The Past and Present of Mutual Fund Fee Regulation

Quinn Curtis is Albert Clark Tate, Jr., Professor of Law at the University of Virginia School of Law. This post is based on his recent paper, published in the Research Handbook on the Regulation of Mutual Funds.

Section 36(b) of the Investment Company Act permits mutual fund investors to sue funds for charging excessive asset management fees. This liability for excessive fees has proven to be one of the more problematic areas of mutual fund regulation. Fund complexes view the suits largely as unpredictable nuisances unrelated to fee levels, while for those concerned about mutual fund fees, section 36(b) has never resulted in a verdict for plaintiffs.

In the Past and Present of Mutual Fund Fee Regulation, my contribution to the Research Handbook on the Regulation of Mutual Funds (John Morley and William Birdthistle eds.) I situate the current state of mutual fund fee litigation in the larger context of the history and development of the section. Many of the problems that have plagued the operation of 36(b) are traceable to the compromises that resulted from the competing efforts of the SEC and Investment Company Institute (ICI) during the adoption of the 1970 amendments to the Investment Company Act. The shortcomings of contemporary 36(b) litigation are rooted in these disputes, which the statute left fundamentally unresolved.

Section 36(b) liability for excessive fees is not expressed as a cap, or even in terms of reasonableness, but instead takes the form of a fiduciary duty flowing from the mutual fund adviser, the recipient of the management fee, to the mutual fund itself. This odd regulatory approach was the result of the disagreement between the SEC and the ICI as to the proper standard to regulate mutual fund fees. The SEC’s preferred approach was to adopt a standard of reasonableness, but the ICI worried that a reasonableness standard was vague and would give too little deference to the judgment of mutual fund boards in approving fees. The ICI did not want courts to become free-ranging fee regulators. The SEC, on the other hand, was deeply concerned that mutual fund boards were beholden to fund complexes and therefore wanted to give minimal deference to their decisions to approve fees.

The result was a compromise bill, providing that fund advisers “shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services” and that courts should give board approval of fees “such consideration by the court as is deemed appropriate under all the circumstances.” The SEC viewed the fiduciary duty language as essentially equivalent to a reasonableness requirement, while the ICI believed that the language would cause courts to “look to the general law of fiduciary relationships which involve the negotiating of fees by a fiduciary with the other party to the particular transaction. In such situations it would appear that there is no question that a fiduciary can negotiate for his fee.” (Dec. 17, 1969 Letter from Robert L. Augenblick, President and General Counsel of the Investment Company Institute, to the Hon. John E. Moss, Chairman of the Subcommittee on Commerce and Finance of the Interstate and Foreign Commerce Committee) The statute’s fiduciary duty language effectively punted on this critical question, leaving he standard of liability to the courts.

The failure to establish a clear standard of review, within the language of the statue is the root cause of the deficiencies of 36(b) litigation. The seminal Gartenberg case established the standard for liability, which internalizes the ambiguous nature of the statute. Consistent with ICI’s hope that courts would not become fee regulators, Gartenberg requires plaintiffs to establish that “a fee … is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” (Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923, 928 (2d Cir. 1982).) But, perhaps consistent with the SEC’s preferred reasonableness standard, Gartenberg requires courts to consider a detailed and fact-bound list of factors. Consistent with the SEC’s concern about market-wide fee problems, Gartneberg explicitly eschewed comparisons to typical mutual fees as a dispositive factor in avoiding liability. By combining a stringent standard for establishing liability with a detailed multi-factor test, Gartenberg created a worst-of-all-worlds arrangement in which strike suits are hard to dismiss, but meritorious suits are almost impossible to win.

When the Supreme Court reviewed the Gartenberg standard in Jones, it did little to clarify the situation. The Court essentially signed off on Gartenberg, including, somewhat remarkably, its skepticism toward market-wide fee comparisons. Jones also modestly expanded potential liability by explicitly noting that comparisons of mutual fund fees to other types of asset management fees was a legitimate basis for arguing that mutual fund fees might be too high. Jones therefore entrenched and even expanded the ambiguity that was born with the statute and reflected in the Gartenberg standard.

A recent wave of mutual fund fee cases reflects these persistent problems. Following Jones a wave of suits targeted funds with subadvisery agreements, in which mutual fund complexes contracted out the management of a portfolio to another adviser. These suits took up Jones’ invitation to compare the costs of different types of asset management by comparing subadvisery fees for portfolio management with all-in fees paid by investors in funds with the same portfolio. These suits stated superficially attractive 36(b) claims and many were able to proceed. But 36(b)’s lack of focus on the actual fees paid by investors as compared with market rates led to strange results. For example, in at least one case, a fund that was the target of a 36(b) suit via its subadvisery services was actually less expensive for investors than the fund purchasing those services. That is, as between two funds with identical portfolios, the confused 36(b) standard induced plaintiffs to target the lower-cost fund.

Whatever the hopes of the proponents of 36(b) at the time of its enactment, there is little evidence that it has been effective in protecting investors. The root of the problem is a statute that failed to resolve a contemporaneous debate over how to achieve the goal of protecting investors against excessive fees. The drafters may have hoped courts would resolve the issue, but instead 36(b) has generated case law that effectively entrenches confusion, and the resulting cases have responded to the incentives created by the case law rather than to problems faced by investors.

The complete paper is available for download here.

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