Mutual Fund Advisory Fees: Forty Years of Failure

In the 1960s, the Securities and Exchange Commission (SEC) attempted to correct an oversight in the Investment Company Act of 1940 (ICA) that allowed investment management firms to overcharge investors, namely, the absence of enforceable protections over excessive fees. Congress, in the 1970 amendments to the ICA, was influenced by the investment management industry and the resultant legislation sent ambiguous signals to the judicial system. Lacking clear guidance from Congress, in the seminal fee case Gartenberg v. Merrill Lynch, the Second Circuit fashioned a fiduciary standard favorable to the investment management industry. Under this standard, no plaintiff has ever won an award under the revised ICA. Recently, the U.S. Supreme Court affirmed the Gartenberg standard and, in the process, amplified the original errors of the Gartenberg court. The economics underpinning advisory services have not changed, the overcharging persists, and the judiciary is forced into increasingly extreme rulings to maintain the fiction that advisory fees are reasonable. In the forty years since Gartenberg, the judicial system and independent directors have systematically failed to protect mutual fund investors from excessive advisory fees. In Jones v. Harris Associates L.P., the U.S. Supreme Court acknowledged the lack of “analytical clarity” of Gartenberg and implicitly invited a resolution of the problem by sorting out the differences between advisory fees and fees determined by arm’s length bargaining. The judicial system and Congress have shown no inclination to take up the challenge. Fortunately, the 1970 amendments to the ICA empower independent directors to address the problem. This paper explores these issues and proposes a path forward restoring mutual fund governance to its intended role of protecting mutual fund investors