Issues
Can an investment adviser for a mutual fund violate its fiduciary duty with respect to compensation imposed by the Investment Company Act when the adviser accepts a fee that has been duly approved by the fund’s directors?
In 2004, Jerry Jones sued Harris Associates, L.P. under § 36(b) of the Investment Company Act for breach of its fiduciary duty with respect to the fees it receives for advising mutual funds of which Jones was a shareholder. Harris Associates created and advised the mutual funds in question. The board of trustees for the mutual funds approved the fees Harris Associates received. Jones’s case was dismissed on summary judgment in the Northern District of Illinois. The district court applied the Second Circuit’s Gartenberg v. Merrill Lynch Asset Management, Inc. standard to analyze the advising fees and found that the fees could have been the product of a normal, arms-length negotiation. The Seventh Circuit affirmed, but rejected the Gartenberg standard, and adopted a more lenient standard that allows court interference in fee arrangements only when there is evidence that the adviser failed to disclose relevant information or misled the board during fee negotiations. The Supreme Court’s decision will define the contours of a mutual fund adviser’s fiduciary duty with regard to compensation.
Questions as Framed for the Court by the Parties
Congress enacted the Investment Company Act of 1940 to mitigate the conflicts of interest inherent in the relationship between investment advisers and the mutual funds they create and manage. See Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 536 (1984). Section 36(b) of that Act imposes on investment advisers "a fiduciary duty with respect to the receipt of compensation for services" and authorizes fund shareholders to bring a claim for "breach of [that] fiduciary duty." 15 U.S.C. § 80a- 35(b). The Act further provides that, in such an action, "approval by the board of directors" of the fund is not conclusive, but "shall be given such consideration by the court as is deemed appropriate under all the circumstances." Id. § 80a-35(b)(2).
The question presented is:
Whether the court below erroneously held, in conflict with the decisions of three other circuits, that a shareholder's claim that the fund's investment adviser charged an excessive fee - more than twice the fee it charged to funds with which it was not affiliated - is not cognizable under §36(b), unless the shareholder can show that the adviser misled the fund's directors who approved the fee.
Facts
Petitioners Jerry and Mary Jones, and Arline Winerman (collectively, “Jones”) were owners of shares in three separate mutual funds in the Oakmark group of funds. In addition to creating the Oakmark group of funds, Respondent Harris Associates L.P. (“Harris”) also provides advisory services to the funds. Harris also provides advising services to other clients and investment funds that it did not create itself, such as pension funds. These clients are commonly referred to as unaffiliated or institutional clients.
Each year, the board of trustees for the mutual funds voted on the compensation Harris would receive for advising the funds. The board of trustees represents the interests of the shareholders in negotiations with the fund’s advisers. During fee negotiations, the board must request information from the advisers, such as fund performance, comparisons with fees charged to other clients, and comparisons of what different advisers charge similar funds for similar services. Based on this information, the board is supposed to approve a fee that is consistent with the best interests of the shareholders. Once the board has approved a fee, the Investment Company Act (“ICA”) imposes a fiduciary duty on the adviser who accepts the fee. .
In August of 2004, Jones filed suit in the United States District Court for the Western District of Missouri, alleging that the fees collected by Harris were so disproportionate to their actual value, that Harris had breached its fiduciary duty under the ICA. The fee schedules for the three mutual funds at issue vary slightly, but as an example, the Oakmark Fund paid Harris “1% (per year) of the first $2 billion of the fund’s assets, 0.9% of the next $1 billion, 0.8% of the next $2 billion, and .75% of anything over $5 billion.” For unaffiliated clients with investment strategies similar to those of the Oakmark Funds, Harris collected .75% on the first $15 million in assets, going down to .35% for any assets over $500 million. The advising services Harris provided to institutional clients varied, but were generally less extensive than the services it provided to the Funds.
The case was eventually transferred to the District Court for the Northern District of Illinois. Harris then made a motion for summary judgment, which the district court granted. In granting Harris’s motion, the district court applied the “Gartenberg standard” from the Second Circuit Court of Appeals. Under Gartenberg v. Merrill Lynch, an investment advisor’s compensation breaches the fiduciary duty imposed by the ICA if the fee could not have been the product of a fair negotiation in normal circumstances because the size of the fee was so disproportionate to the value of the services rendered. Jones then appealed this ruling to the Seventh Circuit Court of Appeals. On appeal, the Seventh Circuit agreed with the district court that Harris did not breach its fiduciary duty, but disapproved Gartenberg. The Seventh Circuit concluded that investment advisers do not breach their fiduciary duty by accepting board-approved compensation unless they fail to disclose all necessary information to the board, or engage in some other kind of deceptive conduct. Jones’s petitioned the Supreme Court for a writ of certiorari, which the Court granted on March 9, 2009.
