What's at Stake as the Supreme Court Examines Fund Fees

Leggio: Professor Coates, a lot of shareholders don't know exactly how their mutual fund fees are set. As a background, Congress passed a law in 1940 called The Investment Company Act, which was later amended in 1970, which helps set the guidelines of how mutual fund fees are actually set. Can you talk a little bit about that framework for us?

Coates: Sure. The fees in the first instance are typically proposed by the advisors or sponsors of the funds, and then they are, in essence, negotiated with the independent trustees of the boards of the funds who are unaffiliated with the advisor.

And then after that negotiation, the fees are disclosed, pursuant to SEC rules, to the shareholders, to the investors in the funds. And then annually the investors approve the fees pursuant to the same mechanism that they use to choose the trustees.

That's the standard framework. And then the statute that you refer to allows investors--although in candor, it's usually lawyers representing investors--to complain about the fees in court if they think they're too high. And there's a standard that the courts then have to apply in evaluating the fees.

That's basically the process for fee setting.

Leggio: Before we get to that standard, in 1970, Professor Birdthistle, Congress amended the act to provide that investment advisors, Harris in this case, have a fiduciary duty with receipt to compensation. That's how the act is worded. Can you tell us a little bit about why Congress amended the statute?

Birdthistle: Sure. That's right. In 1970, Congress passed amendments to the Investment Company Act, and one of the most important ones was the one that Professor Coates referred to there at the end of his comment, which is Section 36b on the Investment Company Act. And it says, as you noted, that investment advisors have a fiduciary duty with respect to the receipt of compensation.

That's an important addition, because investment advisors typically, as a matter of corporate law, have fiduciary duties with respect to their own shareholders. That's the people who invest in companies like Fidelity and other advisors.

But in order to have a fiduciary duty with respect to shareholders in another business entity, that is the mutual fund, Congress imposed this Section 36b duty.

Why did they do it? Well it's always a difficult question to ask why 450 people did anything, why Congress passed the act. But there was a Senate report that accompanied the passage of the 1970 amendments, and in it there was a fair amount of language suggesting that Congress, or at least the people who signed the Senate report, thought that the market was somewhat uncompetitive.

They thought that the fact that funds are created by advisors--and then essentially dominated as a matter of management--created in their phrase an "incestuous relationship." And this attempt to impose a fiduciary duty was an opportunity for them, Congress, to allow shareholders who were disgruntled about the fees to have an opportunity to sue for them in court.

Leggio: And the big question that this case surrounds is really, what did Congress mean when they wrote "fiduciary duty"?

I know you disagree with Professor Coates as to specifically what the law requires. Maybe we'll start with you, Professor Birdthistle. In your opinion, what does it mean and how does that opinion differ from the famous Gartenberg standard that Professor Coates alluded to earlier?

Birdthistle: Sure. To understand what the lay of the land is now, just because Congress passes a passage or a law, doesn't tell us everything we need to know about what it exactly means.

And as you said, the phrase "fiduciary duty" is kind of a loaded one. It means a lot of things in a lot of different legal contexts. And so not surprisingly, it took a while for courts to add an additional gloss and to try to interpret that phrase and to come up with what it might mean.

The most important court to do that was the Second Circuit, which did it 12 years after the passage of the law. It did it in 1982. And what they said was that whatever this duty means, in order to violate the duty, the fees that are set have to be greater than something that could be achieved in arm's length bargaining.

Now that phrase is also somewhat vague. So they provided a set of factors--what have become known as Gartenberg Factors in the industry--and with additional cases, they were expanded to five or six characteristics. They included looking at things like costs of other mutual funds, fallout benefits, economies of scales, things like that.

What do I think it means now? That's a very complex question, and we're going to spend most of the remaining time talking about it.

What I think it means, broadly speaking, is that we've got a circumstance here where the advisers have a lot of control over the fees that are originally set. I think we also have a circumstance, when you look at empirical data, that a lot of shareholders don't actually spend an awful lot of time figuring out what exactly they're paying and knowing what it is at any particular time.

