Oakmark Lawsuit Highlights Mutual Fund Fee Issue
Is transparency enough to keep fund fees reasonable?
Fund Spy
As regular readers can attest, Morningstar is always pushing for reasonable expense ratios on behalf of shareholders. Although we're not the only one out there calling for lower fees, it isn't every week we read about a shareholder lawsuit against a fund we cover (and a Fund Analyst Pick at that). But that is exactly what happened to Oakmark I (OAKMX), which is managed by Bill Nygren and Kevin Grant. (For more background on the lawsuit, please see this New York Times article.)
The issue before the Seventh Circuit Court of Appeals was whether the investment adviser to Oakmark, Harris Associates L.P., breached its fiduciary duty by charging excessive fees in violation of Section 36(b) of the Investment Company Act of 1940. The test used by many courts (the Gartenberg test) is if the fee schedule is within the range of what would have been negotiated at arm's-length, then the fee schedule is not excessive and there is no breach in fiduciary duty. Plaintiffs argued Harris may charge its mutual fund clients no more than its other clients; in this instance, Harris charged mutual fund clients twice the management fee it charged institutional clients.
The Seventh Circuit rejected the Gartenberg test and replaced it with a simple requirement: transparency. Judge Easterbrook, writing for the majority in upholding Harris' mutual fund fees stated, "A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth." Easterbrook makes one qualification to this rule: if the fees are "so unusual" that a court could infer that deceit must have occurred. (See the full text of Easterbrook's opinion.)
However, fellow Seventh Circuit Judge Richard Posner rejected this new test and the logic behind it, writing in dissent:
The panel's "so unusual" standard is to be applied solely by comparing the adviser's fee with the fees charged by other mutual fund advisers. Gartenberg's "so disproportionately large" standard is rightly not so limited. The governance structure that enables mutual fund advisers to charge exorbitant fees is industry wide, so the panel's comparability approach would if widely followed allow those fees to become the industry's floor. And in this case there was an alternative comparison, rejected by the panel on the basis of airy speculation�comparison of the fees that Harris charges independent funds with the much higher fees that it charges the funds it controls.
(See the full text of Posner's opinion.)
The reason the tests are such polar opposites (Easterbrook is deferential to fund board oversight of fees while Posner is inherently skeptical) is because the starting point for each of these "law and economics" judges is so different. Easterbrook's economic analysis is that due to ample competition in the mutual fund industry, only transparency is required because high fees will drive investors away. Posner is skeptical since investors may be left with an industry full of higher fees than a free and competitive market would predict because of the "feeble incentives of boards of directors to police compensation."
The reason this dispute even exists is simply because the Congress did not define what a "fiduciary duty" means under this law, and the legislative history is conflicting on the issue. Thus, we have two very capable judges with differing opinions as to what the law requires.
This story is far from over, as the Times article points out. We will keep you updated if the Supreme Court decides to review the case. Until then, what do you think about the case and the differences of opinion between Posner and Easterbrook? Post your thoughts on Morningstar's Fund-Blazing blog.