The U.S. Supreme Court vacated a lower court ruling that set a very high standard for establishing that a mutual fund investment adviser's compensation constitutes a breach of fiduciary duty. AARP had asked the Court to hear this dispute, had briefed the case in lower court consideration, and had filed a "friend of the court" brief with the Supreme Court noting that millions of people are investing in mutual funds, either on their own or through 401(k)s or IRAs, and that excessive fees jeopardize their retirement security.
A mutual fund is an investment company that pools money from many people and invests the money in stocks, bonds, short-term money-market instruments, other securities, or some combination of these instruments. Mutual funds do not have employees, and while they do have a board of directors, the board primarily plays an oversight role but is not involved in the fund's day-to-day operations. That role is played by an investment adviser who decides which securities to buy and sell in order to meet the fund's specified financial goals. Because investment advisers simultaneously direct and are compensated by the funds they manage, they may have interests other than maximizing investors' returns, and the typical relationship between the fund and its adviser is fraught with potential conflicts of interest.
In order to minimize such conflicts, Congress passed the Investment Company Act of 1940, which established a system to regulate transactions between funds and their advisers. In the years that followed, however, conflicts that harmed investors remained, and studies showed that the mutual fund industry "even as regulated by the Act, had proven resistant to efforts to moderate adviser compensation." To further address the inherent conflicts, Congress passed the Investment Company Amendments Act of 1970, which, in part, imposed a fiduciary duty on investment advisers with respect to their compensation and gave investors the right to sue when advisers breached that duty.
Owners of shares in several of the Oakmark family of mutual funds sued the Fund's investment adviser, Harris Associates, contending that the Funds paid excessive fees in violation of Harris's fiduciary duty under the federal law. A federal trial court dismissed the case, finding that the fees were typical for the industry and the investors' challenge did not meet the threshold to make a claim that was set out by the U.S. Court of Appeals for the Second Circuit in the 1982 Gartenberg case. Gartenberg established that in order to constitute a compensation-related breach of fiduciary duty, a fee must be "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."
On the investors' appeal, the U.S. Court of Appeals for the Seventh Circuit agreed that the compensation in this case was not excessive, but rejected the Second Circuit's Gartenberg test, setting an even higher threshold to permit a claim to go forward. The Seventh Circuit adopted a test that requires only that investment advisers make "full disclosure" to the fund's board of directors and "play no tricks" in negotiating their compensation. The investors here had not claimed that "Harris Associates pulled the wool over the eyes" of the board of directors and therefore, the court said, they could not establish a breach of fiduciary duty.
Upon denial by the Seventh Circuit of the investors' request that the full court review the issue (as opposed to the three-judge panel that made the initial ruling), a strongly worded dissent argued that the court had relied too heavily on market forces, such as competition, to set fair compensation levels, in disregard of the fact that those forces do not operate effectively in the mutual fund industry. That dissent also criticized the part of the ruling that said an adviser's compensation should be compared to that of advisers to other mutual funds, noting that because the "governance structure that enables mutual fund advisers to charge exorbitant fees is industry-wide," making comparisons to practices by other industry participants is an invalid way to determine the reasonableness of compensation. The dissent relied on a study published in March 2007, and noted that abuses in the industry had only become more pronounced since the study was published, particularly in the wake of recent market collapses.
The investors, supported by AARP, successfully petitioned the Supreme Court to grant review to resolve the "split in the circuits" and establish a fiduciary duty standard that will apply nationwide and recognize the structural issues raised by the relationship between mutual funds and their advisers.
Attorneys with AARP Foundation Litigation filed a "friend of the court" brief in Jones v. Harris Associates LP on behalf of AARP and Consumer Federation of America, urging the Court to overturn the Seventh Circuit decision.
The brief detailed the reasons underlying Congress's passage of The Investment Company Amendments Act of 1970 to address the potential for abuse inherent in the structure of mutual fund companies and how, despite the Act, little has changed to improve the situation. The brief argued that the standard created by the Seventh Circuit contradicts the realities of the mutual fund marketplace, particularly in the light of how the relationship between funds and their advisers overrides traditional market forces that otherwise might ensure that advisers' compensation remains consistent with their fiduciary duty.
AARP's brief cited numerous studies by the Securities and Exchange Commission, Government Accountability Office, scholars, and industry analysts that have documented the factors that drive inflated compensation levels and how even slight fee increases harm the millions of people relying on mutual fund investment income for their retirement security.
The brief also noted that while beneficiaries of pension funds benefit from having plan managers negotiate with investment advisors to reduce investment fees, individual investors in mutual funds lack collective bargaining power to lower such fees. Fund holders are also captive investors because they cannot freely exit and move their money to alternative funds, because of costs imposed by the funds or by law (for example, investors in 529 funds who benefit from the tax treatment of the funds are tied by the tax law's associated requirements). The brief notes that financial incentives coupled with the fee-generating opportunity for mutual fund advisors created by the captive-like status of the investors pose a threat that calls out for more — not less — regulation of the mutual fund investment vehicle.
The Supreme Court Decision
After noting the "exponential growth" of the mutual fund industry and the history of the Gartenberg standard, the Supreme Court by a unanimous 9-0 ruling found that the Gartenberg approach fully incorporates the understanding of the applicable fiduciary duties and "insists that all relevant circumstances be taken into account." The Court ruled that "by focusing almost entirely on the element of disclosure, the Seventh Circuit panel erred … The Gartenberg standard, which the panel rejected, may lack sharp analytical clarity, but we believe that it accurately reflects the compromise that is embodied in [the law] and it has provided a workable standard for nearly three decades."
What's at Stake
More people than ever are investing in mutual funds on their own and through Individual Retirement Accounts, employer-sponsored 401(k)s, and similar plans, and expenses associated with inflated adviser compensation get passed on to all of the investors reducing their earnings. The stakes for investors inside and outside of retirement plans are substantial.
A major AARP priority is to assist people in accumulating and effectively managing retirement assets. The shift away from traditional defined benefit pension plans (in which employers bear the responsibility of asset accumulation and the risk of loss) to defined contribution plans (under which plan participants bear those responsibilities and risks) places a significant weight on individuals, including many first-time investors, to make appropriate investment choices. Yet, the brief notes studies by AARP and others that indicate that many investors lack basic knowledge about how investment vehicles operate and are unaware of key features of their own investments. These findings apply to the various fees and other expenses charged by their funds and how the fees reduce investors' earnings and overall accumulations. It is crucial that mutual fund fees and expenses be clearly disclosed, and that they be set appropriately. Otherwise, millions of people risk seeing their hard-earned savings and retirement accumulations drained away.
The Court's ruling in Jones v. Harris Associates LP helps ensure that investors have as many enforcement tools as possible to help protect themselves.
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