October 20, 2019

Time To Demand Accountability Regarding Mutual Fund “Risks”

A version of this article was published by the Harvard Law School Forum on Corporate Governance.

The case law on who bears the risks inherent in a mutual fund’s operations is becoming paradoxical, and may now require intervention by mutual fund boards. Investment advisors have, incredibly, convinced some federal courts that they bear enormous risks in operating their mutual funds -- so much so that they’re justified in charging hundreds of millions of dollars in extra advisory fees -- but, at the same time, should not be held liable if and when those risks materialize, even if the result is a catastrophic meltdown of the fund.

Two cases exemplify this state of affairs. Last year, JPMorgan was trapped in a litigation requiring it to justify charging $132 million more, annually, to certain JPMorgan-branded funds than it charged third-party funds for the same investment advice. To justify the difference, the advisor hired an economist from Ohio State University to opine about the “substantially greater risks” JPMorgan assumed as to its own funds, which JPMorgan argued “require it to charge higher fees.” [1] This was the argument, despite the fact that, like virtually every other investment advisory contract in the country, JPMorgan’s contract included provisions that immunized it for everything short of bad faith and intentional misconduct. Nonetheless, the court apparently found the argument persuasive because it copied and pasted a section of the economist’s opinion into its order, and ruled in favor of JPMorgan. [2]

Setting aside that JPMorgan’s argument, though clever, was plainly litigation-driven (no contemporaneous evidence suggested that the advisor quantified, or even considered, the “substantially greater risks” when it originally set its fees), one would expect that if an investment advisor is paid big money to assume all manner of risks associated with its self-branded funds, then when some of those risks materialized, the advisor might step up to the plate and make the fund whole. (I mean, not only would one expect that, but it’s essentially what JPMorgan argued: “[We will] incur additional costs when risks materialized.” [3])

But that brings us to a decision this summer involving the Catalyst Hedged Future Strategies Fund -- an example of when risks do materialize in mutual funds. The fund “lost $600 million in value over a matter of days,” primarily as a result of writing uncovered options. [4] Investors brought suit against the fund’s investment advisor, Catalyst Capital Advisors, for misrepresenting the fund’s options trading and risk management strategies. However, rather than compensating the fund for the materialization of the risks that the advisor had been paid to assume (at least according to the logic of the JPMorgan case), Catalyst obtained dismissal of the entire action with prejudice.

The court essentially ruled that the risks that had materialized to cause the massive losses had been sufficiently disclosed in the offering materials, and therefore investors had no legal recourse. As to whether investors should have been aware that the fund was using a risky uncovered options strategy, the court all but acknowledged that the disclosures were less than clear, but found that investors could have figured the whole thing out if they had examined the fund’s schedule of investments closely enough. [5] As to the advisor’s statements about its “strong focus on risk management” -- which had clearly not been enough under the circumstances -- the court found that such statements expressed only a “goal,” and did not give rise to liability, even though investors alleged that both the trading and risk management strategies were never designed work to on a fund the size of the one at issue. [6]

Thus, we are left in a world where advisors sponsoring their own funds believe they are entitled to a “premium” for certain unquantified, nebulous risks generated by such products, but are almost certain to resist (often successfully) efforts by investors to extract payment when those risks materialize. For sure, investors since the ancient trade routes have assumed risks in exchange for potential returns, and they haven’t always made money. But the traditional narrative becomes difficult to accept where, as in the JPMorgan case, an advisor seeks to justify hundreds of millions of dollars in extra fees in exchange for its own assumption of broad risks arising from the fund’s operation.

What exactly are funds and investors paying for under such agreements? If you ask the investors in Catalyst, it would seem to be little more than nothing.

Members of the defense bar will undoubtedly point out that the advisor in JPMorgan never argued that it assumed “investment” risks, but only “liquidity risks, business risks, operational risks, pricing risks, litigation risks, regulatory risks, and reputational risks.” [7] But, in reality, are such risks readily distinguishable?

