Jones v Harris Associates: the Supreme Court on mutual fund management fees

Jones v Harris Associates

Jones v Harris Associates, a lawsuit that  has been going on for a while, finally took what may be a terminal turn when the Supreme Court issued guidelines and sent the case back to an appeals court for a last tuneup.

a strange lawsuit

The suit struck me from the first as a bit odd.  The plaintiffs, shareholders of Oakmark mutual funds managed by Harris, claim to have been damaged, by Harris.  Suing a money manager isn’t the strange part.  The reasoning is.

The “damage” was caused, the plaintiffs contended, not by the funds performing poorly or losing them money, but by the fact that Harris also manages money for institutional clients like corporate pension plans and charges lower fees to the latter.

I can see that the lawyers for the plaintiffs could have enjoyed a huge payday if their suit were successful–and that they would have clients of other fund management groups falling all over themselves signing on for similar litigation.  Of course, the big recession has doubtless put a big dent in their other, hopefully more useful, legal work.  But really…

pricing in the real world

At the risk of providing more fodder for the law profession, everyday life is filled with instances where individuals pay different prices for identical products.  For example:

–airlines, and now busses, practice “yield management,” which typically means that  the price of a seat rises progressively from the first passengers to book to the last.  Most large corporations have arrangements with airlines that get them very deep discounts over what private individuals pay.

–my wife and I booked a beachfront hotel room in Florida through Hotwire recently.  We paid $110 a night for a room the hotel would have charged us $199 for–and which it probably sold to Hotwire for $85.

–almost every automaker has a premium brand–Acura, Cadillac, Infiniti–that is uses to rebadge a vehicle and sell it for thousands of dollars more than the equivalent with a Chevrolet, Honda or Nissan label.

–household goods makers manufacture private label products for Wal-Mart in the same factories, with basically the same ingredients and same processes as the price of getting shelf space for their (much higher-priced) brand name goods.

–and what about the Early Bird Special for senior citizens, or what about the process of buying a car?

I’m sure you could add dozens of items to this list.  And remember, in the case of mutual fund and institutional investment management services, it’s not clear that they are the same product.  More about this below.

questioning the board of directors actions

The plaintiffs didn’t just point out that the fees were different.  They also asserted that the boards of directors of the Oakmark mutual funds were so under the influence of Harris that they would agree to any fee Harris asked for.  It’s not clear whether this was simply name-calling or they offered some evidence.

The initial trial judge agreed that this was not much of a case.  He did the equivalent of laughing it out of court by issuing a summary judgment in favor of Harris.

The plaintiffs appealed.

The appeals court wound up even further in the Harris camp, by ruling that the plaintiffs would have to show that in negotiating with the directors of a mutual fund about fees, Harris had both:

–received an absurdly high fee with no relation to the services rendered, and

–defrauded the directors into agreeing to such a fee.

The plaintiffs apparently did neither, and they lost a second time.

The plaintiffs appealed again, and the Supreme Court said it would hear the case.  It recently put its two cents in and returned the case to the lower courts.  The SC’s comments:

1.  It’s not obvious that institutional products and mutual fund products are identical.  Even if they are, it’s not necessary to have the same prices.

2.  It’s not the courts’ job to second-guess the boards of directors of mutual funds, nor to get into the business of setting investment fees.

3.  Comparing one fund family’s fees with other fund families’ is irrelevant, since it begs the question of whether the fees in the comparison group have been set fairly.

Are the products different?

As someone who has managed both kinds of money, my answer is that they are.

–as the plaintiffs in Jones v Harris Associates contend, the fees are different.  Mutual fund management fees are higher than institutional, by a factor of about two.  An international manager might charge mutual fund clients 80-110 basis points a year, and pension fund clients 45 or 50.

–the money flows are different.  Institutional clients may give a portfolio manager $10 million to manage.  Provided the performance is satisfactory, that money could stay with the manager for ten or twenty years–or even longer.  At the moment, retail investors are turning over a third of their stock mutual fund holdings a year.

As a result, the mutual fund can require constant tweaking of the portfolio to adjust for money flows.  This implies having a larger trading room and a more complex record keeping apparatus.  The mutual fund requirement for daily pricing (officially done by the custodian bank) also necessitates not only coordination with the bank, but also a parallel pricing mechanism to verify that the bank’s pricing is correct.  Why do this?  –to ensure that buyers and sellers on any given day receive either the correct number of mutual fund shares or the correct amount of money.

marketing is different.  Institutional investors typically rely on a small number of pension consultants for decisions about hiring/firing managers and for analysis of results.  This makes marketing and communication relatively easy, and relatively inexpensive.

Retail clients, on the other hand, are extremely difficult.  They have very high, and unrealistic, expectations.  Even reaching them as potential clients is hard.  In the no-load world, fund management companies may have to rebate, say, 25% of the management fee simply to appear on the websites of the major discount brokers.  A load fund may have to rebate a similar amount just to gain access to the sales force of a retail broker.

Retail marketing also involves expensive marketing materials, a public relations effort to cultivate the media, and at least in the load-fund case a network of wholesalers to make the fund company’s case to retail financial advisors.

Mutual funds, as specialized corporations, have boards of directors.  This means preparation for, and possible portfolio manager attendance at, quarterly meetings of the board.

In short, although gross fees for mutual funds are higher, gathering and retaining assets is also much more difficult, expensive and time-consuming.

Are mutual fund boards so bad?

I don’t think so.  They certainly can’t be any worse than the boards of the big commercial banks!!

Yes, they’re typically nominated by the management company and, yes, they do have liability insurance.  They also get much of the information on which they base their decisions from briefing papers and oral presentations by the management company–which, naturally, frames the issues in a favorable light.  But this is no different from what happens on any other kind of American corporate board.

On the other hand, the structure and functioning of  a fund management company isn’t overly complex technically.  And there’s been enough litigation suggesting board members can be held personally liable for especially poor decision-making that a board has to take its responsibilities seriously.

My impression is that fund boards have more members with deep knowledge of the corporate business than the boards of industrial or banking companies.  Once elected, board members have an enormous amount of power, since they must periodically vote to renew the advisory contract of the fund management company.  Just the suggestion that this might be a problem is enough to get a management company to make any changes a board might want.

Why target Harris Associates? The short answer is that I don’t know.  I suspect that it has little to do with Harris itself.

You’d think the target firm would have to be successful, or otherwise it wouldn’t have an institutional business.  And the assets under management (about $50 billion at yearend 2009 for Harris) would have to have a certain minimum size so that the payoff from a successful suit would be large enough.  Within these parameters, I’d think a law firm would pick a relatively small, independent firm.  The the high cost of defending oneself might make the company amenable to a settlement, and the potential loss of future legal business from other parts of the firm or its suppliers/customers would be minimal.

The ultimate outcome?

I think we’ve seen it already.  No changes to today’s practices.  I also think that’s the right result.

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