Chalk One Up for Mutual Fund Investors
Mutual fund investors "were at the mercy of a faithless fiduciary" who "lined their pockets at the expense of investors whose interests they were obligated to protect."
Strong words, no? Even stronger when you consider that they come not from one of the mutual fund industry's critics, but from a decision issued by the U.S. Court of Appeals for the Second Circuit.
According to Stradley Ronon Stevens & Young attorney John Baker, the February 16th decision "strongly emphasizes the fiduciary duty and disclosure obligations owed by fund advisers and their affiliates."
It's about time. Because prior to the past year or so, our nation's courts have placed far too much faith in open markets, and placed far too little emphasis on the fiduciary duty that mutual fund managers owe their fund shareholders.
Presented with the facts in this most recent case, most observers would not have had to think too long before siding with the fund investors. The case concerns a lawsuit filed against Citigroup Asset Management by shareholders of the firm's funds, who claim that Citigroup defrauded them of millions of dollars.
How so? In 1997, Citi hired an outside consultant -- Deloitte & Touche -- to see if they could save money by bringing the Citi funds' transfer agency duties in-house instead of hiring an outside firm (First Data Investor Services) as their transfer agent.
Transfer agents handle a number of "back office" responsibilities for mutual fund managers: they calculate share prices, conduct shareholder transactions, handle shareholder service, and so on.
Deloitte's study found that Citi could indeed save a substantial amount of money by taking over these duties. So Citi created a subsidiary, which Citi's funds then hired as their transfer agent. This subsidiary then turned around and hired First Data to provide essentially the identical services they had under the previous arrangement, but at a greatly reduced rate.
So far, so good, right? The problem is that Citi failed to share these savings with their fund shareholders. Instead, they pocketed them, charging their shareholders the same amount for transfer agency services that they had paid under the original First Data contract. (An SEC investigation found that Citi's transfer agent subsidiary earned about $100 million in pre-tax revenues. In 2005, Citi agreed to settle with the SEC, paying more than $200 million in fines and disgorged profits.)
Unsurprisingly, the details of this new arrangement were never fully disclosed in the fund prospectuses.
You might expect that a manager inflating their own revenues by having their fund shareholders pay higher-than-market fees to the manager's subsidiary would be a starkly obvious violation of the fiduciary duty those shareholders are legally owed.
Alas, a 2007 District Court ruling in this case encapsulated the depressing track record investors have earned in cases like this one. The District Court ruled that because the transfer agent fees were fully disclosed, "neither the fees' allocation nor the transfer agent's profit margin is material. Finding that only the amount of fees is relevant ... the court reasoned that an investor who knows the amount of fees a fund pays can, when deciding to invest, compare the fees to those of its competitors." (Quoted from the Second Circuit Court's decision.)
Raise your hand if you can ballpark your mutual funds' transfer agent fees, and offer an informed opinion of how they compare to those charged by other funds.
I thought so.
But that is the logic that has guided the legal decisions handed down in cases like this one for decades. Disclosure -- even the incomplete disclosure provided in this case -- was all that mattered. As long as the fees were disclosed, and seemed "reasonable" (based upon a comparison to other funds engaged in the same practices), nothing else was material.
But over the past year or so, it seems that this mindset has begun to shift. Demonstrated most clearly in Judge Richard Posner's dissent in the Jones v. Harris Associates case, many courts are beginning to recognize that the enormous conflicts of interest that are inherent in managing other people's money are not always solved with a simple reliance on disclosure and open markets. More importantly, they're beginning to examine these cases through the lens of the fiduciary duty that fund managers owe fund shareholders.
Such a change is long overdue, and fund investors will benefit enormously should this evolution continue. Which leads to the big question: will the Supreme Court's forthcoming decision in Jones v. Harris Associates continue this momentum, or set it back? We shall see, and soon.