And I think what the fiduciary duties should help us do is to impose some sort of standard on advisors to treat similarly situated shareholders alike. And one of the big problems that occurs in the industry today is that there's a very large discrepancy in the fees that institutional investors pay compared with what ordinary shareholders pay, and that discrepancy is troubling. It's what caused Judge Posner to dissent in this case, and it's attracted a lot of attention.

I think that whenever we do come up with a definition of "fiduciary duty," I would like to see the Gartenberg Factors expanded to include an observation by the trustees and by courts, if necessary, to find out why those fees are different and if there's no good reason for them not to be different, for the funds to be equalized.

Leggio: Professor Coates, I know you generally agree with the Gartenberg Factors as laid out. Where do you disagree with Professor Birdthistle?

Coates: Well, I disagree with Professor Birdthistle in a couple of factual respects. I don't think it's fair to say that advisers are dominant in setting the fees. In the process I described earlier, there's a number of checks on advisers.

But even more important than the process I described earlier is the fact that investors of mutual funds, unlike customers of most other companies that sell them services, like auto mechanics, mutual fund investors can pull their money out at any time and reinvest somewhere else.

And they can do that for any reason, no reason at all, and they do it all the time. Between 25% and 70% of the funds out there experience net outflows, meaning more investors pulling their money out than putting money in at any given year.

And there are thousands of investment choices for investors to choose from and there is very specific competition in advertising, in marketing--which costs money for these advisers to pay for--focused just on fees. And as a result, over the past 20 years, the lowest fee funds have increased their market share significantly as investors have, in fact, used this competitive marketplace to discipline advisers.

So my first point of factual disagreement is just the claim that advisers somehow are free to set whatever fees they want. They're not.

A second disagreement--not quite stated this way by Professor Birdthistle, but I think implicit in what he said--was the idea that institutional investors and individual investors in mutual funds are similarly situated.

The average mutual fund account balance is in the neighborhood of $25,000. The average institutional account balance is in the neighborhood of $50 million. Institutions don't pull their money in and out on a frequent basis, not nearly as frequently as individual investors.

They don't need additional services like the ability to reallocate within a fund complex, the way typical retail investors in funds prefer. They don't need accounting services or tax tracking services. They don't need many of the kinds of things that mutual fund families provide to their investors. Not all of them of course do, but many of them choose to.

So I agree in principle with the idea that a court, in applying the Gartenberg standard, ought to take into account basically all relevant facts, including if there is evidence that there are similarly situated clients being charged one fee when another set of clients are being charged another fee. But you have to be very careful, and I think the courts should be careful, in saying what is similarly situated.

In this case, I'll point out the plaintiffs had an opportunity at the lower court level to convince--as they're required to do under the statute--the trial judge that the institutions were being charged a different fee than the individual retail investors and therefore the fee was unfair. And the trial judge who's closest to the facts in these cases didn't think they had made that case.

Leggio: And so generally, then, you are supportive of the Gartenberg Factors as they were originally laid out by the Gartenberg court, Professor Coates?

Coates: For the most part. I would disagree with the Gartenberg Factors in one respect. I should note by the way, the Gartenberg Factors don't rule out the institutional-individual comparison that Professor Birdthistle was pointing to. They certainly would permit a court to look at that comparison.

But one thing that the Gartenberg court said in passing, which other courts have picked up on and I think mistakenly applied, is the court said that because boards of mutual funds rarely fire their advisors, which is true, that therefore the competitive marketplace was not that relevant.

And I think what the court missed, then, and other courts have gotten even more incorrect, is to focus on the boards' choices as opposed to the investors' choices.

As an investor myself in Vanguard's S&P 500 fund, I would be very unhappy with the Vanguard board, the fund board, if the Vanguard fund board fired Vanguard and hired some advisor that I had never heard of, or even, frankly, Fidelity, for that matter. I would like, as an investor, to be able to choose between Fidelity and Vanguard.

So with that one exception, focusing on the investors in the marketplace, I think Gartenberg is perfectly fine.

