Mutual Fund Fees Get Their Day in Court

Recently, I wrote a Kiplinger's column about the mutual fund fee case before the Supreme Court. You can read it below, but first I want to share the comments from a judge who ruled in a separate fee case against American Funds. American won the case, and as one of the lowest-cost providers in the fund world, it seems a strange target, but Judge Gary Feess made my point much better than I did. The problem is that while fund directors are charged with setting fund fees, they readily accept what the fund company recommends and then simply go through the motions of setting fees. Here's what he said:

"There is not a shred of evidence that any director asked management to identify who CRMC (Capital Research and Management Company) perceived as its competition, to provide information regarding compensation levels at those competing firms, to compare those compensation levels to compensation paid to CRMC and [American Funds Distributors] employees, or to explain why those compensation levels were necessary to attract and retain personnel or to provide services at a specified level of quality.

"Thus, although the directors were represented by counsel and were provided with detailed materials to which they and defendants can point to and say, 'see how thorough and careful we were,' the entire process seems less a true negotiation and more an elaborate exercise in checking off boxes and papering the file."

Exactly. Directors are more concerned with checking all the legal boxes they need to check than thinking about what's right for shareholders and marshalling all the information and willpower needed to enact it.

As I wrote in Kiplinger's, a pending fee case could embolden boards, but I hope it won't unleash an army of lawyers on fund companies. Here is what I wrote:

When it comes to setting fees for mutual funds, sponsors have a fiduciary duty to act in the best interest of their customers. What that duty entails has long been the subject of debate. But sometime in the next few months the U.S. Supreme Court may clear up the matter once and for all.

The high court recently heard arguments in a lawsuit filed against Harris Associates, the Chicago money-management firm that runs the Oakmark funds. The case revolves around the discrepancy between what Harris charges for managing the funds and what it charges to run institutional accounts. The Seventh Circuit Court of Appeals ruled that courts needn't get involved because the marketplace could handle the matter efficiently--investors, for example, could vote with their feet by switching to lower-cost fund providers.

Easy standard.
If upheld, the lower court's ruling would essentially mean that fund companies have almost no fiduciary duty on behalf of shareholders when it comes to fees. That is much less rigorous than the already soft Gartenberg standard, a 1982 lower-court ruling that said that fees "should be within range of what would be produced by arm's-length bargaining" between mutual fund sponsors and independent third parties. In practice, that's proved to be such an easy standard to meet that no fund investor has ever won a lawsuit over fees.

I hope the Supreme Court comes up with a new, clear standard for fiduciary duty that disappoints the fund industry and trial attorneys alike. I don't like the idea of giving fund companies a blank check. After all, a fund is owned by its shareholders, not the sponsor. But I would also hate to see fund companies hamstrung by scores of lawsuits that serve only to enrich lawyers rather than shareholders.

The oral arguments don't give me much confidence, though, that the high court will decide wisely. My impression is that the justices wouldn't know a mutual fund from an iguana. The plaintiff's counsel mistakenly asserted that a fund board couldn't fire the advisor and hire a new one, and the justices seemed to agree. In fact, a board can fire the advisor. It just doesn't happen often.

Chief Justice John Roberts suggested that higher cost equals higher quality. In a way, it does, but only in terms of dollars spent on management, not in terms of fees as a percentage of assets, as he implied. For example,  PIMCO Total Return (PTTRX), run by the estimable Bill Gross, charges annual management fees of 0.25%. But because the fund, the nation's largest, holds some $200 billion in assets, PIMCO clears about $500 million a year.

Meanwhile, the middling  Federated Bond (FDBAX) charges a yearly management fee of 0.75%, which, on $1.1 billion in assets, generates fees of $8.3 million. So, does Federated charge triple PIMCO's management fee because its bond-pickers are three times better than PIMCO's, or are the Federated folks less talented, as the huge gap between PIMCO's and Federated's revenues implies? I'd say it's the latter.

The fund industry says, rightly, that you can't compare the fees of funds and separate institutional accounts because retail investors require more servicing. In many instances, however, a mutual fund's management fee includes a kitchen sink's worth of other charges, such as distribution costs, that aren't used to pay investment professionals. Thus, investors and fund directors alike are in the dark when they compare fees, both between mutual funds and institutional accounts and among different mutual funds.

The most intriguing potential outcome of the Harris case would be a Supreme Court ruling that puts downward pressure on fees. For example, the court could rule that to meet their fiduciary duty, advisors must treat mutual funds and institutional accounts similarly. That would hardly be the worst thing in the world for fund investors.

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