Excessive Fee Case – Earthquake or Tremor?

by Eric Daugherty
Look for the Supreme Court to send a message to the fund industry, but not to support fee caps or other interventionist measures. Even if the Court does not find in favor of the plaintiffs in the Jones v. Harris case (for background, see this Wall St. Journal online article), firms should anticipate continuing scrutiny around fund simplicity, independence, and transparency going forward.
It is remarkable enough, and a sign of the troubled times in the financial industry, that the Supreme Court is going to hear a case on excessive mutual fund fees. What will the outcome and lasting implications be for the asset management industry?
The case hinges on the fairness of fees and the independence of the directors that set those fees. With all the focus on executive compensation lately, the case has drawn attention to the level of executive and Board compensation and how those costs can inflate fees.
The precedent in question in this case is the so-called Gartenberg standard, which indicates that an advisor breaches his fiduciary duty only if fees are so disproportionately large that they bear no resemblance to fees that could be negotiated on an arms-length basis.
Fund industry veterans know that fees are unjustifiably high for some funds. It is clear that not all fund directors are truly independent and that boards take most of their direction on fees from management. However, one is hard pressed to say that investors do not have choices or that competition does not drive expenses lower . Fund flows are increasingly going to lower cost funds (laid out here – and this trend continues today).
So no matter how egregious the fees of a fund, investors have plenty of choice and can take their money and turn to lower-expense funds at will – and they do. That is competition. As such, while I am not a lawyer, I do not see the Court deciding for the plaintiffs in this case.
However, I do think the Court will find a way to send a strong statement to the industry: SIT! In this case, SIT stands for Simplicity, Independence, Transparency. The system we have in place for investors to invest in mutual funds works, but only if products are simple enough to understand, boards are independent enough to undertake strong oversight, and communication is transparent enough for all to see what is going on. Don’t expect an earthquake of change and reform to germinate from this case, but there will be some tremors resounding after it is over. Asset managers should be anticipating these tremors, and should be thinking now about how to position their products to meet the SIT test.

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