A New Lawsuit Over Fund Fees

A Double Standard Owing to an accident of history, mutual fund directors are held to a lower standard of fiduciary duty than are plan sponsors for 401(k) plans.

If a 401(k) plan carries a pricier version of a fund when a cheaper share class is available, the company that sponsors the plan could lose a class-action lawsuit. Such happened to Edison International this May, when the Supreme Court unanimously ruled (now that's a phrase that you rarely see) that the company was liable for not monitoring that it could have replaced its retail shares with cheaper institutional shares. Commenting on the Supreme Court's signal, retirement-industry lawyer Marcia Wagner stated, "[Plan sponsors must have] a damned good reason to pay higher fees if they don't have to--a really, really, really good reason."

This scrutiny comes courtesy of ERISA (the Employee Retirement Income Security Act of 1974), which covers employee-sponsored retirement plans. ERISA expects fiduciaries to conduct their businesses for the exclusive benefit of the plan participant. The desires of the investment-management companies that serve 401(k) plans are immaterial. They are vendors, no more and no less.

But mutual fund directors, being governed by the Investment Company Act of 1940 rather than ERISA, do not work solely for their shareholders. True, the legislation pays lip service to the idea of arm's-length negotiations, but nobody believes that to be strictly correct. For example, in the 2010 mutual fund fee case, Jones v. Harris Associates, the Supreme Court wrote that fund directors face a "delicate compromise" in balancing shareholder and fund-company interest. In other words, fund companies are not simply vendors.

This mindset has made things very difficult for those who wish to file excessive-fee cases on mutual funds--more than difficult. In the 75 years since the passage of the Investment Company Act of 1940, no mutual fund company has lost a lawsuit on excessive fees. Not funds that charge 2% annually, or 3%, or even higher. Not funds that swell from $10 million to $20 billion without altering their expense ratios. Not any fund, anywhere, any place.

When Worlds Collide A new case has brought together the (relatively) suit-friendly world of ERISA and the not-suit-friendly world of the Investment Company Act.

Wayne County Employees Retirement System, a defined-benefit pension plan that is covered by ERISA, holds $800 million in a retail mutual fund,

That places Wayne County pension out of immediate harm. At some point in the future, large ERISA institutions may be expected to avoid retail share classes altogether. (If the fund company does not offer institutional shares, then the ERISA institution would request that the company create a lower-cost separate account.) That time has not yet arrived.

But surely Wayne County pension officials are thinking such things. They know from Tibble v. Edison International that the Supreme Court believes ERISA institutions should seek volume pricing for their investments. They know that FMI's margins on its large cap fund have skyrocketed as the fund has grown to $9 billion from less than $100 million in 2005. Wayne County officials must be wondering, where's my cut? They are being asked to fight hard for their employees who, through the pension fund, indirectly own FMI Large Cap shares. Should not FMI's directors be asked to fight as hard for the fund's direct owners?

With those questions in mind, Wayne County filed a suit against FMI on Sept. 30.

Same Coat, Different Price? The suit's specifics: Although FMI does not officially sell an institutional version of its large cap fund, it does so in the form of three subadvisory relationships with other mutual funds. Those contracts have breakpoints, wherein the management fee paid to FMI declines as the fund's assets increase. FMI Large Cap, on the other hand, has no such breakpoints. This is because when negotiating with FMI, the fund directors are "captive" negotiators who accept "markups" of 86%-167% over the true arms-length pricing that was extracted by the subadvisory clients, claim the plaintiffs.

This complaint covers similar ground to that of Jones v. Harris Associates, which also featured a plaintiff who owned a retail fund stating that the fund was overpriced because there were (much) cheaper institutional separate accounts. That might seem on the surface to doom this current suit, as Jones lost. However, there are some differences.

The major difference is that today's plaintiff is an institution. In Jones v. Harris, the Court rejected the plaintiff's claim that the prices paid for retail and institutional accounts should be similar because the services rendered (that is, investment management) to retail and institutional owners were substantially similar. In dissenting, the Court wrote "there may be significant differences between the services provided by an investment adviser to a mutual fund and those it provides to a pension fund." But what if the plaintiff is a pension fund?

There are several counterarguments that can be made to that question such that this case remains a long shot. However, it's not an impossible shot. The Supreme Court indicated that it is open to the notion of liability for excessive fees if the plaintiff can demonstrate that the services rendered for two different price points truly were similar. Perhaps Wayne County the institution will be able to achieve what Jones the individual could not, and prove that as a legal matter.

So, maybe the suit will work. I wouldn't bet on its success. The claim is mostly a hope and a prayer. But there is some hope along with the prayer.

When Down Is Good One thing is for certain: Whether by lawsuit or redemptions, institutional pressures or advisor decisions, high-cost funds are under pressure as never before. Every week, another fund (or series of funds) cuts its expense ratio, as assets flow from pricier fare to index funds and institutional share classes.

This squeeze on asset-based fees has been quietly accompanied by a steep decline in the flat fees charged by 401(k) administrators. The trade publication Ignites (no link, the story is paywalled) reports that the average recordkeeping fee for 401(k) accounts has plummeted to $64 from $118 in 2006.

As with asset-based fees, there are several reasons for the slide. Chief among them are technology improvements, industry consolidation, and increased customer scrutiny as recordkeeping fees have become unbundled from other fees and thus more vulnerable to price-shopping. Whatever the motives, though, the trend has but a single implication for 401(k) investors.

Never say that I only bring bad news.

Oh, Wait... Also never say that I only bring good news. NPR took the caustic view yesterday on 401(k) plans. The piece strikes me as overdramatic, and I don't buy the argument that fee-based advice is better and cheaper than commission-based advice, but it does offset my happy talk rather nicely. Another perspective, as they say.

Note: After this column was published, I was notified that state and local pension plans are exempt from ERISA. My oversight; I knew that once. Fortunately, that would not seem to damage the column's argument, as most states have adopted standards of acting with the sole interest of the investor that match those of ERISA. In this case of Wayne County, the State of Michigan states that a fiduciary has the "duties of undivided loyalty" toward the participants that the fiduciary represents.

As this column argues, that is a different standard than the "delicate balance" (to use Supreme Court Justice Samuel Alito's phrase) that a mutual fund director takes in balancing the need of fund shareholders and the shareholders of the company that manages the fund.

Also, Wayne County holds $1.5 million in the FMI fund, not $800 million as reported above. I was stung by a secondary source, the same way that those who reported on the apparently mythical Fidelity study were stung. Let that be a lesson to all of us who write about mutual funds or who are on the speech circuit--primary sources only.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.