Fund fees face legal scrutiny

Two legal cases that will be decided by courts this year may significantly affect the mutual fund and investment advisory industries.
APR 26, 2009
By  MFXFeeder
Two legal cases that will be decided by courts this year may significantly affect the mutual fund and investment advisory industries. Financial planners and advisers should be aware of the cases and consider the likely impact on the industry if the plaintiffs win. Both cases involve the level of fees charged to mutual funds by their advisory firms. The U.S. Supreme Court has agreed to hear one case, that of Jerry Jones et al. v. Harris Associates LP. In the other, Gallus et al. v. Ameriprise Financial Inc., the 8th U.S. Circuit Court of Appeals overturned a district court decision in favor of Minneapolis-based Ameriprise and sent the case back to the district court "for further proceedings not inconsistent with the views set forth in this opinion." In the Jones v. Harris case, the plaintiffs argued that the adviser's fees were too high and thus violated the fiduciary standards of the Investment Company Act of 1940. A district court rejected this argument, ruling in favor of Chicago's Harris Associates based on a precedent set in a 1982 case stating that the test should be whether the fees are within the range of what would have been negotiated at arm's length and that the fees are not so disproportionately large as to be unreasonable in light of the services provided. The plaintiffs appealed, arguing that precedent should not be followed, because it relies a lot on market prices as the benchmark of what are reasonable fees. The benchmark is not valid, they argued, because fees are set incestuously. They further argued that if any market fees are used, they should be the fees for unaffiliated institutional clients. The 7th U.S. Circuit Court of Appeals again rejected the plaintiffs' arguments, ruling: "A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trustees, rather than a judge or jury, must determine how much advisory services are worth." The decision of the Supreme Court to hear the appeal suggests that at least some of the justices are ready to revisit the issue. In the Gallus case, the 8th U.S. Circuit Court of Appeals ruled that while the 1982 decision provides a useful framework for looking at advisory fees, in deciding if the Ameriprise's mutual fund fees were reasonable, the lower court should have compared them with the firm's institutional fees. These two cases suggest that the courts are beginning to recognize that the mutual fund industry has changed greatly since the 1982 decision and that some of the assumptions underlying it may not be valid. They may be ready to require mutual fund boards, who are fiduciaries, and the fund companies, also fiduciaries, to negotiate at arm's length and to negotiate more reasonable fund advisory fees. If they do so, revenue and profit margins in the mutual fund industry almost certainly will come under pressure. That could mean more fund company mergers as firms attempt to offset the lower revenue with economies of scale. That in turn may lead to fewer fund choices. It could also mean fewer client services, separate fees for some of those services and possibly lower commissions for commission-based advisers. Overall, these cases bear watching because their outcomes could have a substantial impact on the mutual fund industry and its clients.

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