Oakmark case raises tough issues and could be headed to the Supreme Court.
As regular readers can attest, Morningstar is always pushing for reasonable expense ratios on behalf of shareholders. Shareholders have many options if they end up owning a fund with high fees, including pushing the fund to lower its fees or simply taking their money elsewhere. Some shareholders, however, have chosen an alternate route: They've taken the issue to court.
A disagreement between two well-known judges in a recent "excessive fee" case deserves attention because it raises important questions as to the role of the judiciary when mutual fund fees are at issue. The shareholder lawsuit in question is against the investment advisor of Oakmark I
The issue before the 7th Circuit Court of Appeals was whether the investment advisor to Oakmark, Harris Associates L.P., breached its fiduciary duty by charging excessive management fees in violation of Section 36(b) of the Investment Company Act of 1940. The test used by many courts (the Gartenberg test) is if the fee schedule is within the range of what would have been negotiated at arm's length (that is, between two independent parties who are on equal footing), then the fee schedule is not excessive and there is no breach in fiduciary duty. The shareholders who brought the suit argued that the fees that Harris charges its mutual fund clients may not exceed those it charges its other clients; in this instance, Harris charged mutual fund shareholders twice the management fee it charged institutional clients.
The 7th Circuit Court rejected the Gartenberg test and replaced it with a simple requirement: transparency. Chief Judge Frank Easterbrook, writing for the majority in upholding Harris' mutual fund fees, stated, "A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth." Easterbrook makes one qualification to this rule: If the fees are "so unusual" that a court could infer that deceit must have occurred, then the judiciary may get involved. (See the full text of Easterbrook's opinion.)
However, fellow 7th Circuit Court Judge (and former Chief Judge) Richard Posner rejected this new test and the logic behind it, writing in dissent:
"The panel's 'so unusual' standard is to be applied solely by comparing the adviser's fee with the fees charged by other mutual fund advisers. Gartenberg's 'so disproportionately large' standard is rightly not so limited. The governance structure that enables mutual fund advisers to charge exorbitant fees is industry wide, so the panel's comparability approach would if widely followed allow those fees to become the industry's floor. And in this case there was an alternative comparison, rejected by the panel on the basis of airy speculation--comparison of the fees that Harris charges independent funds with the much higher fees that it charges the funds it controls. (See the full text of Posner's opinion.)
In other words, Posner believes that courts must be able to look at all of an investment advisor's clients when comparing fees, not just mutual fund clients who often pay more as a group than institutional clients.
A Closer Look
One might reasonably ask, "How can two well-regarded judges read the same statute and come to such different conclusions as to what the statute means?" The answer is simple: The statute is vague. Congress did not define what a "fiduciary duty" means in the statute, and the legislative history is apparently unclear as to Congress' intent. Therefore, the judges have to decide what Congress probably meant when it used the term "fiduciary duty." This explains why two capable judges can have two very different, and defensible, readings of the statute.