Leggio: And I definitely want to get into the facts of this specific case and the competition landscape in the industry. But before we get there, I thought I would talk a little bit about the argument that you make in your brief to the Supreme Court, Professor Birdthistle, that we have had Gartenberg for a few decades now. There have been numerous court cases using these Gartenberg Factors against advisors, and yet, no shareholder has ever won in a court of law against an investment advisor.

And you write, "It is either no advisor has breached its fiduciary duty during that time, or as Johnson concludes and said, 'Something is amiss under Section 36b.'"

Professor Coates, I am going to give you this question first. Has no advisor done anything wrong in the last few decades?

Coates: To be able to answer that question, I think, honestly, would require far more fact inquiry than either Professor Birdthistle or I have been able to do, because you have to look at each individual case separately.

What I can agree with is that, to my knowledge, there has not been a trial following which a court has found fees unfair. On the other hand, I think it is important to bear in mind that very few of these cases go to trial. In fact, to my knowledge, less than a half dozen.

And the reason is not because the courts are ruling against the plaintiffs in the vast majority of these cases, or nearly all of these cases, or in all of these cases, as was just implied, but rather because most of them settle, as most litigation does. 90% or more of almost every case brought to the court system settles.

And there are strong incentives for the parties on both sides of a case, including the plaintiff lawyers representing the investors, to reach an agreement. Most of the time, both sides also keep those agreements confidential.

And so while I know secondhand that there have in fact been payments by advisors pursuant to these cases, that is, they have settled cases and they have paid money in damages as a result of these cases, I don't think anybody is in a position to say whether this is common or uncommon, because we just don't know.

Leggio: Professor Birdthistle, is that a fair characterization that in essence plaintiffs have won, it has just been in out of court settlements, not in actual court rulings?

Birdthistle: Well I think it is a factual observation. I think there is an enormous difference between attempting to settle a case in a legal context in which no plaintiff has ever won a verdict.

I will quibble slightly with your characterization. There has been a victory by a plaintiff in a court of law in one of these cases. It was not a trial, as Professor Coates pointed out. It was on appeal, and it was something of an interlocutory appeal. The case will go back to trial and now be reheard. That was in the 8th Circuit in Gallus v. Ameriprise a few months ago.

But sure, it is true that there have been settlements in these cases. How many or for how much? We have no idea. But I can tell you this: if I were a plaintiff's lawyer or any lawyer attempting to settle a case, I would far rather attempt to do that in a context in which there was some conceivable possibility of me winning the case. The difference in the magnitude of the settlement payout would be enormous.

If you've never won one, the kind of payout that it would take to make a plaintiff go away is going to be a lot lower than in a scenario in which a possible victory is on the horizon.

I will also just return for one second to Professor Coates' observation that there are a lot of differences between institutional and individual shareholders in this context. That is undeniably true. There are many differences between them.

And yet, across the industry, when institutional and individual investors are investing in very similarly situated funds, that is funds with the same strategic investments, same in actual investments and policies, the difference in fees is about two to one. Individuals pay about twice what institutions pay.

Now Professor Coates speculated as to why that might be true. There are a lot of differences. The size of the accounts is larger. There may be different transaction costs. But we don't know any of that.

As long as we are speculating, it's also possible that it costs more to maintain institutional clients. They're much more demanding. They have a much higher standard. You might have to put your best team to make sure they're happy.

We don't have that information. And it strikes me as surprising that we don't have that information, because if, in fact, it was there and it was true, I would imagine that the industry would be in a hurry to disclose the fact that the reason why they charge one customer twice what they charge another customer is borne out by a set of data. Why not produce that information?

The industry has resisted at every turn any calls for information justifying the discrepancy in costs. It could be there, as Professor Coates speculated, but it might not be there. The fact that they haven't turned it over suggests to me that they're not confident that it exists.

Leggio: Professor Coates, are you confident that there is a large difference in servicing institutional mutual funds compared to retail mutual funds using the same strategy?

Coates: I have exactly the opposite suspicion. Which is to say, plaintiffs' lawyers, when they bring cases under the statute that's in question here, have a right--as all federal court plaintiffs do--to get information from the companies they are suing.

