Fund Investors Take a Hit from the Supreme Court
Last week the Supreme Court struck a blow against the rights of mutual fund investors, and in the process might have opened a Pandora's box, providing corporate America a road map that will allow them to avoid liability from investor suits.
The case concerned Janus Capital Group, the management firm that operates and manages the Janus mutual funds. In the early-2000s, Janus was one of the prime offenders in the mutual fund timing scandal that roiled the fund industry. The facts concerning their actions and guilt in the timing scandal are beyond dispute.
For years Janus Capital Group knowingly permitted at least ten hedge funds to market time their mutual funds. These investors would trade rapidly in and out of the funds, taking advantage of the mutual funds' stale prices to earn guaranteed profits. Those profits, of course, came directly out of the pockets of the individual investors in those mutual funds. Essentially, Janus allowed these hedge funds to rip-off its mutual fund investors.
Why would Janus Capital Group agree to such an arrangement? Because, as one internal Janus email unearthed by then-New York Attorney General Eliot Spitzer's investigation described it, those trades were in Janus Capital Group's "best interests," and resulted in "increased profitability to the firm."
How so? Because in exchange for permitting these trades, the hedge funds agreed to place large investments in some of Janus's other funds, boosting the advisory fees Janus earned.
In 2004 Janus Capital Group settled with Spitzer and the SEC, agreeing to to pay $225 million worth of fines and fee reductions for what the SEC called a violation of the "investment advisor's fiduciary duty to investors."
And in an effort to assure the regulators that they had learned their lesson, Janus assured the SEC that in the future they would "cause the Janus funds to operate" in strict accordance with their responsibilities. (Remember that admission of control as you read on.)
But while that settlement helped make the owners of the Janus funds whole, there was a second group of investors who were also harmed by Janus's actions: the owners of Janus Capital Group's stock. As you can imagine, the scandal caused the stock price to plummet, saddling those investors with losses that have yet to be recouped.
Those investors accused Janus of making false statements in their mutual fund prospectuses, which said that the funds had taken steps to deter market timing. Clearly, that statement was false, because at the same time that was written, Janus's managers were cutting market timing deals with large investors.
Janus's guilt seems fairly cut-and-dry, right? But here's where it gets interesting.
In defending themselves from the lawsuit, Janus Capital Management argued that they were not responsible for the language contained in the Janus fund prospectuses. Rather, they asserted, those statements were made by the mutual funds themselves, which are set up as separate legal entities, with their own board of directors.
Now you, I, and anyone who's spent two minutes thinking about it know that the notion that a mutual fund is independent of its advisor is laughable. It's true that each fund is legally separated from the management firm that created it, but those funds are staffed, managed, and operated by the management firm. Further, the fund's board of directors is almost invariably chaired by the CEO of the management firm. And where does the board get the information they need in order to provide their oversight? Well, from the management company, of course.
The funds, essentially, are completely controlled by the advisor, which is what Janus was acknowledging in their attempt to assure the SEC that they would no longer permit their funds to be market timed.
The relationship between management company and mutual fund is so entrenched that I can recall only one -- one single instance -- in which the mutual fund board of directors told the management company to take a hike because they weren't performing well. In 2005, when the Clipper Fund's board spurned their existing manager in favor of Davis Selected Advisers, it was hailed as a "watershed event for the fund industry," an occurrence so rare and unique that it generated widespread notice.
The clearest proof of control that fund managers have over the funds they manage is the enormous amounts of money that mutual fund advisors reap on the sale of their firms. If the underlying funds are beyond the control of the manager and likely to be pulled at any given moment, it's difficult to explain why those managers are being paid hundreds of millions of dollars to transfer those funds to another manager.
But in Janus Capital Group v. First Derivative Traders, the Supreme Court ignored reality, along with decades of history, in favor of a breathtakingly narrow reading of the law. In writing for the majority, Justice Clarence Thomas wrote that despite Janus Capital Management's inarguable role in preparing those prospectuses, the statements therein were "made" by the Janus funds. As such, according to the Court, the funds are responsible for those statements, not Janus Capital Group.
The ruling doubtless generated huge sighs of relief not only at Janus but in the mutual fund industry at large, for it clearly established that the management company has no liability for statements made in fund prospectuses. Even better, from their perspective, the funds that are ostensibly responsible for those statements have no assets that can be pursued by wronged investors.
But the Court's ruling is clearly, in my opinion, well beyond the pale. It's beyond argument that the management company is essentially responsible for writing the prospectus. Yes, that language is signed off on by the funds' board of directors, but who do you think they turn to in an effort to vouch for the statements made therein? Why, the fund manager, of course.
If, for instance, a Janus fund director was interested in verifying that the language about market timing was indeed accurate, they would pose that question to the fund manager -- the same fund manager who for all intents and purposes wrote the statement at the same time they were arranging market timing deals on the side. If the fund's board cannot rely on the information they are receiving from the management company, I wonder where the Court supposes they should turn?
The statements in fund prospectuses are "made" by the funds in the same sense that a puppet "makes" statements. In both cases the language is chosen by the entities that control them.
Even more troubling is the broader ramifications that this ruling holds. Chicago-Kent College of Law professor William Birdthistle (who filed a brief in this case supporting the Janus shareholders) told Bloomberg that it provides "a blueprint for operating companies ... to make themselves as bulletproof as the investment advisers."
But if there is a silver lining in this ruling, perhaps it is this: It might heighten fund directors' awareness about the importance of the role they play in fund governance, bringing into clear relief both their responsibilities and the folly of relying exclusively (or even heavily) on the management company for the information they need to fulfill their duties.
Perhaps fund directors will be slowly awakened from their slumber, and decide that their relationship with their fund's management company deserves to be much less chummy and more adversarial. Perhaps they'll actively bid out the contract to manage the assets of the fund investors whose duties they represent, seeking to lower costs and thereby increase investor returns. Even better, perhaps they'll stop blithely going along every time the management company wants to sell out to a larger competitor, demanding proof that any such deal is clearly in the best interests of their investors.
Or perhaps none of that will happen, and mutual fund managers are simply made more bulletproof then they had been before.
That would be a sad development indeed.
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