What's an 'Excessive' Fee? Courts Leave It to Funds to Decide

Imagine you're on your deathbed, worried about whether the family trust you created will adequately provide for your spouse and your 12 children after you are gone. Your trustee proposes to add this provision about his fee to the trust:

To be found excessive, the trustee's fee must be so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining.

Would you agree to these vague terms? I wouldn't, and neither would anyone in a group of about 50 fund-industry executives who were asked the same question at a recent conference.

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What the executives might not have known, however, is that this is the legal standard used to determine whether a mutual fund adviser's fee is excessive. It's lifted verbatim from the 1982 landmark decision, Gartenberg v. Merrill Lynch Asset Management.

That decision held that a fund advisory fee need only satisfy this exceedingly low standard to pass legal muster. It has been applied unquestioningly by trial courts ever since. One court found that this standard would allow directors to approve fees generating pretax profits for the adviser as high as 77%.

But don't blame the Gartenberg court. It simply applied the standard that Congress intended when it settled a heated debate between the Securities and Exchange Commission and the fund industry by revising the mutual fund laws in 1970.

In the 1960s, the Wharton School of business at the University of Pennsylvania and the SEC each conducted exhaustive studies of the mutual fund industry. Wharton found that fund shareholders' lack of bargaining power resulted in higher fund fees. The SEC concluded that shareholders had limited recourse to recover excessive fund fees because the legal standard of proof applied at the time was impossible to meet. So the SEC recommended to Congress that it require that fund fees be "reasonable."

The fund industry objected to the reasonableness standard, claiming that courts would substitute their judgment for that of fund directors, who are responsible for negotiating and approving the fund's contract with its adviser.

Congress resolved the dispute by placing a "fiduciary" obligation on fund advisers with respect to their fees, and authorizing shareholders to sue advisers who violated this obligation. It is this vague fiduciary standard that the Gartenberg court applied in its 1982 decision. Congress also required fund directors to consider, and fund advisers to provide, all information necessary to fairly evaluate the advisory contract.

Fund managers won the great fund fee debate, hands down. Thirty years later, no shareholder has ever proved a violation of the Gartenberg standard, and the SEC has never sued a fund director for failing adequately to review the advisory agreement. Perhaps the fund industry is run by unusually law-abiding angels, but its perfect record more likely shows that, as a practical matter, it's impossible to fail to satisfy the new standards set by the 1970 amendments.

In fact, fund directors who try to do their jobs may do so at their own risk. In 1997, the directors of the (NASCX Quote)Navellier Aggressive Small-Cap fund complained to the SEC that the fund's adviser, Louis Navellier, had refused to provide information they needed to evaluate his services. The SEC did nothing to support the directors. Intent on proving that no good deed goes unpunished, Navellier dragged the fund's directors through years of litigation, which was resolved in the directors' favor last year.

Times have changed, however, and expectations for directors are increasing. The SEC recently adopted reforms to strengthen fund directors' independence and authority any day now. (For more, see my column here.) The Mutual Fund Directors Education Council, an SEC brainchild sponsored by Northwestern University, held its second annual conference earlier this month.

Investors also have good reason to hope the greater prominence of mutual funds on the financial landscape may prompt Congress to revisit legal standards for fund fees. In 1970, mutual funds held only $47 billion in assets. Ten years later, fund assets still stood at less than $200 billion, and only 5.7% of U.S. households held mutual fund shares.

Mutual funds are now Americans' favorite retail financial product. Fund assets exceeding $7 trillion are held by 88 million shareholders representing 51% of U.S. households. From 1990 to 1998, fees paid by owners of stock mutual funds rose from $2.5 billion to $22.9 billion, an 801% increase.

More importantly, as reported by Investment News, these fees were paid by investors who, according to John Zogby, CEO of polling group Zogby International, made up 70% of voters in last month's election.

These numbers are making politicians take notice and moving the great fund-fee debate back into the national spotlight. Congress held hearings on fund fees in 1998, while the industry and academics released dueling studies reaching opposite conclusions about whether fund fees were going up or down. Congress ordered the Government Accounting Office to conduct a study of fund fees, which it released last June, and the SEC recently released its own study. (For more, see my column.)

Another factor that may prompt congressional action is the market's recent poor performance. High fees are easy to overlook when funds produce 20% annual returns. Poor performance -- even average performance -- more starkly exposes the large bite that fees take out of fund performance.

As a bonus, fixing the standard for fund fees provides Congress with an ideal issue for bipartisan cooperation.

Although Democrats generally are more inclined to regulate, Republicans may recognize that overturning Gartenberg would hold special appeal for their constituents. A recent Zogby International poll found that investors were far more likely to be Republican than Democrat. Zogby said in the same Investment News interview that investors voted 51% to 46% for Bush, reversing the 1996 results, when investors favored Clinton (46%) over Dole (37%).

The industry will oppose changing the standard, claiming that it would foster more shareholder litigation. And its arguments will undoubtedly have the ear of the executive branch. Lynne Cheney, wife of the vice president, is an independent director for the American Express funds.

Whether President Bush and company appreciate the need for a meaningful legal standard for fund fees, however, they should recognize that Republicans' chances in 2002 and Bush's in 2004 may depend on ensuring that the growing class of American investors are getting a square deal.