduciary duty.
"What are the fiduciary duties of retail plans to their clients?" Bullard asked. "This case is a failed cause of action," he said. "We need a different approach from Gartenberg. I would remove the emphasis on profitability.
"There is a lot more at stake with the Jones case," he added. "This case will be the overriding precedent for future Section 36(b) cases."
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