For example, what risks materialized in Catalyst? Investment risks? Sure, given that market movements upset the advisor’s uncovered options strategy, but the other risks are inextricably tied. Operational risks, which JPMorgan suggests are assumed by advisors, also materialized, given the allegations that the trading and risk management strategies were risky and not designed to work for a fund of that size. Nonetheless, shareholders took the loss. Litigation and regulatory risks likewise materialized, but shareholders presumably paid the bill for those costs pursuant to the advisor’s indemnification provision. How about reputational risks? Perhaps the advisor did feel some pain associated with investors pulling their dollars. But shareholders had already compensated the advisor for that risk, under the JPMorgan theory, which only begs the question: Why does an advisor that loses $600 million in a few days deserve to be compensated, in advance, for the ensuing fall-out?

If you think all of this is confusing, that’s the point. It’s impossible to actually determine which risks and resulting liabilities investors have paid their advisors to assume, and which they haven’t.

And if you can answer that question, then an equally difficult and perplexing question is: What amount should investors pay for the advisor’s assumption of risk, and on what basis? In the JPMorgan case, the amount each fund paid was equal to the seemingly random and uncorrelated spread between the advisory fees paid by JPMorgan-branded funds and the amount that JPMorgan charged third-party funds for the same investment advice (i.e. the “subadvisory spread”).

In other words, however much extra money JPMorgan could charge retail investors versus third-party mutual fund companies happened to be exactly the right amount of compensation for JPMorgan to assume the “risks” at issue (whatever those might be). It didn’t matter if one fund pays $10 million for risk assumption while another pays $500 million. Nor did it seem to matter in relative terms (i.e. that one fund pays a spread of 2x while another pays 10x). All’s fair so long as you accept the tautology that every subadvisory spread perfectly matches the market-determined price among investment advisors to assume certain impossible-to-define risks that rarely create actual liabilities.

Stated more simply: it seems, at least in light of JPMorgan and Catalyst, that shareholders are doomed to pay for the risks of operating their funds in advance, at a seemingly random price that varies by fund, but also when the risks actually materialize, in the amount of the actual loss.

What reforms might improve this state of affairs? Mutual fund boards could force advisors to pick a “risk regime.” Boards could refuse to renew advisory agreements that contain limitation of liability and indemnification provisions unless the advisor demonstrates that their advisory fees reflect an arm’s-length payment for the actual, perceptible services being provided without reference to unquantified and abstract risks. In the alternative, if the advisor insists that its fees include the assumption of such risks, then boards should not agree to limit the liability of advisors for losses resulting from the advisor’s activities.

If a loss is incurred, boards and advisors would be free to engage regarding whether it resulted from a true “investment” risk (like a market sector’s underperformance), or if there were components of the advisor’s activities that must be accounted for within the fund’s particular risk regime. Likewise, if another party is at fault, then the advisor or the fund would be free to seek contribution. But, in any event, at least shareholders would have a slightly better understanding of which risks they’ve assumed and which ones they’ve paid for in advance.

‍[1] Defendants’ Memorandum in Opposition to Plaintiff’s Motion for Partial Summary Judgment, Goodman v. J.P. Morgan Investment Management Inc., No. 2:24-cv-00414 (ECF 142) at 19-20.

[2] Goodman v. J.P. Morgan Investment. Management, Inc., 301 F. Supp. 3d 759, 770 (S.D. Ohio 2018). The case is now on appeal for multiple reasons, including that the court failed to genuinely address whether the risks at issue actually justified the amount of the extra advisory fees at issue.

[3] See Defendants’ Opposition, supra note 1, at 20.

[4] Emerson v. Mutual Fund Series Trust, No. 2:17-cv-02565, 2019 WL 2601664 at *4 (E.D.N.Y. June 25, 2019).

[5] Id. at *19.

[6] Id. at *21.

[7] See Defendants’ Opposition, supra note 1, at 19-20.