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Wednesday
Jan122011

Will Bad Funds Make Good Law?: Janus v. First Derivative Traders Part III

Presumably, that news in early September of 2003 of “widespread illegal trading” made shareholders of Janus Capital Group (“JCG”) unhappy and nervous. Thus, the sell off and price decline. The owners of  the NYSE-listed JCG stock understood that JCG was a holding company that derived over 90% of its revenue from its mutual fund operations.

Through its subsidiaries JCG created, marketed and controlled the various Janus brand-name mutual funds. One of those wholly-owned subsidiaries, Janus Capital Management, LLC (“JCM”) was the “investment adviser” to the assorted Janus mutual funds. In this role, JCM collected a management fee. This fee was a percentage of assets under management. Given this source of JCG income, stockholders of JCG were concerned. They feared that if investors took out money from the mutual funds run by JCG and its subsidiaries, this would hurt the profitability and thus the value of JCG shares. As it happened, investors in the Janus mutual funds withdrew around $14 billion.

As the 4th Circuit wrote, summarizing stockholders’ assertions:

"Materially misleading statements regarding defendants’ policies on market timing fraudulently induced investors to purchase shares in the Janus funds, increasing the assets under management by JCM. JCM’s management of the Janus funds’ assets was responsible for generating more than ninety percent of JCG’s revenue. Consequently, any decrease in the value of the assets in the various mutual funds would adversely affect JCG’s revenues and profits.”

Mutual Fund Operations and Fees

It is worth taking a moment to cover briefly what a mutual fund is, how it is created and operated and how the sponsors become the managers (“investment advisers”) and typically hold the funds captive. A mutual fund is a pool of money and securities. It is often organized under Massachusetts or Delaware law as a business trust. It has no employees of its own. To the extent that a handful of people are identified as a mutual fund’s employees, typically, their salaries would be paid by the “investment adviser.” And those same employees would likely have full responsibilities and titles at the advisory firm.

Notably, at Janus, according to Respondents, “Every one of the Janus Funds’ 17 officers was a Vice President at JCM.” According to Petitioner’s counsel only one person, the President of the Janus mutual funds was not also an employee of JCM. At Janus, according to the Janus funds prospectuses, JCM “is responsible for the day-to-day management of the investment portfolios” of the Janus mutual funds and JCM “furnishes certain administrative, compliance and accounting services for the Funds . ..[and] provides office space for the Funds."

Without independent employees of its own, a mutual fund depends upon a board of trustees and an investment adviser to function. Investment Advisers to mutual funds earn fees as a percentage of the total assets in the mutual funds. The rough average is between .5% and 1% per year. If a mutual fund adviser oversees fund portfolios totaling $200 billion in assets, a 1% advisory fee would result in $2 billion per year in management fees.

And these are not the only fees fund investors pay.  The term “adviser” is a bit of a misnomer with the advisory firm or its affiliates often performing multiple other services for the funds.  As the 4th Circuit opinion stated:

“As investment advisor to the various Janus funds, JCM ‘is responsible for the day-to-day management of [the] investment portfolio and other business affairs of the funds.’ . . . ‘[A]s a practical matter’ JCM runs the Janus family of funds.”

Part of the job of running a fund family involves creating the legal documents required in order to offer shares in the fund. As the 4th Circuit noted:

“Shares in the Janus funds were offered for sale by prospectuses that JCG and JCM ‘caused . . . to be issued’ and ‘made. . . available to the investing public.’ . . The prospectuses were made available to potential investors on a joint Janus funds-JCG-JCM website, www.janus.com.”

Moreover, many of the costs associated with operating the mutual funds are borne not by the sponsor of the funds but by the fund investors. These include marketing and distribution expenses, brokerage fees, transfer agency fees, legal fees, accountants’ fees and custodian fees.

And at many fund families the “adviser” or its corporate affiliates perform a good number of these services. This can transform what in another industry would be a cost into a revenue center. Total expenses paid by mutual fund shareholders each year, thus exceed the advisory fee. According to Bill Barker writing for the Motley Fool, the “typical” expense ratio for an actively management mutual fund is 1.5%. This figure would include the advisory fee, administrative expenses, marketing and distribution fees and other general operating costs. An index fund should average much lower.

For more details on the nature and operations of mutual funds see Jennifer S. Taub, Able but Not Willing: The Failure of Mutual Fund Advisers to Advocate for Shareholders Rights, 34 J. Corp. Law 843 (2009), cited in Brief for AARP and the North American Securities Administrators Association, Inc. as Amici Curiae in Support of Respondent. For an eye opening account of the ongoing sales fees, see: a previous post, Mutual Fund Distribution Fee Reform.  

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