Bench Memos

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The Trial Lawyers’ Latest Target: Mutual Funds


Federal judges are usually, well, judicious in choosing their words. So the rebuke that a panel of judges from the U.S. Second Circuit of Appeals aimed at the plaintiffs’ bar in a recent decision was, in judicial terms, sharp and stinging. “We cannot help but observe that the Complaints filed in this case are strikingly similar to prior claims brought—including one in this Circuit—by Plaintiffs’ counsel, all of which have been dismissed.” The panel tossed out the case in question, but that hasn’t stopped contingency-fee lawyers from bringing more suits.Today, these lawyers will have their day before the U.S. Supreme Court—and if they win, the real losers will be American investors.

What burning issue is attracting these swarms of trial lawyers? It’s the fees that portfolio managers and advisors charge for running mutual funds. It’s hard to see any injustice: Overall, the cost of investing a dollar in a mutual fund has fallen by around 60 percent over the last 30 years. Yet mutual fund fee litigation is growing. In some years, cases involving funds represent almost 10 percent of all U.S. federal securities class actions. Overall, according to Securities Litigation Report, more than 500 private class actions and derivative suits have been filed against mutual fund advisers.

The case of Jones v. Harris Associates L.P. is the trial bar’s best shot yet at turning the mutual-fund industry into a contingency-fee bonanza.

In 1940 and 1970, Congress gave the task of negotiating mutual-fund advisory fees to funds’ independent directors—trustees who are unaffiliated with the fund adviser and charged with a fiduciary duty to represent fund shareholders. The Supreme Court has recognized these trustees as “independent watchdogs” for shareholder interests. And the Second Circuit set the standard for how judges should consider claims that fees are excessive, including a requirement that a court give considerable weight to the judgment of the independent directors, in the 1982 case of Gartenberg v. Merrill Lynch.

The plaintiffs’ bar wants to gut this precedent, inviting contingency-fee lawyers to file annual lawsuits to drag each fund’s fee decisions in front of a federal judge. The results could be higher costs for funds, fewer advisers in the fund business, and less choice for investors.

How do the trial lawyers justify this legal attack? First, they insist that there is no competition in the fund industry, as demonstrated by the fact that fund boards rarely fire advisors. But that misses the point. The real competition is for investor dollars, and investors hire and fire fund managers every day. With more than 8,000 funds to choose among, investors can move their money with a couple of phone calls or a few clicks of the mouse—and they do. Each year from 1990 to 2008, between 25 percent and 70 percent of fund advisers experienced net cash outflow.

The contingency-fee lawyers also point to the gap between fees that advisers charge mutual funds and the generally lower fees they charge such institutional clients as pension funds. The two fees should be identical, the plaintiffs say. But the services, capital commitments, risks, and regulations involved in serving these two classes of clients are worlds apart. With an average mutual fund account balance of $26,000; an adviser must gain and service more than 1,500 fund accounts just to match the $41 million average balance of an institutional account.

But facts like these have rarely stood in the litigators’ way. In 2006, a commission headed by Brookings Institution Chairman John Thornton and Columbia Business School Dean Glenn Hubbard warned that the unique American institution of class action suits in securities law resulted in $150 million of liabilities in 1995. “(B)y 2004, this had exploded to $3.5 billion.” A commission headed by Senator Charles Schumer (D., N.Y.) and New York Mayor Michael Bloomberg warned in 2007 that the U.S. must “reduce spurious and meritless litigation and eliminate the perception of arbitrary justice.”

We can only hope that judges are taking note. One small but hopeful sign is the slap that the Second Circuit gave to a mutual fund fee case similar to Jones. One member of the judges on that panel was Sonia Sotomayor, now the newest member of the Supreme Court. Let’s hope that the high court recognizes that if the trial lawyers win, it’s investors who will get stung.

 – Paul Schott Stevens is president and CEO of the Investment Company Institute, the national trade association for mutual funds and other registered investment companies.


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