Supreme Court Takes On Mutual Fund Fees

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By Mark Jewell, AP Personal Finance Writer

BOSTON (AP) — The U.S. Supreme Court is taking a close look at a question individual investors have long asked about their mutual funds, but the courts have largely ignored: Why am I getting charged twice as much as big institutional clients?

Sure enough, the money-management services that different classes of fund clients get aren't the same. Institutions like pension funds and foundations may not need toll-free customer hotlines. They don't require as many of the prospectuses and other fund reports that individuals often throw away, even though they're printed and mailed at great expense. Individuals move relatively paltry sums in and out of a fund, piling up higher transaction costs than big clients.

Still, the investments a fund makes are often the same for both groups, and the returns similar — though individuals' higher fees take a bigger bite from their results, regardless of whether markets are up or down.

So it can be galling for an individual to pay an expense ratio of, say, 1% of cash invested as an annual fee, versus 0.5% for an institutional client enjoying what is in effect a bulk rate.

Courts have been reluctant to consider such disparities, and have rarely sided with investors. Instead, the comparisons that courts have allowed focus on whether a fund's fees are so far out of line from what similar competing funds charge as to be unreasonable.

Another key factor: Whether expenses were so out of whack that they couldn't conceivably have been the product of honest negotiations between the investment adviser running the fund and the fund's board of directors, which is supposed to advocate for shareholders.

But now, the Supreme Court could be on the verge of ruling that the individual-vs.-institutional disparity should be thrown into the mix of factors central to deciding a case's outcome. The issue dominated much of the discussion in arguments presented Monday in a long-running fee challenge, Jones v. Harris Associates.

Some of the court's more liberal justices suggested the disparity shouldn't be left out of the equation in considering the fairness of fees that the more than 52 million U.S. fund-owning households pay.

"Wouldn't that be a normal question to ask?" Justice Stephen Breyer asked an attorney for Harris Associates, which advised the Oakmark complex of funds.

Under questioning from Breyer, the attorney, John Donovan, agreed that such a comparison "is likely to be relevant," although Donovan added that the disparity shouldn't necessarily become a key consideration in every fee challenge.

The court is expected to rule sometime before its current session ends in June. It remains unclear what, if any, changes justices will make to a fee-setting legal standard that the fund industry says has served investors well since 1982.

There appears to be some sentiment for the status quo: During Monday's arguments, questions from two court conservatives, John Roberts and Antonin Scalia, suggested they're unsympathetic to having courts second-guess fund boards' fee-approval decisions.

But a scholar who sat in on Monday's arguments said he wouldn't be surprised to see a decision directing judges to pay close attention to whether the higher fees that individuals pay are fair compared with what big clients pay. The current standard says such comparisons can be considered, but don't have to be.

"What I think you're going to see is a new standard in which this comparison is raised to greater prominence from the mere footnote status it is now," said William Birdthistle, an assistant professor at the Chicago-Kent School of Law who filed a brief signed by 25 other professors in support of the challenge against Harris Associates.

If the court wades into the issue, it could open a can of worms for the fund industry. It's long maintained individual-vs.-institutional fee comparisons are almost always flawed because of the different costs to serve each client group.

"Fund boards up and down the industry are determining that it's not a fair or apt comparison, because the job the advisers have to do for the fund, and the job the adviser has to do for the institutional account are very different," said Paul Schott Stevens, CEO of the Investment Company Institute, a fund industry group. "A mutual fund is looking to get the patronage of thousands and thousands of people, very often with small accounts" of a few thousand dollars.

The industry, which manages nearly $11 trillion, also notes that fund fees have fallen over time. As more money flows in, funds can be run more efficiently.

Mutual fund companies and their boards are reluctant to let courts set a new standard that might encourage more fee challenges. The fear is that such cases will inflate legal costs, which ultimately could be passed on to fund shareholders in the form of higher fees.

"You expose shareholders to paying litigation fees in cases where an engaged and informed board has made a reasoned decision that the services are very different," said Susan Wyderko, executive director of the Mutual Fund Directors Forum. "It's going to come right out of the shareholders' pockets."

Birdthistle contends such an argument tries to obscure what he considers a more crucial issue: whether the industry can offer data to back up its contention that costs to serve smaller investors are truly so large as to justify fees that are often twice as large as for bigger clients. That's the size of the disparity in the case now before the high court.

"I think the reason why they don't want the comparison made," Birdthistle says, "is because the data is damning, and doesn't support their position."

Copyright 2009 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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