Many mutual fund managers charge investors more than they should. Someone ought to do something about it, but should that be Congress, the courts, a government agency such as the Securities and Exchange Commission, or investors themselves?
The U.S. Supreme Court is considering this question. I suspect the courts are going to involve themselves more deeply, albeit reluctantly, in trying to protect investors. But the underlying problem is the way public companies are governed, and ultimately only Congress can do something about that.
The dispute before the Supreme Court involves three investors in the Oakmark family of mutual funds, managed by Harris Associates. Investors Jerry N. Jones, Mary F. Jones, and Arline Winerman contend that Harris breached its fiduciary duty under federal law by charging the funds too much for its services.
Harris notes that the fees were approved by the funds’ boards of trustees, and that they were in line with fees paid to other advisers by similar funds. But the investors counter that, like virtually all mutual fund sponsors, Harris controls the selection of the trustees who, in turn, approve Harris’ fees. The investors note that Harris charged the funds about twice as much as it charged other clients, such as pension funds, whose decision-making is genuinely independent of Harris. Harris replies that this is an apples-and-oranges comparison because mutual funds have different needs and require different services than pension funds and other institutional investors.
The case, Jones, et al., v. Harris Associates, was dismissed by a district court without trial. The Seventh Circuit Court of Appeals upheld the district court’s summary judgment, saying that Harris had done everything the law required of it by fully disclosing its fees to the funds’ boards of directors and to shareholders. The Supreme Court heard oral arguments last week.
The Seventh Circuit said the fees were a product of market forces, since shareholders were free to put their money elsewhere if they thought what they were paying was excessive. Writing for the majority, Judge Frank H. Easterbrook declared that the law requires only that investment advisers “make full disclosure and play no tricks.”
A driver who chooses to fill up at a station with a posted price higher than that of another station across the street cannot later sue because he paid too much. Likewise, according to the Seventh Circuit judgment, shareholders cannot retroactively claim that they paid too much when they knew the rate up front.
But, while the driver is responsible for picking his fueling station directly, shareholders do not directly negotiate fees with management companies, and that is where the analogy breaks down. Because shareholders must rely on boards of directors hand-picked by fund managers, Congress determined in a 1970 amendment to the Investment Company Act that investment advisers have a “fiduciary duty with respect to the receipt of compensation for services.” It is this duty that the Jones plaintiffs say Harris Associates violated by charging them an unfair fee.
The Supreme Court must decide whether disclosure by itself is enough to satisfy this fiduciary duty, as the Seventh Circuit ruled, or whether mutual fund managers and directors are obliged to take further steps to ensure fairness. If mere disclosure is not enough, which is what I believe the justices are likely to conclude, the case probably will go back to the lower courts to develop further evidence on whether the fee-setting process was fair to investors.
Our firm’s experience has shown how ineffective fund directors can be in representing investor interests. Back in 2006, my colleague Jonathan Bergman protested when Deutsche Bank proposed to triple the fee it charged a stock index fund that our clients had been using for six years. We withheld our vote for the fund’s directors, whose rubber-stamp approval was such a foregone conclusion that the bank reported it to the government four days before the vote was taken. The bank delayed the increase after we objected on our clients’ behalf, but it proceeded to boost its fees by 50 percent (rather than the original 200 percent) early this year, after the complaints and resulting adverse publicity died down.
If the Supreme Court decides that disclosure is not enough to guarantee that market forces will ensure fair fees, then Harris will have to provide more specific proof that its fees were fair. The Second Circuit’s 1982 decision in Gartenberg v. Merrill Lynch Asset Management, Inc. provides a test for the fairness of fees, saying that a breach of fiduciary duty occurs when an investment adviser “charge[s] 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.”
Most of the attention these days is on excessive compensation for corporate executives, not mutual fund managers. The two issues have one major element in common, which is the lapdog nature of many boards of directors who are supposed to represent the interests of the company’s owners, not its managers. While shareholders nominally elect boards of directors, nominees are generally selected by company insiders, leaving shareholders with little real choice. Boards of directors, then, end up being more beholden to management than to the shareholders whose interests they are supposed to represent.
Judge Richard A. Posner, a member of the Seventh Circuit Court, dissented from the Jones decision and tied it to the broader topic of executive pay. “Executive compensation in large publicly traded firms often is excessive,” he wrote, “because of the feeble incentives of boards of directors to police compensation.”
He is right. To address the problem, Congress should require public companies to adopt more democratic methods of selecting directors. Once shareholders gain some actual control over the companies that they own, management fees and executive pay will drop to reasonable levels, allowing courts and politicians to step aside.