( Disponible en anglais seulement )
Few lawyers who attended law school in the eighties and nineties can have failed to come across the writings of Richard Posner, surely one of the most energetic and prolific academics ever to have graced a Senior Common Room. In 1981, Professor Posner became Judge Posner, having been appointed by Ronald Regan to the U.S. Court of Appeals for the Seventh Circuit, a federal appellate court. And it is to Richard Poser that we owe, in part, anyway, the first decision of the Supreme Court of the United States in a quarter century discussing mutual funds.
The case in question is Jones v. Harris, one of the most widely reported, highly anticipated and blogged-about commercial cases in recent memory. The background is this. It may come as a surprise to many of us in Canada that the American statute that regulates mutual funds, the Investment Company Act of 1940, contains provisions to guard against “excessive fees”. Investors in a US mutual fund, called “fund shareholders”, may bring a claim against the advisory firm that manages the fund, alleging that the fees received were excessive. And that is what happened in Jones v. Harris. The plaintiffs, investors in the Oakmark mutual funds, claimed that the manager, Harris Associates, LP had violated its fiduciary duty in setting fund fees. Although Oakmark’s fees were competitive when compared against fees of similar funds charged to individual investors, the plaintiffs pointed out that these retail fees were much higher than the rates paid by institutional investors such as pension funds. Canadian investors will note with envy that the flagship Oakmark Fund, a mid to large-cap US equity fund, paid Harris Associates fees of 1% (per year) of the first $2 billion of the fund’s assets, 0.9% of the next $1 billion, 0.8% of the next $2 billion, and 0.75% of anything over $5 billion. The fees for the other funds that were the subject of litigation were similar. The evidence indicated that this level of fees was roughly the same (in both level and breakpoints) as those of other funds of similar size with similar investment objectives.
Furthermore, all three of the funds significantly outperformed their peers. For example, the Oakmark Global Fund was ranked No. 1 in net return among 254 comparable funds, as defined by Lipper, for the three-year period ending March 31, 2004, and charged fees that were below the median for its peer group.
Although the statute permitting private civil action for excessive fees has been on the books since 1970, fund investors have never succeeded in court. Of the four cases that have gone to trial, the defendant fund companies prevailed in all. There have been other actions commenced and settled, but the terms of such settlements typically provide for any amounts paid to be kept confidential.
At the District Court, the plaintiff’s claim was again summarily dismissed on the basis of the principles established in Gartenberg v. Merrill Lynch Asset Management Inc. Through almost three decades, Gartenberg has, in the United States, become entrenched as setting out the standard for fiduciary duty for mutual fund advisers and boards. In that case, decided in 1982, the U.S. Court of Appeals for the Second Circuit held that a fiduciary breach will be found to have occurred if the fee charged “is so disproportionately large that it could bear no reasonable relationship to the services rendered and could not have been the product of arms-length bargaining.”
But when Jones v. Harris went to appeal, the Seventh Circuit split. In affirming the decision of the lower court, Judge Frank Easterbrook, another former academic of the law and economics school and in fact Posner’s colleague at the University of Chicago, went out of his way to declare that the markets should set fees and the fund advisor is obliged only to be fully transparent and to make full disclosure. In so doing, Easterbrook appeared to reject the long established Gartenberg standard of fiduciary duty. In an ironic (or deeply satisfying, depending on how you view these things) turn of events, the father of the law and economics movement, Judge Posner, wrote a blistering dissent. In a widely quoted passage, Posner noted:
The panel bases its [decision] mainly on an economic analysis that is ripe for reexamination. . . . Competition in product and capital markets can’t be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds. Mutual funds are a component of the financial services industry, where abuses have been rampant.
The context here is that Posner has had something of a change of heart. In 2009, he published A Failure of Capitalism: The Crisis of ‘08 and the Descent into Depression, and in it, he argued that the modern financial system is not in fact automatically self-correcting, and best left more or less alone. To the contrary, Posner argued for strong financial regulation to counter inherently self-destructive aspects of the markets. We will never know for sure, but it certainly has been speculated that one of the reasons the Supreme Court agreed to hear this case is because of the opposing views of two legal heavyweights in the Seventh Circuit.
In the end, the U.S. Supreme Court unanimously affirmed Gartenberg and rejected Easterbrook’s view of the adviser’s fiduciary obligations. Easterbrook had opined that an investment advisor must merely “make full disclosure and play no tricks, but is not subject to a cap on compensation”. The Supreme Court noted that in “focusing almost entirely on the element of disclosure, the Seventh Circuit panel erred.”
For Canadian observers, the take-aways may be as follows. Firstly, in Canada as in the US, there is awareness and concern on the part of policymakers and regulators regarding the level of fees charged by retail mutual funds. Fees reduce returns to investors. The concern with high fees and their deleterious effect on retirement savings is informing the national conversation on pension reform. Policymakers are justifiably reluctant to take any overtly interventionist measures. Nevertheless, we can expect Canadian regulators to reflect on the American position that disclosure alone, no matter how ample, timely and transparent, may be insufficient to fully protect the interests of investors.
Secondly, the decision in Jones v. Harris reinforced the principle that courts should not substitute their judgment for that of fiduciaries behaving reasonably. Under US legislation, the fees paid by mutual funds are negotiated between the fund’s adviser and the board of the funds company. The Supreme Court stated unequivocally that “It is important to note that the standard for fiduciary breach…does not call for judicial second-guessing of board decisions.” So, as long as the process adopted by the board in conducting business and making decisions, particularly in regards to fees, is robust, courts should defer to the outcome arrived at.
And finally, the court unanimously and without reservation affirmed that investment advisers owe a fiduciary duty to the funds they manage, even in the matter of setting fees. The court implicitly rejected the reasoning that since mutual fund investors have plenty of choice and can “vote with their feet”, the advisor’s duty is discharged once full disclosure is made. While admitting that the exact meaning of “fiduciary duty with respect to the receipt of compensation” is “hardly pellucid”, the court stated that fiduciary principles require that the fees charged must be reflective of those that would be charged by arms-length third parties bargaining in good faith. So, in theory anyway, there can be a breach of fiduciary duty in charging non-arms length fees, even where they are fully disclosed.
While industry analysts and legal commentators on both sides of the border ponder the longer-term meaning of Jones v. Harris (is it a victory or defeat for fund investors), the prodigious Judge Posner has written yet another book, The Crisis of Capitalist Democracy.