The most recent wave of mutual fund fee litigation is now over and investors should not be happy with the result. The wave consisted of 25 or so cases alleging that the fees charged by mutual fund advisers were excessive. While a handful settled, most were dismissed at various procedural stages by federal judges who couldn’t find an excessive fee in the entire lot.
That result is remarkable. There are 16,000+ U.S. registered investment companies. Professional plaintiffs’ attorneys selected a few dozen of the most egregiously priced funds to challenge on contingency, meaning that they would not be paid unless the cases succeeded. The fact that 25 federal judges in districts across the country could not find a single excessive fee begs the question: is the problem the standard or the judges? [1]
This is, of course, a trick question because the answers are functionally the same. The standard under Section 36(b) was invented by judges. [2] Congress imposed a “fiduciary duty” with respect to management fees and left courts to figure out what that meant. With help from the defense bar (the real beneficiary of this whole affair), the courts invented an arbitrary multi-part test (based on the so-called Gartenberg factors eventually blessed by the Supreme Court), which was seemingly designed from the outset to result in protracted litigation. Then, over the following years, judges applied the test in increasingly unreceptive ways (again, with the help of the defense bar), making it difficult to imagine an investor ever proving an excessive fee.
The Great West Case As A Shining Example
The final case to be tried exemplified some of the legal absurdities that were characteristic of the recent wave of litigation. In an action against the money manager arm of Great West Life & Annuity Insurance Company, the plaintiffs targeted, among other things, a range of products bought from other advisers and repackaged under the Great West name.
As an initial matter, it would seem that no one would buy these rebranded funds on their own choosing. They are significantly more expensive than the identical funds they copy, given that after repackaging the products Great West has to pay itself an additional amount as the middleman.
One of the funds at issue was the Great West Templeton Global Bond Fund, which was licensed from Franklin Templeton but was, obviously, more expensive than the flagship fund. Why would you pick the Great West version? Well, you wouldn’t, unless, you are picking funds in a retirement account administered by Empower (a Great West affiliate) and only the Great West fund is available as a result of the deal between Empower and the plan sponsor (i.e. your employer).
Trial evidence demonstrated that this was basically the only way Great West could sell its funds, which is both a confirmation and an indictment of the open market. At least the open market wouldn’t tolerate marked-up generics of otherwise popular funds. But, less heartening, fund advisers have found ways to section off portions of the retirement market from competitive pressures, creating a safe haven for the worst funds to be foist upon customers with no other options.
Another fund factoring prominently in the Great West case was a pure S&P 500 tracker, but with a twist: a management fee of .25% and an expense ratio over .50%. Even when the case was filed in 2015 average index fund expense ratios were below .15%. In 2021, you can get them for free. Again, why would you buy this fund when there are dozens of identical alternatives with exponentially lower prices? Again, you wouldn’t, unless this was the only index fund available in your retirement plan and the other actively managed options were even worse! Trial evidence showed that this was how Great West sold its fund. It couldn’t sell it in the open market and didn’t even try.
With that backdrop, I’ll cut to the punchline: the federal court found in favor of Great West in every possible way. It not only found that the “Plaintiffs failed to prove by a preponderance of the evidence that Defendants breached their fiduciary duties,” but also that “even though they did not have the burden to do so, Defendants presented persuasive and credible evidence that overwhelmingly proved that their fees were reasonable.” (Emphasis added.)
The sheer naivety of that holding cannot be overstated. These are funds that are actually so bad that it’s difficult to imagine a fiduciary recommending them to a client without the risk of being sued, save for possibly the odd circumstance of a retirement account with no alternatives. Take, for example, an RIA picking funds for a client in a regular brokerage account. What possible basis would the adviser have to recommend the Great West S&P 500 fund over the dozens of identical cheaper funds, or the Great West Templeton Global Bond Fund over the cheaper flagship fund? There’s no conceivable investment rationale that would justify picking the most expensive version of identical products. It’s a nonstarter for any sane RIA.
How in the world did the court find “overwhelming” evidence that the “fees were reasonable”? Therein lies the dark magic of Gartenberg.
