The executive branch has a “pay czar” to set compensation for executives of financial institutions and auto companies bailed out by taxpayers. Congress is busy writing legislation governing executive pay in the financial industry. The Federal Reserve is working on its own guidelines for paying bank bosses and limiting systemic risk.
Now comes the Supreme Court, which on Monday will hear a case, Jones v. Harris Associates, that will likely determine the role federal courts will play in deciding how investment advisers for mutual funds are paid.
The case matters because 93 million individuals from more than 50 million households pay investment advisers an estimated $100 billion per year to manage their $10 trillion investments in mutual funds, an amount equivalent to nearly 20 percent of U.S. household net worth.
In 2004, three investors in the Oakmark family of mutual funds sued Harris Associates, which created the Oakmark funds, managed their daily operations and selected the members of their board of trustees.
The plaintiffs charged that Harris violated its fiduciary duty by charging excessive fees. The investors pointed out that Harris charged fees to the Oakmark mutual funds that, in percentage terms, were about twice what Harris charged other clients, such as pension funds, for comparable services.
Harris charged an effective rate of 0.88 percent to manage $6.3 billion in assets in the Oakmark Fund compared with an effective rate of 0.45 percent to manage $160 million in assets for an independent client, the investors complained. By doing so, Harris further breached its fiduciary duty by denying the mutual fund the benefit of the economies of scale Harris exploited from the much-larger mutual fund, the investors charged.
The investors also accused Harris of appointing a board of trustees that was not sufficiently independent. The board was responsible for approving the fees that Harris charged to manage the funds.
“Victor Morgenstern, the chair of the funds’ joint board and one of the designated disinterested trustees, was a former Harris partner who received deferred compensation from Harris worth hundreds of thousands of dollars per year,” reads the plaintiffs’ Supreme Court brief.
Harris responded that the services it provided to independent clients were in no way comparable to the much costlier services it provided Oakmark funds.
For the three- and four-year periods ending March 31, 2004, Harris noted in its Supreme Court brief, “the Oakmark Global Fund had the single-best net returns of the 200-plus comparable funds in its Lipper-defined ’performance universe.’ ” For this achievement, the Oakmark Global Fund charged a fee that was 0.17 percent below the median for its peer group.
The Investment Company Institute (ICI), a trade group representing mutual funds, says its industry is vigorously competitive.
“Compensation paid to advisory firms has been going down, down, down,” said Paul Schott Stevens, president and chief executive of ICI. As a percentage of invested assets, fees paid to investment advisers are 40 percent of what they were 25 years ago, he said.
The U.S. District Court in Chicago granted summary judgment to Harris and dismissed the Jones suit by applying a widely accepted standard established in 1982 by the 2nd U.S. Circuit Court of Appeals in Gartenberg v. Merrill Lynch Asset Management.
“Congress … recognized … the potentially incestuous relationships between many advisers and their funds,” the 2nd Circuit Court observed.
“To be guilty of a violation,” the 2nd Circuit Court said in Gartenberg, “the [adviser] must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.”
The plaintiff Jones appealed the case to the 7th U.S. Circuit Court of Appeals, petitioning the court to disregard Gartenberg. Instead, the court should use the fees that Harris charges its independent, institutional clients as a benchmark for fees it assesses to the Oakmark mutual funds, the plaintiff said.
A three-judge 7th Circuit Court panel headed by Chief Judge Frank Easterbrook unanimously upheld the dismissal of the suit, but declined to apply the Gartenberg standard, which the 7th Circuit Court appellate judges disapproved. Judge Easterbrook said the robust competitiveness of the mutual-fund marketplace could be trusted to regulate fees.
In a dissent from the 7th Circuit Court’s decision not to hear the case before the full court, Judge Richard Posner said Judge Easterbrook’s “economic analysis” underlying the panel’s decision was “ripe for re-examination.”
Judge Posner noted that “executive compensation in large, publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation.” He said this also applied to the boards of mutual funds, which “are a component of the financial services industry, where abuses have been rampant.” Judge Posner seemed to embrace the plaintiffs’ argument against the practice of advisers charging mutual funds twice the fees they charge independent funds.
In accepting the case, the Supreme Court will now resolve the differences between the 2nd and 7th circuit courts and, indirectly, referee the intriguing 7th Circuit Court dispute between Judges Easterbrook and Posner, two intellectual giants in the “law and economics” school of jurisprudence who normally see eye-to-eye.
The ICI and its allies have charged that the recent “swarming” of lawsuits protesting adviser fees represents an effort by the contingency-fee plaintiffs’ bar to establish a “line of attack” on another industry.
“The plaintiffs want the Supreme Court to disregard mutual fund boards and their independence and let federal judges be the arbiter of whether fees are just or not,” Mr. Stevens said. “If [the mutual-fund industry] becomes a happy hunting ground for plaintiffs, shareholders will lose.”
Karrie McMillan, ICI’s general counsel, said, “The reputational damage in an industry dependent on public trust will encourage mutual funds to settle” when they are sued.
William A. Birdthistle, an assistant professor of law at the Chicago-Kent College of Law who served as counsel of record for a group of 25 other law professors in a brief supporting Jones, offered a simple solution.
“Why speculate” about the cost differences between advising mutual funds and institutional clients like pension funds? Mr. Birdthistle asked. “The investment advisers should produce the data to prove precisely how much costlier it is to advise individual shareholders in mutual funds.”
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