The Legal Double Standard for Mutual Funds

Presumed Innocent It's difficult for mutual fund producers to lose a lawsuit—or even face one.

They can launch whatever funds they like, no matter how bad the investment concept or venial the intent. They can rush to market with Internet funds at the peak of the New Era; sell “American” bond funds stuffed with Mexican and Argentinean debt (true story that); and peddle U.S. Treasury funds that have “yields” (once again, the irony quotes) spiked by capital gains made from selling options. Perfectly safe.

They can levy whatever fees they like. The next suit that a fund company loses for overcharging its customers will be its first. If there are rival funds with higher expenses, the fund company will successfully defend itself by stating that its costs fall within the normal range. If the fund has the single highest cost in existence, then the company will argue that somebody has to finish last, or that its investment process is uniquely expensive. Or something. Anyway, it always works.

They can say whatever they like, as long as it’s not an outright lie. Deception, however, is perfectly fine. Shareholders who sued Alliance North American Government Income Fund for holding mostly non-U.S. securities lost every case they filed (although, in a rare semi-victory for investors, Alliance eventually did settle out of court). As long as fund companies state things that are literally true, they are pardoned for giving false impressions, or for downplaying the relevant risks.

(For example, the short-term multimarket income funds of the early 1990s depended entirely on the convergence of European exchange rates, as governed by the exchange-rate mechanism. Mum was the word on that; shareholders learned only after the fact that their funds lived or died—died, as it turned out—because of a single risk factor.)

Presumed Not The corporate buyers of mutual funds, on the other hand, face very real dangers on all three fronts.

Consider the latest action against 401(k) plan sponsors, filed in mid-December. It comes not courtesy of the usual plaintiff's counsel, Schlichter, Bogard & Denton—Jerry Schlichter having invented the field of 401(k) class action suits—but instead from a Los Angeles firm, Solouki & Savoy. Legal diversification! (Or, from the perspective of plan sponsors, a sign that the zombie apocalypse is spreading.)

That suit implies that while mutual fund producers might be able to offer whatever funds that they wish, corporate plan sponsors enjoy no such luxury. Among its charges are that the defendant, Starwood Hotels, erred because it presented employees with a money market fund for their safe option, rather than a stable-value fund.

“Starwood’s failings and breaches of fiduciary duties include, but are not limited to the following … b) Failing to offer a stable-value fund, and instead had Plan participants maintain excessively high cash balances in money market funds resulting in the loss of millions of dollars to participants had they been able to invest in stable-value funds which offer higher return and the same level of risk as money market funds.”

Note that the plaintiffs define "loss" as opportunity cost. Starwood's money market fund made money. Every employee who invested in that fund turned a profit. The claim is not that they were directly harmed, but rather that they were indirectly damaged, because the plan sponsor could have chosen an otherwise identical option that would have paid them more.

Leaving aside the issue of whether stable-value funds are in fact perfect substitutes for money market funds (not on my planet, but perhaps in a Los Angeles courtroom), note how the bar has moved. Mutual fund producers don’t get sued for selling losing funds, never mind winners. Meanwhile, a 401(k) plan sponsor is defending itself because it chose a fund that consistently, always, made money.

Which means that the organization that gets paid for providing investments is held to a lower legal standard than is the organization that does not get paid. Hmmm.

Double Standards The same holds true for costs.

The 401(k) filing attacks Starwood for having plan administration and record-keeping fees that were $100 per participant, as opposed to the cited average of $64 for plans of a similar size. (Once again, there is more than can be said on the matter, as the plan holds institutional index funds. In such cases, when the asset-management revenue is relatively low, the administrative fees are usually higher.) Mutual fund producers don’t get in trouble for exceeding the norm. They are compared with the very worst, not to the averages.

Also under assault are the plan’s target-date funds, which have annual expense ratios of 0.28%. As with the money market fund, the argument is not that such costs are particularly burdensome, but rather that the plan sponsor could have done better yet by using another vendor. Alright, we’ll apply that same standard to mutual fund producers. You’re all sued for not being Vanguard. Prepare your defenses.

Finally, the suit alleges improper disclosure—that Starwood did not inform its employees about the details of the revenue-sharing that occurred between the plan’s funds and record-keeper. (Such sharing is common with 401(k) plans.) Fair enough, if true. But what about the disclosure that fund companies have failed to provide? Not only with respect to their fund’s investment strategies, but also about other forms of revenue-sharing? In their retail businesses, fund companies compensate brokerage firms for distribution, often with neither party being forthcoming to investors. Where are those lawsuits?

The reason for the double standard is straightforward: Mutual fund producers are governed by the Investment Act of 1940, while 401(k) providers abide by the stricter rules of the Employee Retirement Income Security Act. We know how we got here. Up for debate is why we continue to behave this way. Why should the corporate purchasers of mutual funds, who make no profit on their actions, be forced to defend themselves in court, while those who live by making mutual funds are not?

Last Words "If I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn't. And contrary wise, what is, it wouldn't be. And what it wouldn't be, it would be. You see?"

Yes, Alice, we see. We do see.

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.