Disappointing Supreme Court Ruling for Shareholders

News you aren’t likely to read anywhere else: this morning the U.S. Supreme Court disappointingly voted 5-4 against shareholders in a lawsuit brought against the Janus Funds.  The lawsuit had been brought back in 2003 when shareholders in the Funds complained that Janus allowed certain shareholders (read: large) were allowed to make frequent, short-term trades in the funds.

In other words, in exchange for lots of money Janus Funds granted those shareholders to engage in “market timing.”  The result was that smaller shareholders in the Funds often got pricing that was worse than the big shareholders.  After complaints the Janus Funds implemented anti-market timing rules in its prospectus.

Yet, New York state officials later brought a lawsuit against Janus claiming that the fund family continued to allow the practice.  The firm then paid $201 million in damages and cut fees by $125 million to settle the claims of both New York state and Federal regulators.

Today’s ruling is disappointing because it is a blow to shareholders against corporate malfeasance.

As a former mutual fund portfolio manager I can say that the argument made by Janus is patently false.  In order to understand the ruling you have to understand how mutual fund companies are structured.

When you and I invest in a mutual fund we buy shares in an investment company which is established per the laws established in the Investment Company Act of 1940.  In turn, the money that the fund collects from shareholders is managed by an investment adviser that is hired by the board of directors of the fund to provide professional money management.

Today the U.S. Supreme Court ruled that the mutual fund is a separate legal entity from the fund’s adviser.  While technically true, the problem is that in practice the adviser dominates the mutual fund’s board of directors, such that there is only the appearance of independence on the part of the board.

Board members are usually recommended by the fund adviser and mutual fund boards frequently just rubber stamp those recommendations.  Additionally, as someone who has attended mutual fund board meetings, board members just do not have enough access to management or enough time in a year to truly monitor the activities of the mutual fund adviser.  That is, the board members rely strongly on the adviser having in place policies that allows for self-policing.

But what if that self-policing and the board fails the shareholders?  Well then there is the ability for shareholders to sue both the mutual fund and its adviser.  Well at least that was true until today.  That’s why this result is disappointing.

Effectively, going forward, shareholders of mutual funds have to rely upon activist board members challenging the policies of investment advisers.  And folks, in the majority of cases, that just isn’t going to happen.

Jason