They can get basically anything that they can argue is relevant from that company. Sometimes they have to keep it confidential, but they can get access to this information.

I know for a fact that many plaintiff lawyers have asked for the kind of information that would allow for the comparisons between institutional fund clients and retail fund clients, or institutional funds and retail funds.

And as Professor Birdthistle has emphasized, they have not yet won on the basis of those comparisons. If in fact there is a similar apples-to-apples institutional-retail fund comparison that can be made, the plaintiffs, under the existing standard, under Gartenberg, have every right to get that information, every right to put it on at trial, and every right to convince a judge that the comparison shows that the retail funds are being overcharged. And they have not yet been able to do that, including in this case.

Leggio: And that is the argument in this case by the plaintiffs. They charge that the retail funds, the Oakmark funds, they were charged twice as much, maybe more, than the institutional funds.

But the important thing is the profit levels, really, of both of those, isn't it, Professor Birdthistle? Because if they are charging the retail funds twice as much but the costs involved in servicing retail funds are twice as much, is the advisor in that case really breaching their fiduciary duty? And what do the facts show in this particular case?

Birdthistle: Oh, absolutely. You're correct about that. If there's a good justification for charging more, twice as much, or any amount more, then, of course, it's reasonable that they would do so.

I think Professor Coates overstates the implication of the evidence a little bit, because if you actually look at Gallus v. Ameriprise, the one case that a plaintiff has won, the court there was impressed by the fact that there was no justification for the discrepancy in fees. There's been a lot of studies that have also shown that this phenomenon is true.

And I think more broadly one of the most troubling facts that come up again and again in studies that have been performed as early as 1966 by William Sharp, a Nobel Laureate, and as recently as October 2009, this month, and published in the Journal of Finance is that this industry repeatedly demonstrates a negative correlation between the performance of funds and the fees that they charge.

Whatever that is, that is to say as performance increases, fees go down, as fees go up, performance goes down. That's not at all what you would expect in a competitive marketplace.

I think that fact is a very troubling one, about claims that this market is competitive. I think the fact that there is broad price dispersion amongst funds generally and amongst even very, very similarly situated funds is also troubling.

Whether the profit margins are different in this case, I don't know, because one of the things that repeatedly happens in these cases is that, as a matter of law, they're thrown out well before we get to trial.

So for instance in this case, when Chief Judge Easterbrook ruled that the market was competitive, he did so on his own motion, on his own observation. It's certainly not something that Congress agreed with when they passed the law. They said that the market wasn't competitive.

And it isn't something that he built on the facts, because as Professor Coates knows, very, very few of these cases ever go to trial. Many of them are tossed out well before any of the facts are discovered or debated in any sort of meaningful way.

So to make conclusions about the profit level in this situation, one can't know because it hasn't been discovered at a trial yet.

Leggio: And I definitely want to get to the competition issue of the industry--the competitiveness of the industry. But before I get there, I did want to note that the United States government filed a brief in this case, and it sounds like you, Professor Birdthistle, you, Professor Coates, and the government all kind of agree that the Gartenberg Factors should be used. Is that right, Professor Coates?

Coates: Yes. As I said before, as long as the court also makes clear that considering other competitive forces affecting the advisors should be part of the calculus. And I'd be interested to hear whether Professor Birdthistle thinks that that also ought to be part of the mix of information before the court.

Leggio: Professor?

Birdthistle: Sure, absolutely. As Professor Coates mentioned earlier, and he's exactly correct about it, the comparison of institutional and retail fees is something that was contemplated in the original Gartenberg decision. It was in a footnote and they declined to do it in that particular case.

But one of the problems when we talk about what standard should be applied in this case, is that to many people, to different people, Gartenberg means different things. So Gartenberg as it was originally written does contemplate for this comparison, and I would be delighted, and I think the petitioners would be, too, for that possibility to be actually done in practice.

But there's a difference between Gartenberg as it was originally written and Gartenberg as it has been applied over the last quarter century, in the Second Circuit and other courts where it's been used. And that factor has disappeared altogether as a matter of application of that case. I would be very happy to see it resurrected by the Supreme Court.