First and foremost, judges have increasingly granted unwarranted deference to board approval of a fee, despite that Congress created Section 36(b) as a protective measure in addition to director oversight.
To set the table, I can think of at least four protective measures that investors could theoretically rely on:
- Market competition can drive lower fees and check outliers, which it does well in some areas, but is also unable to do in other areas, like closed-universe retirement plans where investors have limited choices. When Section 36(b) was passed, Congress felt that the market was not working as well as it does in less complicated industries, and thus felt that additional statutory protection was required.
- Independent directors can oversee and check the adviser’s financial interest in maximizing its fees. The effectiveness of director oversight can be debated (industry insiders have seen their share of rubber-stamping directors getting paid six figures to meet five times per year). Either way, Congress passed Section 36(b) as an additional protection, acknowledging that boards are not infallible.
- Fund activism can hold advisers accountable by challenging their control of a fund if the management or fees are bad enough. However, given the difficultly of accumulating meaningful positions in open-end funds (which can print new shares every day), this historically has not been a genuine threat. Among closed-end funds (which have a fixed number of shares trading publicly), fund activism has been more effective in pressuring underperforming or overcharging advisers. Closed-end funds, however, make up a small minority of U.S. investment companies.
- Finally, Section 36(b) can hold advisers legally accountable for excessive fees through a private right of action granted to investors. This protection was granted by Congress after years of SEC and congressional study, which ultimately concluded that fees were not declining as fast as they should be in light of asset growth (something that some academics believe continues to be true), and that additional protections were required.
Although four lines of protection may seem significant, in reality, some or even all can be easily negated, permitting advisers to charge excessive fees.
For example, there are significant portions of the market that do not feel price competition, as the Great West case demonstrated. When there is one S&P 500 index fund in a retirement account, and it is the Great West fund, it turns out that investors will pay 50 basis points to track the index. The market can’t do much about that, at least on an individual-investor basis.
We can also rule out shareholder activism here, given that we are largely focused on more prevalent open-end funds, such as those at issue in Great West.
That leaves director oversight and Section 36(b). But how effective were the directors of the Great West funds?
Without exploring the rabbit hole of the board’s actual process, one might ask: How good could the oversight have been if the result was an index fund that pays 50 basis points in expenses? Is there any amount of process—say 10,000 pages, five meetings, two consultants and a special committee—that could justify agreeing to pay multiple times the average rate for an indistinguishable index fund?
The courts in Great West seemed to think so. Both the trial and appeals courts made much of the “robust push and pull process” “with the Board continuing to press for reductions and breakpoints.” But with what result? The board had the power every year to fire Great West and hire any of the dozen advisers that provide low-fee index services for single-digit basis points. By the time the case was over, the best the board could show is that they succeeded in getting a few basis points knocked off (which Great West unilaterally proposed in any event), and expenses continued to exceed .50%, despite that the average is now .13% among passive funds.
The court cited “$1.6 million” in savings, but how is that amount material to a fund with $3.2 billion in assets? Investors will pay tens of millions of dollars in excessive fees over the coming decade as a result of the board’s failure to obtain near-average rates.
Such circumstances would seem the perfect candidate for a Section 36(b) case. But under Gartenberg, both the trial and appeals courts granted profound deference to the board’s decision on fees, despite its lame efforts to obtain relief for shareholders. Indeed, the appeals court went as far as to state that the board “factor weighs heavily in Defendants’ favor and puts reversal or remand far out of reach.” (Emphasis added.) Far out of reach? Based on directors that, even by the end of the period, couldn’t get fees anywhere near the average, but continued to approve the fee anyway?
Unfortunately, the courts’ view appears to have been that even these inept efforts were entitled to extreme deference. But, even so, what did the courts have to say about the army of lower-priced funds? That brings us to perhaps the second most-notable legal absurdity in this wave of litigation: the surprising propensity of courts to latch onto immaterial quirks in a fee structure to justify an excessive fee.
For example, as to the Global Bond Fund, the appeals court found that Great West’s “decision to charge a higher fee than Franklin does not render its fee excessive” because: (1) Franklin’s fund was “as much as one hundred times larger,” (2) “did not have unitary fees,” and (3) “was not subadvised like the Great-West Funds.”
