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The Legal Double Standard for Mutual Funds

It's difficult for mutual fund producers to lose a lawsuit, but it's a different story for corporate buyers.

John Rekenthaler, 01/04/2017

Presumed Innocent
It’s difficult for mutual fund producers to lose a lawsuit—or even face one.

They can launch whatever funds they like, no matter how bad the investment concept or venial the intent. They can rush to market with Internet funds at the peak of the New Era; sell “American” bond funds stuffed with Mexican and Argentinean debt (true story that); and peddle U.S. Treasury funds that have “yields” (once again, the irony quotes) spiked by capital gains made from selling options. Perfectly safe.

They can levy whatever fees they like. The next suit that a fund company loses for overcharging its customers will be its first. If there are rival funds with higher expenses, the fund company will successfully defend itself by stating that its costs fall within the normal range. If the fund has the single highest cost in existence, then the company will argue that somebody has to finish last, or that its investment process is uniquely expensive. Or something. Anyway, it always works.

They can say whatever they like, as long as it’s not an outright lie. Deception, however, is perfectly fine. Shareholders who sued Alliance North American Government Income Fund for holding mostly non-U.S. securities lost every case they filed (although, in a rare semi-victory for investors, Alliance eventually did settle out of court). As long as fund companies state things that are literally true, they are pardoned for giving false impressions, or for downplaying the relevant risks.

(For example, the short-term multimarket income funds of the early 1990s depended entirely on the convergence of European exchange rates, as governed by the exchange-rate mechanism. Mum was the word on that; shareholders learned only after the fact that their funds lived or died—died, as it turned out—because of a single risk factor.)

Presumed Not
The corporate buyers of mutual funds, on the other hand, face very real dangers on all three fronts.

Consider the latest action against 401(k) plan sponsors, filed in mid-December. It comes not courtesy of the usual plaintiff’s counsel, Schlichter, Bogard & Denton—Jerry Schlichter having invented the field of 401(k) class action suits—but instead from a Los Angeles firm, Solouki & Savoy. Legal diversification! (Or, from the perspective of plan sponsors, a sign that the zombie apocalypse is spreading.)

That suit implies that while mutual fund producers might be able to offer whatever funds that they wish, corporate plan sponsors enjoy no such luxury. Among its charges are that the defendant, Starwood Hotels, erred because it presented employees with a money market fund for their safe option, rather than a stable-value fund.

is vice president of research for Morningstar.

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