Top Judges Battle over Mutual Fund Fees
Oakmark case raises tough issues and could be headed to the Supreme Court.
As regular readers can attest, Morningstar is always pushing for reasonable expense ratios on behalf of shareholders. Shareholders have many options if they end up owning a fund with high fees, including pushing the fund to lower its fees or simply taking their money elsewhere. Some shareholders, however, have chosen an alternate route: They've taken the issue to court.
A disagreement between two well-known judges in a recent "excessive fee" case deserves attention because it raises important questions as to the role of the judiciary when mutual fund fees are at issue. The shareholder lawsuit in question is against the investment advisor of Oakmark I (OAKMX), a fund that we cover (and a Fund Analyst Pick at that). (For more background on the lawsuit, please see this New York Times article.)
The issue before the 7th Circuit Court of Appeals was whether the investment advisor to Oakmark, Harris Associates L.P., breached its fiduciary duty by charging excessive management 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 (that is, between two independent parties who are on equal footing), then the fee schedule is not excessive and there is no breach in fiduciary duty. The shareholders who brought the suit argued that the fees that Harris charges its mutual fund clients may not exceed those it charges its other clients; in this instance, Harris charged mutual fund shareholders twice the management fee it charged institutional clients.
The 7th Circuit Court rejected the Gartenberg test and replaced it with a simple requirement: transparency. Chief Judge Frank 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, then the judiciary may get involved. (See the full text of Easterbrook's opinion.)
However, fellow 7th Circuit Court Judge (and former Chief 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.)
In other words, Posner believes that courts must be able to look at all of an investment advisor's clients when comparing fees, not just mutual fund clients who often pay more as a group than institutional clients.
A Closer Look
One might reasonably ask, "How can two well-regarded judges read the same statute and come to such different conclusions as to what the statute means?" The answer is simple: The statute is vague. Congress did not define what a "fiduciary duty" means in the statute, and the legislative history is apparently unclear as to Congress' intent. Therefore, the judges have to decide what Congress probably meant when it used the term "fiduciary duty." This explains why two capable judges can have two very different, and defensible, readings of the statute.
Let's dig a little deeper into Easterbrook's analysis first. During oral argument, the court compared the fiduciary duty in the lawyer-client relationship to the fiduciary duty created by statute for investment advisors. While somewhat oversimplified, the comparison goes something like this: A lawyer can charge a client whatever the market will bear as long as the lawyer is honest and transparent when negotiating his fee. Because a client should rationally want to negotiate the lowest fee possible, the parties are at arm's length when negotiating the fee. And of course, it is possible for the lawyer to charge clients different amounts for the very same service (the lawyer may charge less when he has less business, for example).
Drawing on this analogy is partly how Easterbrook concludes that the law only requires investment advisors to be transparent. Because Harris was honest and transparent when negotiating its fees, Harris did not breach its fiduciary duty. Harris has every right to charge different clients different fee structures because the statute does not forbid mutual fund boards from negotiating very poorly on behalf of shareholders! If shareholders don't like the fee structure, they can walk away at any time. Case closed.
Judge Posner's response is that the lawyer-client relationship analogy is flawed. Among other reasons, he states that investment advisors' fees are not negotiated at arm's length with mutual funds because fund investors don't negotiate their own fees--the fund's board does that. And the fund board has less of an incentive to negotiate for the lowest possible fees than the shareholders do, because shareholders--not the board of directors--ultimately pay the fees. What else can explain mutual fund investors paying twice as much as institutional investors?
Thus, we are left with one judge who is deferential to fund board oversight of fees and one judge who is inherently skeptical. Easterbrook thinks that because the mutual fund industry offers thousands of funds from which to choose, shareholders will act rationally and choose the lowest-cost funds. Posner is skeptical, because 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." He worries that while investors may choose the lowest-cost funds in the end, even the lowest-cost funds will end up charging more than they should because of those feeble incentives.
We see merit in both judges' views. Easterbrook is surely correct that investors can affect matters by choosing lower-fee funds. We have seen a dramatic shift in assets toward lower-fee families--most notably Vanguard, American Funds, and Dodge & Cox--in recent years.
On the other hand, Posner's concern that fund boards don't always seem to act independently has good company. Warren Buffett describes the records of independent directors as "absolutely pathetic" because he sees the situation in the same way as Posner: "Under the current system, [fee] reductions mean nothing to 'independent' directors while meaning everything to managers. So guess who wins?" To help remedy the situation, Buffett suggests that directors could earn a portion of any fee savings that they realize.
While everyone agrees that transparency is essential when investment advisors negotiate their fees, it may be just as essential when it comes to shareholders understanding how much they are paying their fund manager. As we have pointed out in the past, investors get a bill every month from their telephone company, but they never get a bill from their mutual fund. Instead, fees are simply subtracted from returns regularly in small amounts without being noted on the statements sent to shareholders. While it is certainly an investor's job to know how much he is ultimately paying in management fees, the fund companies should make the task a little more open and obvious for fund shareholders by listing right on their statements, in dollars and cents, how much the shareholder paid in fees during the period in question.
What's Your Take?
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.
Ryan Leggio does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.