And I think it's true that where there are a lot of areas of agreement, particularly legally, on the fiduciary standard in this case that Professor Coates and I have, and that the U.S. Department of Justice have, it's also worth noting and pointing out that the Solicitor General of the United States of America filed on behalf of the petitioners. In that oral argument they'll be using time from the petitioners. They agree with the petitioners' interpretation of things.

So while we have a lot of areas in common, the fact that they came down on that side versus the industry side, I think is extremely telling, particularly in a case that involves private parties.

Coates: I can't help but follow that one up. The reason the Solicitor General is coming in on the side of the petitioners here is not because they agree with the plaintiffs on the facts. They're coming in because the lower court, not the trial court, but the appellate court below, wrote a new standard, which neither I nor Professor Birdthistle, nor as far as I know most of the industry agree with.

And so the Solicitor General is completely consistent in their approach here on the law with the vast bulk of the fund advisors out there. So in this there is agreement, and the fact that they're on one side or the other is simply a matter of -- frankly, it's a legal technicality.

I also have to correct one other thing that Professor Birdthistle said. While it is true that Professor -Sorry, he is a professor. Professor Easterbrook, who is also Judge Easterbrook in the lower court, ruled as a matter of law against the plaintiffs. The previous judge at the trial court level ruled against the plaintiffs after factual discovery and on the basis of all of the evidence that the plaintiffs had an opportunity to present, and he did so under the Gartenberg standard.

So in fact, the plaintiffs' position in the Supreme Court is exactly what they got at the trial court, and they lost before that judge. So there's a difference here between what the Supreme Court is reviewing on the law and what you can infer from the facts preceding the lower court opinion.

Leggio: One of the issues the Supreme Court will be reviewing, which was mentioned not only in the majority opinion of Judge Easterbrook and the dissenting opinion of Judge Posner, is the competitiveness of the mutual fund industry.

And that's where I want to go to next, because there is a big disagreement between you two and between the industry and the plaintiffs in this case.

Professor Coates, I'll start with you. The Investment Company Institute in their brief to the Supreme Court wrote, and I quote, "The mutual fund industry is virtually a textbook case of a competitive market, with many firms vying for cost-conscious investors." Question: do you basically agree with that statement?

Coates: Yes, it's factual. There are 8,000 funds, thousands of fund complexes. Even within a given segment there are numerous competitors all seeking to attract investor flows. Investment can be moved quickly and easily from one fund to another across the vast majority of accounts. Not all of them, but the vast majority.

And more importantly, new flows into the fund industry for which there is no impediment to choice have completely dominated the funds that have already been invested over the years.

So if you started with 1980 as your benchmark, the assets that were in place in 1980 are down to 5% of the current assets. That's how big the fund industry has grown over that period, and during that period every new investor has been able to make a free choice.

And finally, the evidence that's in the research that I've conducted shows that there's a very sharp price sensitivity between investors, so they look at fees and they choose to put their money in funds that have lower fees on average.

Leggio: There's no question that Morningstar research also indicates that investors are very cost conscious and look for the lower-cost funds. In addition, there are somewhere around 8,000 different mutual funds out there. Isn't the industry competitive, Professor?

Birdthistle: The number of products that are available and the size of the industry don't really suggest anything necessary about the industry's competitives. They are helpful, they would be good indicia generally. But we have more direct ways of asking whether or not the industry is actually competitive. Which is, for instance, to compare the fees and performance.

And as I said a second ago and I'll repeat now, we have something just out of this month's "Journal of Finance" that repeats a study that was found originally in 1966 by William Sharp, repeated by multi-million book selling author, Burton Malkiel. Numerous financial studies again and again repeat that fees and performance do not travel together. As fees go up, performance goes down.

I think it's true to suggest that there are some price-sensitive customers in the market, and I think those are the customers that go to low-fee, competitive index funds. It's also true, and these studies demonstrate, that there is an enormous pool of investors that are not particularly price sensitive.

