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Loyola University Chicago

Institute For Investor Protection

School of Law

Investor Protection for Mutual Fund Investors

The mutual fund industry is experiencing exponential growth.  From 1965 to 2008 for example, the number of investors in mutual funds increased from 3.5 million to 92 million, and the assets under management grew from $38.2 billion in 1966 to over $9.6 trillion in 2008.  According to the 2010 Investment Company Factbook, available here:  http://www.icifactbook.org/, the United States has the world’s largest mutual fund market.  A mutual fund is a pool of assets, consisting primarily of a portfolio of securities, and belonging to the individual investors holding shares in the fund.  More important than the growth in fund assets, however, is the increasing role mutual funds serve as an investment vehicle for American investors.  As reported by the Securities and Exchange Commission, mutual funds have almost 88 million shareholders, with 49% of U.S. households investing.  The SEC also notes that mutual funds account for 17% of total retirement assets and almost 42% of 401(k) assets.

 

Mutual Fund Fees


Shareholder Fees              Annual Fund Operating Expenses
- Sales Load                          - Management Fees
- Redemption Fee                  - Distribution and Service Fees
- Exchange Fee                     - Other Expenses
- Account Fee                       - Total Annual Fund Operating Expenses
- Purchase Fee

A mutual fund, like any other business, has operating costs that are passed on to investors.  A mutual fund will identify in its prospectus under “shareholder fees” and in the fee table under its “annual fund operating expenses,” fees associated with an individual investor’s transaction and account, and fees as a result of regular and recurring, fund-wide operating expenses.  The SEC explains and breaks down mutual fund fees here:http://www.sec.gov/answers/mffees.htm

 

One of the costs associated with a mutual fund—the mutual fund adviser’s fee—may be a source of investor-abuse.  A mutual fund is usually formed by the fund’s investment adviser, who is selected by the fund’s board.  In the case of publicly held mutual funds, advisers often offer their services, including their fees, on a “take it or leave it” basis.  Thus, a mutual fund adviser’s compensation is often not the product of arms’ length bargaining and may be too high.  Advisory fees can be very expensive for long-term investors, and investors of mutual funds, according to the 2010 Investment Company Factbook, are predominately those saving for retirement.  In addition, these high fees are unlikely to drive investors away.  Apart from the deterrent in terms of taxes, time, effort, and reinvestment expenses, these investors often have nowhere to go: “The chief reason for substantial advisory fee level differences between equity pension fund portfolio managers and equity mutual fund portfolio managers is that advisory fees in the pension field are subject to a marketplace where arm’s-length bargaining occurs. As a rule, mutual fund shareholders neither benefit from arm’s-length bargaining nor from prices that approximate those that arm's-length bargaining would yield were it the norm. Jones v. Harris Associates L.P., 537 F.3d 728, 731-32 (7th Cir. 2008) (Posner, J., dissenting from denial to rehear en banc) (citing John P. Freeman & Stewart L. Brown, Mutual Fund Advisory Fees: The Cost of Conflicts of Interest, 26 J. Corp. L. 609, 634 (2001).

 

THE GARTENBERG FACTORS FOR SETTING ADVISORY FEES

Court decisions provide important guidance to mutual fund advisers and mutual fund boards regarding how to set fees and the extent of an adviser’s liability under Section 36(b) of the Investment Company Act of 1940.Courts evaluate the facts and circumstances of the fee contract to determine whether the adviser charged a fee that is so disproportionately large, that it bears no reasonable relationship to the services renders and could not have been the product of arms’-length bargaining.  Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923, 928 (2d Cir. 1982)


Relevant facts and circumstances that courts will consider when evaluating a Section 36(b) claim for excessive mutual fund advisory fees include: 
(1) The nature and quality of the services provided by the adviser, including the performance of the fund;
Courts consider the nature of both investment and non-investment services, which includes accounting, shareholder servicing, and legal compliance activities. Schuyt v. Rowe Price Prime Reserve Fund, Inc., 663 F. Supp. 962, 974-76 (S.D.N.Y. 1987). Courts also consider the quality of the service, which includes an assessment of the yield-and-expense ratio, and the fund’s growth and gain in market share. Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1222, 1229 (S.D.N.Y. 1990).
(2) The adviser’s cost in providing the services and the profitability of the fund to the adviser;
An adviser’s cost includes costs from multiple services and costs incurred by the adviser’s affiliate. Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923, 931 (2d Cir. 1982).  An advisory fee does not violate Section 36(b) merely because it is profitable to the adviser.  Moreover, calculating exact profitability is difficult.  Thus, courts have shown considerable flexibility by allowing multiple methods to calculate profit percentages and in refusing to set limits on the profits an adviser can earn.
(3) The extent to which the adviser realizes economies of scale as the fund grows larger;
Congress adopted Section 36(b) because Congress recognized that fees, which were often a percentage of overall assets, although reasonable when the fund was launched, may have grown disproportionate to services provided as the fund grew.  Fogel v. Chestnutt, 668 F.2d 100, 111 (2d Cir. 1981).  Break-points at certain asset levels may show reasonableness of fees.  Investors must show, not only that the fund has grown, but that the adviser’s per-unit costs produced economies of scale. 
(4) The fall-out (or collateral) benefits that accrue to the adviser and its affiliates as a result of the adviser’s relationship with the fund (e.g., soft dollar benefits);
Investors must quantify the fall-out benefits and then show that the benefits are of a range beyond what would have been negotiated at arm’s length.  Krinsk v. Fund Asset Mgmt., Inc., 715 F. Supp. 472, 495-96 (S.D.N.Y. 1988).   
(5) The performance and fees of comparative funds; and
The Supreme Court in Jones v. Harris Associates, L.P., addressed the propriety of comparing fees mutual fund advisers charge their captive mutual funds with fees advisers charged to institutional investors for whom the adviser managed separate accounts.  To determine whether an investment adviser’s fees are disproportionately large, no categorical rule prohibits comparisons between fees that the adviser charges to a captive mutual fund and the fees that it charges to its independent clients, but these comparisons may nevertheless be problematic as these fees may not be the product of arms’ length bargaining.  Jones v. Harris Assocs. L.P., 130 S. Ct. 1418, 1428-29 (2010) (available here:http://www.supremecourt.gov/opinions/09pdf/08-586.pdf.).  Moreover, a court will consider both the procedure in which the fee was negotiated and the substance of the terms.  If disinterested directors of a board considered the relevant factors when negotiating and reviewing adviser compensation, their decision to approve a particular fee agreement is given considerable weight.  Jones, 130 S. Ct. at 1429.  But if the board’s process was deficient or the adviser withheld important information, the fee agreement is viewed with more suspicion.  Id. at 1429-30. 
(6) The independence, expertise, care, and conscientiousness of the board evaluating adviser compensation
Courts carefully consider the directors’ education, experience, financial business acumen, the information provided by the board, the manner in which the information is provided to the board, the directors’ activities in weighing the information, and whether the directors consulted with independent counsel.  See Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1222, 1242-47 (S.D.N.Y. 1990).

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