Jones v. Harris Associates: Let 8,000 Lawsuits Bloom, Part 2

Let’s return to Attorney Donovan’s suggestion during oral argument, that the Supreme Court  “consign 8,000 mutual funds to trial.”  Given that Donovan spoke as counsel for Harris Associates, L.P. (the fund manager), this is a startling recommendation. Yet, his invitation to litigation was merely a rhetorical flourish. It was used to demonstrate a presumptively horrible result that would materialize should the Supreme Court side with the mutual fund investors who brought the case. Context reveals his meaning:

“If you take the plaintiffs' point of view and say that a comparison to institutional accounts is always required and may be dispositive and is always a fraction of what mutual fund charges and that judges are the, in the first instance, the ones to decide who is fair and reasonable or what is fair and reasonable, as opposed to directors, I suggest you consign 8,000 mutual funds to a trial.”

Let the Lawsuits Begin

Donovan does not actually support increased investor lawsuits. Nevertheless, the Court should take him up on his “suggestion.” Access to courts to bring excessive fee litigation would help to exert downward pressure on mutual fund fees. Historically and currently, neither market forces nor mutual fund director oversight has managed to do so. Indeed, the conditions that prompted Congress to enact Section 36(b) still prevail. These include mutual fund shell entities that are captive to the firms that created and manage them (the “Advisers”). In turn, members of boards are captive to the Advisers that initially selected them and continue to nominate them to the occasional (not annual) uncontested elections. As put in the Brief of Robert Litan, Joseph Mason, and Ian Ayers Supporting Petitioners,

• “Allowing courts to use a reasonable competitive benchmark like the fees advisers charge to pension fund clients in evaluating excessive fee cases will encourage the mutual fund industry to price more efficiently and increase consumer welfare.”
  

Background on the Fiduciary Duty under Section 36(b) of the 1940 Act

In 1970, Congress enacted Section 36(b)  to impose “a fiduciary duty with respect to the receipt of compensation for services” upon fund managers.  It also created a right for investors to sue for breach of that duty. While the right to sue has existed for nearly 40 years, very few cases have been brought. After the 1984 Gartenberg decision, “no plaintiff has ever prevailed under any litigation purporting to interpret these standards” according the Brief of the Amici Curiae Law Professors in Support of Petitioners.  The need for Section 36(b), the lack of arms-length bargaining between boards and managers still exist. Jack Bogle, founder and former CEO of the Vanguard Group of mutual funds in his Amicus Brief contends that:

• “concerns that led Congress to enact Seciton 36(b) are still present today. Certainly, the structural problems in the industry have remained: Mutual fund boards remain completely dependent on their investment advisers . . and even greater fees have been reaped by advisers as mutual fund assets have ballooned.”
  

New Test Expected for Determining If Management Fees Result in a Breach of Fiduciary Duty

Given the direction of oral argument, it’s quite possible that Jones, Jones and Winerman will never get their day in court, let alone prevail. If the Court affirms the decision, it will still need to grapple with the problem of the 7^th Circuit opinion. Neither petitioner nor respondent support Easterbrook’s reasoning. A new standard (or reaffirmation of Gaternberg) for interpreting the fiduciary duty under 36(b) is expected. Whatever legal standard prevails, the factual outcome is important. U.S. mutual funds managed nearly $10 trillion in assets and earn annually an estimated $100 billion in management fees. With over 90 million U.S. investors in mutual funds, the potential savings to captive investors is substantial.

(For additional background on mutual fund fees see, Jennifer S. Taub, “It’s a Wonderful Lie: Mutual Fund Advocacy for Shareholders’ Rights,” Part 2,  The Race to the Bottom.org., Aug. 17, 2009 )