Analysis
Background
Congress enacted the Investment Company Act of 1940 (“ICA”), 15 U.S.C. § 80a-35(b), to protect investors from the abuse inherent in the structure of mutual funds. . The ICA created structural safeguards designed to combat the excessive fees charged by investment-advisors to their clients. In 1970, Congress amended the ICA, imposing upon investment-advisors a “fiduciary duty with respect to the receipt of compensation for services.” This amendment also created a private right of action for a breach of that fiduciary duty.
The Fiduciary Duty Owed by an Investment-Advisor to Shareholders.
Section 36(b) of the ICA imposes upon investment-advisors “fiduciary duty with respect to the receipt of compensation for services.” Section 36(b) does not proceed to explicitly define the precise requirements of the fiduciary duty owed. Section 36(b) does, however, direct courts to give board approval of the adviser’s fees only “such consideration by the court as is deemed appropriate under all the circumstances.”
Before the Seventh Circuit’s decision in this case, courts generally followed the approach of the Court of Appeals for the Second Circuit in evaluating adviser fees. In Gartenberg v. Merrill Lynch Asset Management, Inc., the Second Circuit announced what has become the leading test for interpreting §36(b): an investment-advisor breaches its fiduciary duty with respect to compensation if the fee charged was so disproportionate to the value of the services rendered that it could not have been the product of fair and even-handed negotiations. The parties disagree, however, as to how courts should construe Gartenberg and § 36(b).
Jones argues that Congress intended to incorporate the common-law meaning of fiduciary duty when it enacted § 36(b). . Making reference to the common-law meaning of fiduciary duty in the area of the law of trusts, Jones contends that an investment-advisor owes the beneficiaries of a mutual fund the duty to act in the beneficiary’s best interest. When a fiduciary is self-interested in a particular transaction such as its compensation contract, Jones argues that the fiduciary must comply with two requirements. . First, Jones contends that “the fiduciary must provide full and accurate disclosure of all material facts relating to the transaction.” Second, Jones argues that the transaction must be fair to the beneficiaries for whom the fiduciary acts. Jones contends that Congress intended for this common-law approach to be directly applicable to compensation for advisor services.
Harris, on the other hand, argues that the Second Circuit’s Gartenberg approach is the appropriate framework for determining whether an investment-advisor has breached its fiduciary duty. Therefore, Harris argues that in order for an investment-advisor to breach its fiduciary duty, it “must charge a fee that is 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.” Harris argues that when Congress passed § 36(b), it was attempting to strike a balance between two extreme approaches to regulating the receipt of advisor compensation. Harris argues that Congress rejected a “reasonableness” approach to compensation because it allowed a court to engage in “fee-setting” and to replace the judgment of informed investment company boards with its own judgment. Harris argues that Congress also rejected another extreme—the prevailing “waste” standard, which gave board approval of fees nearly total deference, because it would only prevent extremely shocking fees. Therefore, Harris contends, Congress struck a balance with § 36(b) by creating a fiduciary duty with common-law origins while tailoring it to fit into the context of compensation for investment-adviser services.
Jones disagrees with Harris to the extent that Congress intended to alter the common law meaning of fiduciary duty. While Jones argues that the Second Circuit’s reference to an “arm’s-length deal” is the correct approach because it accurately reflects the core of the common law fiduciary duty, it regards as “erroneous” the “so disproportionately large” language of Gartenberg. Jones argues that this language does not comport with traditional fiduciary principles and that is has misled subsequent courts in interpreting § 36(b). Jones argues that both Harris and the Second Circuit’s Gartenberg opinion fail to offer any textual or historical support for the assertion that a fiduciary breaches its duty only when it charges fees that are “so disproportionately large” compared to the services rendered. . Thus, Jones concludes that because both Harris and Gartenberg fail to offer adequate support for a departure from the traditional fiduciary principles, such a departure is improper.
In arguing that Congress intended to depart from a strict adherence to the common-law meaning of fiduciary duty, Harris calls attention to the explicit differences between the common law and the language of § 36(b). Specifically, Harris highlights the fact that at common law, a fiduciary had the burden of proving that its fees were within the range that would be produced by an even-handed bargain. Harris points out, however, that Congress reversed the burden of proof in § 36(b)(1), which states that “the plaintiff shall have the burden of proving a breach of fiduciary duty.” Thus, Harris contends that the Gartenberg approach is correct because it properly balanced the statutory language regarding the burden of proof with the cautionary and controlled deference Congress directed courts to give to board approval of compensation. .
How Should a Court Determine How Much is Too Much?
When a court is called upon to determine whether an investment-adviser charged excessively high fees, what point of reference should it use to decide? A significant component of Jones’s argument that Harris charged an excessively high fee for adviser services is that it charged Jones’s mutual fund twice as much as it charged independent clients for comparable services. . While Gartenberg rejected a comparison between fees charged to a money-market fund, on the one hand, and the fees charged to a “large pension fund,” on the other hand, Jones argues that this specific rejection was not a blanket statement that comparisons between fees charged to different funds would never be probative. Jones argues that where the services rendered are comparable, a comparison between the fees charged to the mutual fund and independent clients is “highly pertinent.” .
