Supreme Court ruling means aggrieved investors' best option is voting with their feet.
When it comes to mutual fund fees, the Supreme Court has essentially chosen to maintain the status quo. That means a fund's board of directors will continue to have wide latitude on setting fees charged to investors. It also means that investors who are unhappy with the fees should switch funds rather than sue in hopes of forcing a fund company to lower them.
The high court made the ruling recently in a case involving management fees charged by Harris Associates, which runs the Oakmark funds. In the case, some shareholders argued that the fees Oakmark mutual funds charged individual investors should be in line with the lower fees Harris charged institutional clients. An appellate court had earlier ruled that shareholders who sue over excessive fees must show that the fund's board had been misled. But the Supreme Court unanimously disagreed and sent the case back to the lower court for another look.
Suing to lower fund fees is already difficult, and the lower-court decision would have made it even harder. Instead, the high court largely upheld the Gartenberg case, which has governed lawsuits related to fund fees since 1982. Gartenberg held that suits can succeed only if the fee is so high that it is outside the range of what parties might reasonably negotiate in an arm's-length transaction (a fair transaction in which buyers and sellers have no relationship with one another). In nearly three decades under this standard, no fund company has ever lost a suit over fees.
Still, the Supreme Court underlined a couple of key points from Gartenberg that may give shareholders a little more power. Specifically, the high court noted that if key information is withheld from a fund's board of directors, then courts should review the deal the board made on behalf of shareholders. The court also said that boards should examine whether the fees paid are comparable to those paid by other clients when the services and investment strategy are comparable.
What are the chances that a management company would withhold key information from a fund's board? Surprisingly, it seems to happen pretty often. In the Oakmark case, for instance, plaintiffs uncovered some discussion at Oakmark about keeping the board in the dark about what institutional clients are charged. In a case that American Funds won in a lower court and that is now on appeal, evidence showed that for at least two years American refused to tell directors about portfolio managers' incentives.
When directors evaluate charges, they begin with a so-called 15(c) report, which compares a fund's fees with those of competitors. Remarkably, most boards allow the fund company to define the peer group. In the Oakmark case, for example, Oakmark Fund's fees were compared with those of just nine other funds. By my count, there are 51 no-load, actively managed, large-blend funds with more than $1 billion in assets. So, what happened to the other 41 funds that didn't make the peer analysis?
Little of what the management company tells a fund's board or how the board determines fees is in the public record until a lawsuit is filed. Consequently, investors have to sue first to find out whether they have a case. Regulators should make the process more transparent, and boards should take control of the 15(c) process. Maybe fund boards will act more vigorously to ensure that shareholders are getting a fair fee deal; maybe they won't. How lower courts--in the Oakmark case and in another case, involving the RiverSource funds--respond to the Supreme Court's decision will determine the degree to which shareholders benefit.
In any case, the strategy that investors should follow is still clear: Seek out low-cost funds with strong managers and let fund companies that overcharge feel it in the pocketbook.