Mutual Funds, Fiduciary Duty and Fairness

A case filed five years ago by three shareholders in the Oakmark Funds, run by Chicago-based Harris Associates, will get its day in court Monday when the U.S. Supreme Court hears arguments from the shareholders that the fees charged by the fund managers are too high and violate fidicuary duty – i.e., they are not set in the best interests of shareholders, as mandated by Congress almost four decades ago.

By some estimates, money-management fees in the mutual fund industry reached close to $100 billion last year in a $10 trillion industry, according to an article in The Wall Street Journal, which notes that “typically, the investment-advisory committee that manages a mutual fund takes a percentage of the assets…. That fee is negotiated with the mutual-fund board, which is set up to represent investors.”

The shareholders claim that Harris charged Oakmark “an effective rate of 0.88% on $6.3 billion in assets, nearly twice the 0.45% rate for an unrelated institutional client like a pension fund,” states The Journal. In addition, the shareholders cite “conflicting business and personal relationships among the trustees and Harris personnel,” including the fact that Oakmark’s board chairman, classified as an “independent director,” was a former Harris partner who continued to earn money from the firm, according to the article.

The Supreme Court’s case on mutual fund fees “is interesting for several reasons,” says Wharton legal studies and business ethics professor Richard Shell. “First, it shows that the problem of how business people set their own compensation in large firms extends to the mutual fund industry and predates the economic crisis. It turns out that mutual fund managers, like executives at big banks, have what some think is a pretty cozy relationship with the board members who set executive pay – and it may come as no surprise that those pay decisions are not always what an average shareholder would approve.”

Second, he notes, “it is further evidence that courts may be increasingly skeptical of the model that says, ‘Markets always get things right.’ Two Chicago-School, economics-minded judges – Frank Easterbrook and Richard Posner – sharply disagreed with one another in the lower court opinion in this case. Easterbrook said, ‘Trust the market and leave the pay issue alone.’ Posner said, ‘We can’t trust the market when there are conflicts of interest.’ Easterbrook got more votes than Posner in the court of appeals, but my guess is that Posner will win the day in the Supreme Court.”

A ruling is expected in June.