And I think when you compare the findings of people as diverse and disparate as the American Enterprise Institute, which also found that there was a lack of competitiveness here, Judge Richard Posner, who also found that there was a lack of competition here.

And in fact even Don Phillips, the esteemed head of this division of Morningstar, said when looking at a study that demonstrated that the fees were not competitive in this market, said, "This study is dead on in its methodology and findings. The study is very damning. It shows that retail mutual funds are not competitively priced."

I'm happy to defer to the judgment and the impartial wisdom of Morningstar on that issue.

Leggio: Well, I don't want to defer to the impartial wisdom of Morningstar. I thought we could take a moment and look at one subset of funds specifically to figure out if it demonstrates that the industry is competitive or not.

Both of you are looking at our latest data on index fund fees. As you note in your law review article, Professor Coates, the majority of assets of index funds are in the lowest cost providers, and the data bears that out. The Vanguard 500 Index Fund has somewhere around $85 billion in assets, and the two other low cost funds, Fidelity has $13 billion, and Schwab has $6 billion.

Professor Coates, my question centers around two other funds that you see in this data table. If we assume that the T. Rowe Price Equity Fund is run at at least a small profit, you have $2.3 billion going into a fund which charges almost twice as much in the Dreyfus Fund and the BlackRock Fund which has $1.6 billion.

In a competitive marketplace, we normally wouldn't expect investors to tolerate paying upwards of two or three times as much for basically a commodity product. Doesn't this data really suggest that there really are some issues and some circumstances with a competitiveness in the industry?

Coates: No, I don't think it does. It's possible. I haven't looked at the facts of those particular fund complexes. It's possible that shareholder plaintiffs might be able to make out a case that the funds there are overcharging their customers.

But one thing to bear in mind is that when you choose a fund, at least when most investors, I think, choose funds, they're choosing a complex as well, and therefore the right benchmark in thinking about potential dispersion across funds even within the index universe is not simply at the fund level but also at the complex level.

So just to give a homely metaphor here, when I take my car into the Volvo dealer to have it serviced, I pay them to wash it for me. They overcharge me in some narrowly defined, strict sense of the washing cost when I have them do that, but it's convenient for me because I can get it done simultaneously and I can save costs by doing it.

If you look at the add-on cost for the washing there, they're having somebody who's doing it probably a little better than you could get it done down the street at the standalone auto wash. But combined, I'm happy to pay the total service because I'm getting a blended product across the whole complex that is in fact good for me.

And I have no reason to think that the customers of T. Rowe Price and BlackRock--and I don't think you do either--are somehow fooled into overpaying for their index fund fees. These are very easy to find out. You can find it out in three clicks on Morningstar. If they wanted to move their money and save whatever tiny fraction of a penny that it adds up to over time, they could do that.

Leggio: Professor Birdthistle, do you agree?

Birdthistle: I think it's possible that those are reasons why people are overpaying for those funds. I don't think there's any evidence of it beyond speculation that it's possible. I think if these are platforms where people can move in and out between funds and there's no reason to be obliged to stay with one fund family for all of your funds, very few people do that as far as I know. Most people have a broad mix of investments.

So there's also no real impediment to switching back and forth. The fact that they don't, I think is troubling. Yeah, broad price dispersion of 1, 2, 3, 500% in the same commodity product, that's troubling. That violates the law of one price in basic economics. There are reasons why it might be happening, as Professor Coates speculated, but I haven't seen any evidence of why it's happening.

Leggio: I've actually talked to some of the directors on these index fund boards, and they've told me that, in most cases, they are extremely reluctant to bid out services to other fund complexes, as you alluded to, Professor Coates, because they want to keep the services in-house.

I want to turn to board quality. Professor Coates, why shouldn't the boards, especially in a commodity type product, really just bid out for the services? It might be another advisor, a low-cost provider in the industry and just keep the same name on the mutual fund?

Coates: As I suggested before, the investors get to choose, not the fund board, in the first instance. I think the fund board's role is to make sure that the advisor is not doing something genuinely unfair for the investors in that fund.

