WSJ Opinion: Tort Lawyers Target Mutual Funds

Updated Nov. 1, 2009 6:55 p.m. ET

If you invest in mutual funds, you should be worried about a case argued today at the U.S. Supreme Court. The lawsuit aims at overturning the way investment managers of mutual funds are paid. The process has worked well and fairly for decades. If it is thrown out, every mutual-fund fee arrangement could end up being litigated in a federal court. This will not benefit the vast majority of investors.

The issue in Jones v. Harris Associates L.P. boils down to this: Should judges or independent directors of mutual funds determine the fees of mutual-fund investment managers? Judges have much on their plates and little practical expertise to guide them. Directors who are not beholden to the fund’s investment manager for their jobs have the time and background—driven by fiduciary duty and knowledge of the marketplace—to scrutinize reams of data and determine on behalf of investors the appropriateness of a fee. Some funds, like index funds, are relatively cheap to manage; others, like international funds, can be relatively costly, because of the special expertise and unique hassles involved in managing a foreign portfolio.

By law in 1940, and again in 1970, Congress said independent directors are best suited to supervise fee decisions, and in 1982 the U.S. Second Circuit Court of Appeals—in Gartenberg v. Merrill Lynch—tried to give more guidance. It instructed courts to consider claims against an investment manager’s fee in light of a variety of factors, giving great weight to independent director approval.

Under Gartenberg, courts can overturn the directors’ determination if the fees are clearly excessive. Consequently, they can effectively weed out meritless claims before trial, and directors have a great incentive to review carefully the manager’s contracts in light of service quality and fees paid by comparable funds. Since state laws give great deference to the directors’ business judgments, Gartenberg correctly set a high bar to challenging their determinations.

The lawyers behind Jones v. Harris want to change that standard. By abandoning the Gartenberg guidance for a very general standard, they hope to open the courthouse door to annual lawsuits over virtually every fund’s management fee. Federal judges could be forced to examine every fund advisory agreement with a fine-toothed comb, because they would lack an up-front test to dismiss meritless cases. Fund managers and directors could spend countless hours responding to lawyers’ questions rather than investors’ needs. The lawyers’ hope, of course, is that to avoid the cost and distraction, funds would settle and pay the lawyers to go away.

Investors would pick up the tab for this paper chase. The mutual-fund industry would become a happy hunting ground for fee litigation, reducing choice and increasing costs for investors as some fund managers leave the field and others are forced to raise fees to pay their legal bills.

This is not necessary because fund boards bring independent and expert business judgment to fee decisions. The law requires that each fund’s independent directors, meeting separately from any directors beholden to the investment manager, can approve the fee to be paid the fund manager. These directors spend months reviewing reams of data on fund performance, costs, services and other factors, comparing each fund’s fees to its competitors’.

The process is highly transparent to investors and the Securities and Exchange Commission. Funds must disclose to investors the factors their boards consider in approving advisory contracts and the basis of their approval.

The mutual-fund market is competitive, and investors are sensitive to management fees. A 2007 study by Columbia Business School Dean Glenn Hubbard and Harvard Law Prof. John C. Coates found that a 10% increase in fees results in a drop of fund assets of up to 28%, after controlling for other relevant factors. Since 1980, Investment Company Institute data show that fees and expenses paid by mutual fund investors are down 57% for equity funds and 63% for bond funds. According to a May 2009 Morningstar report, the U.S. has the world’s lowest-cost mutual funds. Moreover, low-cost exchange-traded funds, which unlike mutual funds are not actively managed, provide even more competition and alternatives for investors who do not want to pay for traditional managed mutual funds.

In 1970, Congress strengthened its standards for independent directors but rejected proposals that could have turned federal courts into rate-setters for mutual funds. The Supreme Court should respect these decisions and turn back the trial bar’s attempt to turn judges into pay czars for the mutual fund industry.

Mr. Atkins, an SEC commissioner from 2002-2008, is now a managing director of Patomak Partners, a consulting firm.