The debate over investment advisors’ fiduciary duty has made it all the way to the Supreme Court. On Monday, November 2, Supreme Court Justices heard oral arguments from lawyers for three investors who claimed that Harris Associates of Chicago, the investment advisor for the Oakmark family of mutual funds, charged them higher fees for similar services than it did to independent institutional investors such as pension funds.
While it’s unclear how the Supreme Court will ultimately decide Jones v. Harris Associates—the High Court likely won’t render its decision until March—the Justices’ questions “got at the heart of the issue in terms of what is fair [regarding] fund fees and how can we develop a process that consistently delivers fair fees to shareholders,” says Laura Lutton, editorial director in the Fund Research Group at Morningstar.
Justice Sonia Sotomayor focused her questions on whether the inequity in fund fees was due to how the fund board is negotiating, Lutton says, while the more conservative Justices questioned whether in a market of 8,000 mutual funds investors could just switch to fundswith lower fees. But as one of the attorneys noted during the hearing, Lutton points out, that’s easier said than done because there are costs associated with switching funds, an investor may be limited to the choice of funds within a 401(k) plan, or there may be embedded gains in a fund and switching would trigger a taxable event.
Important questions were raised during the hearing, such as whether it’s okay for a fund to charge higher fees if it’s outperforming, Lutton says. However, based on Morningstar’s research, she says, “fees are the most important predictor of performance.” The lower the fee, Lutton says, “the more likely the fund will outperform over the long term.”
The Supreme Court case also shines the light once again on how fees are disclosed to investors. “The industry’s accounting when it comes to fees has not been as clean as it could be,” Lutton says. Case in point is the Securities and Exchange Commission’s goal to revamp 12b-1 fees, which took root a couple years ago. “Where are these fees going in terms of offsetting costs for the funds or compensating brokers, or distribution platforms? That’s not clear,” she says.
SEC Chairman Mary Schapiro has said that the SEC still plans to tackle 12b-1 fees. The question still remains, however, as to “whether the SEC takes that matter up and changes the way fees are disclosed,” Lutton says.
Both Lutton and James Gregory, a partner in Proskauer Rose LLP’s Employee Benefits and Executive Compensation Group in New York, agree that the Supreme Court may vote to give more teeth to what’s known as the Gartenberg standard, which Lutton says “has been the standard that fees have been judged legally on the last 20 or so years.”
The Investment Company Institute (ICI) filed friend-of-the-court briefs in support of Harris Associates. As the ICI notes in a recent overview of the Jones v. Harris case on its Web site, “At issue in the case is the standard a federal court would use to review a claim by a fund shareholder alleging that a fund adviser received excessive fees under Section 36(b) of the Investment Company Act of 1940.” The Seventh Circuit’s decision departed from the standard established in 1982 by the U.S. Court of Appeals for the Second Circuit in Gartenberg v. Merrill Lynch Asset Management Inc., the ICI says, “which held that a fund adviser breaches its fiduciary duty to shareholders if it charges a fee ‘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.’”
There was speculation that the Supreme Court would use the mutual fund fees case as a springboard to issue a larger ruling on executive compensation. However, Gregory of Proskauer says that “after reading the transcript from the oral arguments, my sense is that the court will take a more narrow approach. A lot of the questions had a narrow focus.”
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