- The Washington Times - Monday, September 7, 2009

BOSTON | For most investors, the first Monday in October will be just another trading day. But after a turbulent year in the stock market, investors may want to pay more attention to the new session of the Supreme Court.

On the docket is the case of Jones v. Harris Associates. If you question why your mutual funds charge so much to manage your investments, you’ll want to follow the proceedings.

The case, brought by shareholders against a mutual fund’s adviser, could lead to lower fees for many of the 45 percent of households owning mutual funds. Potentially, it could also rebalance a pecking order where individuals working to build a retirement nest egg can pay twice as much as big institutional clients.

The fund industry, which has largely succeeded in beating back fee challenges, warns that a victory for individual investors could unleash lawsuits targeting many of the nearly 8,000 funds holding more than $10 trillion. Much of the cost from that litigation would could ultimately be passed onto investors. The industry says investors have been served well by a fee-setting standard in place since 1982.

The Supreme Court will hear arguments Nov. 2 over a key test investors must meet to successfully challenge fund fees. They’ve got to show expenses were so out of whack that they couldn’t conceivably have been the product of honest negotiations between the fund’s adviser and its board of directors.

That requirement is part of the so-called Gartenberg standard, which had been considered largely unassailable until the 7th U.S. Circuit Court of Appeals weighed in last year. That court ruled against a fee challenge but also suggested the wrong standard has been applied all these years.

The court concluded that investors must show not only that fees were excessive, but that a fund’s adviser somehow misled the fund’s board in winning its approval for their compensation.

But even that court was split in its decision. One of the panel’s judges dissented, suggesting boards are failing to adequately scrutinize compensation in the fund industry and Wall Street broadly — an argument that industry critics hope the Supreme Court will take up.

The dispute has drawn a flurry of friend-of-the-court filings, including one by John “Jack” Bogle, founder of the Vanguard Group. In an interview, the 80-year-old fund industry gadfly and pioneer of low-cost index investing said it’s the first time in more than five decades in the investment business that he’s filed an amicus brief.

“It’s a fundamentally flawed economic system we have for setting fees in the industry,” said Mr. Bogle, who served two decades as chairman and CEO of Vanguard, which hasn’t filed a brief in the case. “We look at everybody else and say, in effect, ‘They’re overcharging, so why shouldn’t we?’”

The case, Mr. Bogle says, “is going to be a wake-up call for fund directors, and I think the Supreme Court is going to come down hard” on the industry.

Also filing a brief was President Obama’s solicitor general, Elena Kagan, who backed the Gartenberg standard. But Ms. Kagan also faulted reasoning the appellate court used to back the fee challenge’s dismissal.

Supporters of the fund adviser targeted in the case filed briefs Thursday. The biggest fund company, Fidelity Investments, argued in its filing that courts “should not second-guess a board’s business judgment” on fees.

The industry group Investment Company Institute (ICI) said the Gartenberg standard has for nearly three decades “ensured investor protection, and served judicial economy by not embroiling the courts in technical disputes over business judgment.”

The ICI also said the fund industry is highly competitive, “with fees falling even as investors have received more and better services.” Costs to invest in both stock and bond funds fell by about 60 percent from 1980 to 2008, the ICI said.

The five-year-old case was brought against Harris Associates, the adviser to the Oakmark family of mutual funds. Harris Associates was paid a fee of 1 percent of the first $2 billion in assets it managed. The fee declined to as low as 0.75 percent once assets topped $5 billion because larger funds can operate more efficiently.

Judges have noted these fees weren’t out of line with those charged at comparable funds. And Oakmark funds continued to attract new money, suggesting investors weren’t running to rival funds over cost concerns.

The lawsuit argues that the relationships between fund boards and advisers are rife with conflict and that market comparisons aren’t good yardsticks to determine whether a fund is overcharging.

The complaint also takes aim at the fact that the Oakmark funds’ individual investors were charged twice as much as other Harris clients like pension funds. Such a pecking order, the lawsuit claims, violates a fund’s “fiduciary” obligation to shareholders.

The industry argues the fee imbalances are justified because it costs more per dollar invested to serve small clients than large ones. For starters, the bigger fish don’t need toll-free hot lines or vast numbers of prospectus mailings, and they often agree to tighter restrictions when it comes to pulling their money out of a fund.

William Birdthistle, an assistant professor at the Chicago-Kent School of Law who filed a brief signed by 25 other professors in support of the challenge against Harris Associates, said a fund’s fiduciary duty to its shareholders should dictate that “you treat similar clients alike.”

But he said the industry has refused repeated challenges to disclose data justifying the higher fees it charges individual investors.

Even if the industry wins before the Supreme Court — a ruling is expected sometime before next summer — Mr. Birdthistle thinks political sentiment has shifted in favor of small-time investors. He says that could open the door for Congress to pursue a legislative remedy putting small investors on more equal footing with big clients.

“Investors have been losing these cases for nearly 30 years,” Mr. Birdthistle says, “and that could definitely attract the attention of lawmakers who might say we need to revisit this, since they’re already revisiting so much of America’s financial regulations now.”

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