On March 30, The Supreme Court of The United States handed down its decision in Jones v. Harris Associates (No. 08-586), 2010 WL 1189560, ___ US ___ (2010), which focuses on “what a mutual fund shareholder must prove in order to show that a mutual fund investment adviser breached the ‘fiduciary duty with respect to the receipt of compensation for services’ that is imposed by §36(b) of the Investment Company Act of 1940, 15 U.S.C. §80a-35(b) (hereinafter §36(b)).”
Because of the nature of an investment fund, the relationship between a fund and its investment advisor is “fraught with potential conflicts of interest.” To limit the effect of these conflicts, the Investment Company Act of 1940, as amended, contains protections for mutual fund shareholders. One of these protections includes a fiduciary duty, imposed upon investment advisers, to ensure that their compensation is proper and granting individual investors a private right of action for a breach of that duty. 15 U.S.C. §80a-35(b).
In this case, shareholders of three different mutual funds filed an action claiming that the fees charged by their mutual funds manager, Harris Associates, L.P., were “disproportionate to the services rendered” and “not within the range of what would have been negotiated at arm’s length in light of all the surrounding circumstances.”
The District Court granted summary judgment based on Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (CA2 1982). There, the Second Circuit had stated that the proper standard for determining if a fee violates §36(b) was “whether the fees charged . . . were so disproportionately large that they could not have been the result of arm’s-length bargaining.” In applying that standard, the District Court examined Harris Associates’s fees for its other clients and the fees charged by other investment advisors. It then compared those fees with the fees charged to the shareholders in this case and found that the fees were not outside the appropriate range for such fees.
On appeal, the US Court of Appeals for the Seventh Circuit affirmed, but explicitly disapproved of the Gartenberg test. The Seventh Circuit relied on trust law relating to the creation of a trust and found that the fiduciary (in this case the fund manager) must “make full disclosure and play no tricks but is not subject to a cap on compensation.” Therefore, to prove a violation of §36(b), a plaintiff would have to show the compensation was “so unusual” that it gave rise to an inference “that deceit must have occurred, or that the persons responsible for the decision have abdicated.”
In overturning the Seventh Circuit’s decision and affirming most parts of the standard laid out in Gartenberg, the Court pointed out that prior to the Seventh Circuit’s decision, “something of a consensus had developed regarding the standard set forth over 25 years ago in Gartenberg.” Not only had a similar test been adopted by at least three other Circuit Courts, but the SEC has formalized similar factors in its regulations. In fact, in this case petitioners, respondents, and the Federal Government as Amicus Curiae all argued in favor of the Gartenberg approach, although they differed on its application.
The Court also agreed with the Gartenberg approach because it encompassed the proper meaning of the phrase “fiduciary duty” for that term’s use in §36(b). Finding that the Seventh Circuit’s trust based definition was too narrow, the Court relied on its own decision in Pepper v. Litton, 308 U.S. 295 (1939) for the proper test when evaluating these kinds of contracts. Quoting Litton, the Court said, “The essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain.”
Finally, the Court also preferred the Gartenberg standard because it recognized the important function played by the “disinterested directors” of the fund, which are mandated by the Investment Company Act. These disinterested directors must approve adviser fees. As such, Courts should be able to consider the approval of the fee by these disinterested directors when determining if the fee violates §36(b).
Given the consensus that had developed around Gartenberg-type decisions, the Court’s own history in defining “fiduciary duty” in similar contexts, and the deference a Gartenberg-like test would give to the disinterested directors of a fund, the Court found that a test based in the theory of the Gartenberg decision is proper when reviewing fees under §36(b).
Jason B. Desiderio, Esq.