None of those points survive even cursory examination.
Points 1 and 3 negate themselves. Franklin’s flagship fund may be very large (point 1), but that fact made Great West’s fee all the more excessive because the fund is subadvised (point 2).
In a subadvised fund, Great West hires Franklin’s personnel to provide investment management services rather than hiring its own people.
From Franklin’s perspective, it has significant assets under management that it has already committed significant resources to managing under the proprietary “Global Bond” strategy. Adding a subadvisory account with, say, Great West creates minimal if any additional costs, which allows Franklin to price the services cheaply. In other words, Franklin can take nearly free money by adding in new accounts under its preexisting framework.
From Great West’s perspective, it’s an insurance company and not very good at asset management. It could try to hire a team of people from scratch to compete with longtime asset managers like Franklin, or it could pick one of Franklin’s popular products and hire that team directly. It not only gets a better team, but it gets “at scale” pricing immediately, given that Franklin has already accumulated billions in assets across which to spread its costs.
This played out in practice just as you might expect. Franklin agreed to provide its “Global Bond” strategy to Great West for less than 30 basis points, despite that the flagship fund charges a management fee of 48 basis points. [3] However, having obtained Franklin’s services for cheap, Great West then set its own fee at 95 basis points, sending the fund’s total expenses (with admin fees and other costs) as high as 1.55%.
Sure, Great West had to provide other services in addition to Franklin’s investment management to bring the fund to market (like legal, compliance, accounting and regulatory services). But these were small costs and shared across the complex. They wouldn’t justify a nearly 50 basis point spread. In any event, neither the trial court nor appeals court (nor the board) engaged in this analysis, much less made a finding on it.
Ruling out justifications (1) and (3) leaves justification (2) above regarding so-called “unitary fees.” A unitary fee is merely a fee structure under which the manager agrees to pay various fund-level expenses that are typically paid by the fund directly. For example, the cost of printing and mailing materials to shareholders is typically paid directly by a fund. Under a unitary fee structure, the adviser covers that cost.
A unitary structure is neither favorable for funds nor relevant to an excessive fee claim.
First, unitary fees preclude funds from benefiting from economies of scale in fixed costs. For example, legal fees are time-based not asset-based, and thus become relatively cheaper as a fund grows in size. A unitary fee may cover the fund’s legal fees, but it also converts it into a variable expense because management fees are asset-based. In other words, the fund could pay its lawyers $200,000 directly or, for some reason, it could pay its manager (x)% of its growing assets, and its manager will in turn pay the fund’s lawyers $200,000. It’s a strange arrangement that’s beneficial at best in the beginning stages of a fund’s life, but even then it could easily be replaced by expense limitations.
Second, and more relevant, the fund-level costs covered by managers under a unitary fee are small relative to the management fees themselves. In the case of the Great West S&P 500 fund, the portion of Great West’s fee that went toward fund-level expenses was only a few basis points, and was irrelevant to the fee comparison to competitors, which were many basis points cheaper.
Nonetheless, the courts credited the unitary fee structure to distinguish Great West’s high fees from the much lower comparative fees.
Conclusion
With this last case closed, it likely will be some time until another Section 36(b) case is tested in the courts. Efforts to obtain a jury in excessive fee cases have thus far failed, and federal judges have demonstrated a striking tolerance for high fees. Fund investors are left with price competition and board oversight to control fees, only one of which has proven in recent years to lower fees. Let’s hope market forces can continue to pervade areas, like retirement plans, where high-fee products have been hiding.
[1] The other potential option—that there are simply no excessively priced funds—remains too implausible to address. If the passive revolution continues to have its way, perhaps such will become reality in future years. But as of 2021, outlier fees continue to abound, especially in areas where advisers have managed to avoid the effects of price competition.
[2] I am referring, of course, to Section 36(b) of the Investment Company Act, and the genre of cases brought thereunder alleging that mutual fund advisers violated their fiduciary duty by charging excessive management fees.
[3] I am using rough numbers here because the precise fees varied immaterially over the years, and the precise amounts are not relevant to the point being made.
