Why Mutual Fund Case Isn't About Executive Pay

Myths and 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 high—0. 88 percent vs. 0.45 percent—as 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 about 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 second of three articles. The first appeared yesterday; the next will run tomorrow.

[See Part I: How the Supreme Court May Make Mutual Funds More Expensive.]

Claim: This is a case about executive compensation. Ever since the Supreme Court agreed to hear Jones v. Harris Associates, onlookers have been quick to link it to the heated public debate about executive compensation. In fact, coverage of the case has consistently couched the proceedings in the context of the uproar over the lifestyles of the heads of struggling companies like American International Group and General Motors.

Are the parallels justified? Not really, argues Susan Ferris Wyderko, the executive director of the Mutual Fund Directors Forum, which provides outreach and education for the independent directors of U.S. mutual funds. "I don't see the linkage at all," she says. "I think they sound like lovely sound bites, but I don't think that's what's at issue in this case."

Adam Bold, the founder of The Mutual Fund Store, an investment management firm with more than 65 U.S. locations, agrees. As Bold sees it, the case is more about the cost of a product than the compensation of advisers. "The government doesn't regulate how much a car company can charge for a car. They don't regulate how much a restaurant charges for a dinner," he says.

Beyond that, the basic question at hand is not Harris's overall profitability, but rather the discrepancies in the prices charged to institutional as compared to retail investors. "What's at issue in this case is the standard of when a court intervenes to review a fee decision that's been arrived at between management and independent directors in a mutual fund, and that's really all that's at issue," says Wyderko.

Ryan Leggio, a Morningstar analyst, also considers the comparison between this case and broader compensation issues to be misleading. That's because unlike other executives, who can negotiate whatever salaries they can get away with, mutual fund advisers have a "fiduciary duty with respect to the receipt of compensation" for the services that they provide, according to the text of Congress's 1970 amendments to the Investment Company Act. "People have been making those parallels, and I see it in kind of a general sense, but I think that's a stretch here because Congress has really created a different kind of playing field for mutual fund advisers than for CEOs of companies," Leggio says.

[See Mutual Funds Singled Out in Proposal.]

So where did all of these comparisons come from? In large part, the answer rests with a dissenting opinion written by Judge Richard Posner of the Seventh U.S. Circuit Court of Appeals. As he rejects Chief Judge Frank Easterbrook's criticisms of the Gartenberg standard, which for years has governed fee disputes, Posner connects the dots between this case and the compensation debate.

"The panel bases its rejection of Gartenberg mainly on an economic analysis that is ripe for re-examination on the basis of growing indications that executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation," he writes. "Competition in the 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."

According to James Gregory, a partner in the Employee Benefits and Executive Compensation Group at the law firm Proskauer Rose, this language caused some observers to speculate that the case would have a downstream effect on paychecks in other industries. This interest only intensified as the market plummeted in the months after Posner's August 2008 dissent. "Especially with what's happened since that opinion was written, with the economic crisis and the credit crunch and so forth, I think people were wondering whether the Supreme Court might actually make some sort of broader statement about executive compensation and some perceived abuse," Gregory says.

Still, this seems highly unlikely, particularly given justices' attitudes during oral arguments. "There was really no suggestion to me that they were going to use this as an opportunity to make some larger statement on executive compensation," says Gregory.