How the Supreme Court May Make Mutual Funds More Expensive

Separating myths from realities in the Supreme Court's mutual fund case.

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As the Supreme Court mulls over mutual funds' fees, analysts have lined up to read between the lines. And while a decision in Jones v. Harris Associates is probably months away, there is no shortage of opinions about its implications.

On its surface, the question at the heart of the case is narrowly constructed: Should courts intervene when investors claim that asset managers' fees excessively favor certain clients? The plaintiffs are shareholders in the Oakmark funds, which are run by Harris Associates. The Oakmark shareholders say that at the time they filed the suit in 2004, they were being charged management fees nearly twice as high0.88 percent vs. 0.45 percentas those assigned to Harris's institutional clients.

[See Retail Investors Get Their Day in High Court.]

Still, this veneer of simplicity hasn't prevented an outpouring of speculation as to how potential outcomes could affect the broader financial industry. With that in mind, U.S. News takes a look at three of the most common claims and examines how likely the suggested impacts are to materialize. This is the first of three articles. The next two will appear Tuesday and Wednesday.

Claim: The Supreme Court's decision could inadvertently make funds more expensive to own. In jumping in to referee a tense dispute in the Seventh U.S. Circuit Court of Appeals, the Supreme Court could create a new rubric for evaluating mutual fund fee disputes. If that happens, some fear it would trigger a wave of litigation as mutual funds and investors spar in court to test the standard's limits. This, in turn, could drive up expense ratios over time as funds pay to defend themselves, which would be an ironic twist of events for the plaintiffs in this case, who are seeking lower fees.

[See Study Shows Increases in Mutual Fund Fees.]

"The Supreme Court could conceivably articulate a new and different standard that may well prompt ... lawyers to bring additional litigation against mutual funds, and those costs will come directly from the shareholders' pockets in the form of higher fees," says Susan Ferris Wyderko, the executive director of the Mutual Fund Directors Forum, a group that does outreach and education for the independent directors of U.S. mutual funds.

Since 1982, courts have used the Gartenberg standard, established in Gartenberg v. Merrill Lynch Asset Management, to resolve fee disputes. While Gartenberg is broadly deferential to fund providers, the circuit court took it a step further in its 2008 decision. In his ruling, Chief Judge Frank Easterbrook takes issue with Gartenberg, which says that a fee should not be "so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining." Easterbrook suggests that there must also be deceit involved in order for a court to intervene. He says that a fiduciary's duty is to "play no tricks" on investors and that market pressures rather than the courts are the solution to high fees.

Currently, the Supreme Court has a number of options: Justices can take Easterbrook's side, create their own standard, or reaffirm Gartenberg. Still, despite concerns that the high court's decision could usher in an era of rampant mutual fund litigation, the justices gave the impression during oral arguments earlier this month that they weren't looking to make any sweeping changes. And even if justices do embrace a new standard, not everyone is convinced that investors will suffer from higher costs. If the new metric is closer to Easterbrook's ruling, for example, it could instead drive down the number of lawsuits, since it would make it harder for investors to sue.

On the other end of the spectrum, even a standard that is more permissive of lawsuits isn't guaranteed to push up expense ratios. "The lawsuits for these particular types of cases are really kind of few and far between. It's not as if plaintiffs attorneys are suing every single asset management company," says Morningstar analyst Ryan Leggio. As a result, if the Supreme Court rules that Harris's fee differentials between its institutional and retail clients are excessive, costs could actually decrease enough to offset any litigation expenses that get passed along to investors. "Since it's unlikely that institutional investors will agree to pay more ... that would mean that retail fees would have to come down," Leggio says.

Another possible outcome is a return to Gartenberg. Paul Atkins, managing director of the consulting firm Patomak Partners and a former Securities and Exchange Commission commissioner, says he likes the Gartenberg standard because it provides judges with criteria for throwing out spurious lawsuits. "The most important thing is to deter the silly lawsuits, and we all know that they exist, and we all know that they're out there where plaintiffs lawyers are basically trying to shake people down for settlements," says Atkins, whose firm advises investment managers.

Ultimately, though, even if lawsuits do prompt funds to pass off extra costs to shareholders, it's unlikely that any increases in expense ratios will be substantial. "Certainly, for a few funds that may be the test cases under a new standard . . . there could be some marginal fee increases, but as kind of a general proposition, I think that's unlikely," says Leggio.