Mutual Funds Go to Washington

John Rekenthaler

It's been quite the week for mutual funds in the Beltway. First, the Senate Committee on Aging convened a hearing on target-date mutual funds on Wednesday. Even though the wonk-to-excitement ratio for the hearing ran about 10:1, it was still kinda fun to watch the industry receive some legislative attention. Then, the Supreme Court reviews a case on mutual funds this Monday. The Supreme Court! Now that's not something you see every day. Or pretty much ever, as far as I recall.

And it's a big case too. At stake is the industry's fee structure. In brief, a 1970 Amendment to the Investment Act of 1940, called Section 36, states that investment advisers (i.e., fund managers) have a "fiduciary duty" in determining the level of a fund's fees. Exactly what this fiduciary duty entails has always been a bit murky. The Supreme Court appears to be in the mood to add some clarity by addressing the case known as Jones vs. Harris Associates L.P.

As with all Supreme Court hearings, Monday's session will not yield immediate answers. The final decision will be released next spring. However, there appear to be three possibilities for the Supreme Court's eventual ruling on Jones vs. Harris Associates L.P.:

1) Uphold the 7th Circuit Court's decision, known as the Easterbrook decision.

This would be a huge victory for the fund industry--too huge, as it turns out.

In the Easterbrook ruling, the 7th Circuit Court effectively absolved fund companies and directors from legal responsibility for setting fees, effectively arguing that the marketplace obviated the need for additional fiduciary protection. Under Easterbrook, fund companies and directors would be expected to bargain honestly, but their responsibilities would end there. If a fund company wishes to charge 3.5% annually for running a money-market fund, it is free to do so. You can ask $30,000 for a used Pinto, too. The Easterbrook argument is that in either case, nobody will be buying.

This would seem to be the ideal result from the fund industry's perspective. After all, what corporate executive likes legislation that limits how much the company can charge? (Legislation that limits how little a company can charge, on the other hand, tends to be quite popular. Funny, that.) But after its initial celebration, the fund industry realized that Easterbrook went a step too far. Under the Easterbrook dictum, shareholders essentially have no ability to sue a fund company or its directors for not acting on their behalf. Such a decision appears to violate the intent of the 1970 Congress, as by all accounts Section 36 was enacted specifically to give fund investors the weapon of legal recourse. Additionally, it's the wrong time politically to be dismantling investor protections. The fund industry recognizes that if the Easterbrook decision is affirmed, then the current Congress is likely to pass new, tougher legislation.

So even the fund industry is backing away from Easterbrook.

2) Reverse the 7th Circuit Court's decision and revert to the status quo: the Gartenberg standard.

This is what the fund industry seeks.

The Gartenberg standard, established by case law in 1982, have served as the legal guideline for interpreting Section 36 for 27 years now. They look strict, requiring among other items that mutual-fund fees be "within range of what would be produced by arms-length bargaining." However, they have the virtue, from the industry perspective, of being nearly toothless. The notion of being within the range of the prices established by arms-length bargaining is a flexible one, and in practice it has been interpreted quite loosely. Rather than benchmark themselves against truly independent arrangements, such as a motivated and powerful third party that forces companies to engage in competitive bidding, mutual funds benchmark themselves against other mutual funds. That is, organizations that do not put their prices out for competitive bids compare themselves against other organizations that do not put their prices out for competitive bids.

As fiduciary approaches go, this one is as soft as a baby's behind. In the 27 years of Gartenberg's existence, fund companies have lost exactly zero lawsuits on fees.

3) Reverse the 7th Circuit Court's decision, and reinstate the Gartenberg standards with a new tougher, interpretation.

This is what the fund industry fears.

With good reason. Consider how Vanguard treats its outside money managers. Vanguard conducts true arms-length negotiations. It has no loyalty to the managers whom it hires. It's quite willing to walk away from its first-choice manager if the price is not right, and select the second or third choice. In short, compensation conversations with Vanguard are no fun at all, and very different indeed than the type of conversation that a fund executive would have with its funds' boards of directors.

As a result, Vanguard pays management fees that are far lower than the industry average. For example, I randomly selected a Vanguard actively managed stock fund and found that the fund paid 12 basis points in management fees to its outside subadvisors last year. These same subadvisors run their own mutual funds, sold and distributed under their own companies' names, with their own boards of directors. Those funds each have management fees that are several multiples higher than what Vanguard collects.

Imagine the Gartenberg decision with fangs, with breach of fiduciary duty defined as not permitting a fund to carry fees that are noticeably higher than those fees negotiated by hard-nosed, informed third parties. To the fund industry, the vision of Gartenberg with fangs looks disturbingly like Dracula. Thus, the industry trade organization, the Investment Company Institute, calls Jones vs. Harris Associates L.P. an "attempt by trial lawyers to subject yet another industry" to a "new and unworkable legal standard." The dislike is palpable.

Finally, there is a fourth possibility--that the Supreme Court could toss out both the Easterbrook and Gartenberg standards, and establish a new approach (the Sotomayor dictum?). There's no predicting what such an arrangement would look like, except that it almost certainly would be tougher than either the proposed Easterbrook or the existing Gartenberg interpretation.

We'll be at the hearing on Monday morning serving as Kremlinologists, reporting back our sense of where the Court might be heading based on its questioning during the oral arguments. I'll post updates to my blog then.