But absent that, as an investor myself, if I woke up tomorrow and read in the Wall Street Journal that the Vanguard board--or let's pick BlackRock. If I were a BlackRock investor and I had chosen the BlackRock index fund, and I woke up to find the BlackRock fund board had fired the advisor there and had hired Vanguard, I would say to myself, "What are they doing? I could have chosen Vanguard. I could have done this in 30 seconds." And I have reasons, presumably, why I have chosen to put my money there.

Unless they've come to me and surveyed me and found out what my preferences are, I think, just in the abstract, that would be a mistake for a fund board to do.

Leggio: Professor Birdthistle, would it be a mistake for a fund board to choose a different advisor if that advisor can provide the same services at a lower cost?

Birdthistle: Sure. I agree with Professor Coates that it would be somewhat bizarre for a board to change the advisor. That is, after all, why many investors choose them.

I do think it's telling that Professor Coates switched his example from Vanguard to BlackRock, because Vanguard is really well known as an advisor that does aggressively auction out its funds to sub-advisors, and that's one of the reasons why it's the market leader and has rock-bottom prices.

Coates: It doesn't have rock-bottom prices. Fidelity has lower. And yet I would be just as unhappy if the fund board moved my money to Fidelity.

Leggio: Since we're talking about fund boards, I wanted to get a general sense of both of your opinions as to the quality of fund boards.

Professor Birdthistle, there has been evidence in numerous cases that either the fund boards had either incomplete data or maybe didn't look at the data correctly in some of the evidence that has been presented. What's your feeling as to the quality of fund boards in general in the United States?

Birdthistle: I think they've improved tremendously in the last three or four years. My experience was that following a lot of the market timing and late trading issues that arose in the early 2000s, a number of boards went looking more aggressively for very expert people to join the boards. And so the quality, I think, really spiked then.

But the quality, and in fact the intentions and good feelings of a lot of the board members, to my mind, is not really all that relevant. I think that boards, they meet three or four times a year, five or six if they're very diligent, and there's no way they can get their hands around all the information that would really be necessary to make a meaningful deliberation when you're talking about a fund family that has 200 funds.

It just can't be done. I have seen those, they are called Gartenberg review processes, when they set the fee annually. And you know, it's like speed dating going through the fund family.

So I think they're good people who are smart and have investors' well-being at heart. I'm not sure the process is terribly helpful, and I think I may be speculating, but I think that Professor Coates and I might agree that the role of the fund boards is not terribly critical to the functioning of this industry.

Leggio: Professor Coates, do you agree with that assessment?

Coates: Not entirely. I'm not sure that Professor Birdthistle agrees with this, but I believe that competition and investor choice is the more important force constraining advisor fees, that boards are, however, important, and they are important for two reasons.

First, there are many other functions that a fund board has to perform, such as reviewing conflict of interest transactions, that I don't think could be very effectively performed by anyone else. In Europe they're performed by regulators. I don't think that's a good model for our industry.

But even within the fee context, there's an important role for boards, which is that they can take account, for example, of growth in a fund and impose, as many have done over the years, break points in the fee schedule so that the fees, as a percentage, get lower as the fund gets larger.

They've done that in numerous instances, and I believe based on conversations with fund boards, that the quality of the board and the intention of the board does matter to whether or not they're able to achieve those cost savings for investors.

Leggio: The Supreme Court's decision is definitely going to have an impact on the fund board's role and the fee review process. Professor Birdthistle, in closing, how do you think the case will come out, and what will that mean, if anything, for mutual fund investors and mutual fund fees?

Birdthistle: I don't know how it's going to come out. I think it will be a close case. I think business cases typically are immune from some of the more profound political differences that separate the court, that split the court, in obvious constitutional contexts. And this year we're going to see a very heavy corporate/business term. There are a lot of cases up there that are involving business law.

But if I had to wager, I would wager that probably the four more left-leaning justices on the court will probably side with the plaintiffs, and the four more conservative justices would probably side with the defendants, even though Easterbrook and Posner are both somewhat conservative libertarian judges.