Harris argues that comparison between fees charged to captive mutual funds and those charges to institutional clients, such as pension funds, should only be probative insofar as the services rendered are comparable. . While Harris and Jones seemingly agree in the abstract, Harris argues that in this case, a comparison between the mutual fund at issue and an independent pension fund is irrelevant. . Harris argues that mutual funds require a higher amount of work and resources, and thus a comparison between the applicable fee schedules is without any probative value. For example, in comparing mutual funds to other accounts, Harris argues that while “an investment adviser provides portfolio management services for both types of accounts, including security selection, research, trading and asset allocation . . . the similarities largely end there.” Harris contends that it “provides a host of services that are unique to its role as the sponsor and manager of the Oakmark family of mutual funds . . . [including] administrative services . . . shareholder communications . . . oversight of third-party vendors . . . and compliance with a regulatory regime that is not required for institutional accounts.” Thus, Harris views a comparison between mutual funds and other accounts as carrying little to no weight due to the vast differences it perceives between the services it must provide to the different accounts.
Discussion
The Supreme Court’s decision in this case will define the contours of the standard courts use to determine whether a mutual fund adviser’s fee is excessive. Petitioner, Jerry Jones, et. al. (“Jones”), argues that courts should decide this question using a fairness standard that takes into account all the circumstances in a given case, including the advising fees an investment adviser charges unaffiliated funds for similar services. . Respondent, Harris Associates L.P. (“Harris”) argues that courts should give more deference to advising fees that boards of directors approve, and only intervene when it is apparent that the fee could not have been the product of a normal “arm’s length” bargaining process. The extent of the power of courts to intervene into private economic arrangements is the crux of this case.
The Mutual Fund Market: How Much Should Courts Intervene?
Jones contends that the nature of the relationship between a mutual fund and its investment adviser justifies allowing courts to take a close look at the fairness of the adviser’s fees. Jones points out that the funds at issue in this case were both created and advised by Harris. Jones argues that the close relationship between a fund and its advisor in this context leads to higher-than-usual advising fees, because once a fund has been created by an investment company such as Harris, it is unlikely to ever hire a different adviser. On the contested question of whether courts should scrutinize the fees investment advisers charge unaffiliated clients for similar services, the United States contends that a significant difference in fees strongly suggests unfairness in the bargaining process and the fee structure for affiliated funds.
The Securities Industry and Financial Markets Association (“SIFMA”) faults Jones’s argument for ignoring the fact that mutual fund stockholders can choose to invest in funds that pay lower advising fees if they so choose. By arguing that there is competition among funds for investors, SIFMA maintains that there is no place for fee regulation by the courts. The Cato Institute goes further, arguing that it is a fundamental right to be able to contract for compensation for one’s labors, and that absent force or fraud, courts have no power to interfere with these private economic arrangements. Harris also maintains that courts should not examine the difference between fees for affiliated funds and institutional clients because affiliated funds require more extensive services than unaffiliated funds do.
Jones responds to these market-based arguments by arguing that Congress, recognizing that the market was not adequately limiting advising fees, specifically enacted § 36 of the Investment Company Act, 15 U.S.C. § 80a-35(b), to allow courts to review fees for fairness. Jones argues that several factors limit competitiveness in the mutual fund market. Jones points out that investors rarely make the choice of which mutual funds to invest in, but leave it up to their brokers, who often receive direct or indirect compensation from companies like Harris for placing money in certain funds. Law professors supporting Jones also argue that competition for investors is weak in the mutual fund market, citing the negative tax consequences of withdrawing money from a mutual fund and arguing that this may often prevent shareholders from changing funds, even if lower fees are available.
Volume of Litigation
Harris argues that allowing cases like Jones’s to proceed to trial would drastically increase the volume of litigation related to mutual fund advising fees in the future. The Chamber of Commerce of the United States of America (“Chamber”) believes that increased litigation fees will only benefit lawyers at the expense of mutual fund shareholders, who have to pay the litigation bills. The Chamber also argues that the increased costs of running a mutual fund would dissuade investment companies from creating them in the first place, making the market less competitive as a whole.
Jones counters that Congress protected advisors from excessive litigation by, among other things, limiting both the damages period and the amount of damages recoverable under § 36(b). Furthermore, Jones argues, the existing procedural rules that allow courts to throw out unmeritorious claims will limit frivolous suits, even if courts scrutinize advising fees closely.
Conclusion
In this case, the Supreme Court’s decision will resolve the split between circuit courts regarding the extent of the fiduciary duty owed by investment-advisors to shareholders in mutual finds . Its decision should provide lower courts guidance in resolving whether a mutual fund advisor’s fee is excessive. The outcome of this case is important not only because it will impact the extent to which courts will intervene in the mutual fund market, but also because of its potential impact on the volume of litigation related to mutual fund advising fees in the future.