So I think, like many disputes, it may come down to the particular feelings of Justice Kennedy. I think that the two options that are viably on the table are Gartenberg, as it has been applied over the last quarter century, versus a Gartenberg-plus in which they vigorously look for a comparison between institutional and retail [fees].

I think what that suggests is that the possible outcomes are if it's a pro-plaintiff decision. And by that, one has to take into account the fact that these aren't just up or down decisions. There are many, many pages, often 60-, 80-, 100-page decisions. And there's a lot of emotion and language that can go into that that will inform lower court judges about how to proceed.

So I think you could end up with a possibly very pro-plaintiff finding that would, I think, impose some price discipline on the market, or I think you could end up with a status quo of Gartenberg.

But I think status quo is different when the Supreme Court ratifies the status quo. And I think it would be troubling, because I think to the extent that there are fund complexes that do not feel bound to impose the lowest possible cost on their shareholders that this would be a carte blanche to raise them higher.

I think it is also possible that in a pro-defendant finding, ruling, by the Supreme Court that the issue would probably make its way to Congress before very long.

Leggio: Professor Coates, do you agree that it's more likely than not that the Supreme Court will end up codifying some type of Gartenberg standard?

Coates: Yes. I think there is probably more chance than Professor Birdthistle does that the court might uphold perhaps a modified version of Judge Easterbrook's approach to this test.

We didn't really ever talk about it much in this conversation, but just to state it, Easterbrook took the position that if the board is there, and the board is independent, and the board gets good information and has a good process, then courts ought to take a very careful--they ought to be very reluctant to then intervene in a fee case.

And I could imagine the court maybe not going quite as far as Judge Easterbrook did, but taking into account that factor more heavily than prior courts had done.

I also think that another option on the table is Gartenberg-plus, but a different plus. Not to necessarily focus, as I think could be misleading on the institutional-retail comparison, although I think that ought to be part of the mix, but rather to allow lower courts to put more weight on the competitive forces that I firmly believe are very present.

And I will say one more thing. I think the Supreme Court will and should take into account something that we have not talked about, which is that there are costs imposed on fund investors by these cases. These cases are not run by investors. They are run by lawyers. They are run by lawyers who have their own interests. They are run by lawyers who face less competitive pressure than the fund advisors that they are attacking. They are run by lawyers who do not have to submit their plan for the litigation, or even get approval for the litigation to investors before they bring the litigation, after the litigation, anywhere along the way.

And to pretend that the court system here is sort of a cost-free check for investors is wrong. And so I do think the Supreme Court will and should take into account the possibility that if they greatly loosen the standard and sort of encourage more cases of this kind, that that in the end might actually worsen results for investors. It might lower fees slightly, but it also might lower performance, because in the end, the costs of the litigation are ultimately going to be borne by the investors themselves.

Leggio: Professor Birdthistle, I think that's an important point. If there is your type of Gartenberg-plus analysis where the profit levels or the fees of retail funds need to come closer in line with institutional funds, but then all that means is additional litigation, are shareholders really going to see a reduction in fees, even in the best-case scenario?

Birdthistle: Well, I think the boogeyman of increased litigation is almost a standard part of every defendant in front of the Supreme Court. Every time you are a defendant in front of the Supreme Court, you can say, "If we lose this case, more litigation will come."

I think it's equally plausible, or it's also plausible, that if they win this case, the costs will go up also. I don't know exactly. I don't think anyone knows exactly what the difference numerically will be.

But I think the judicial system has plenty of ways already of dismissing cases that are without foundation. And that happens all the time. Can you guarantee that you'll have a ruling in which no frivolous lawsuits will be brought? Of course you can't. People will bring them all the time.

But if, in fact, the fees do come down and there is no basis for a lawsuit, then the lawyers will lose. And after losing one or two, they won't bring many more.

So I don't think the possibility of a floodgate of litigation will be there unless of course they start winning, in which case it would suggest that there was something wrong.

Leggio: Well great. Professor Coates, Professor Birdthistle, thank you so much for joining us today.

Birdthistle: Thank you very much, Ryan.

Coates: Thanks for the invitation.

Leggio: And thank you for joining us. This is Ryan Leggio for Morningstar.