There has been a lot of focus on the Supreme Court’s acceptance of the PCAOB case: Free Enterprise Fund v. PCAOB (08-861). It squarely addresses an interesting administrative law question. I also find it interesting that this case originates from the last bout of financial fraud in the press (the collapse of Enron) and comes to the Supreme Court during the media coverage of the next bout of financial fraud.
Although it is less interesting, the Supreme Court also agreed to hear another case that may interest compliance professionals: Jones v. Harris Associates, L.P., (No. 08-586). This case focuses on the fees paid to the investment adviser of a mutual fund.
Harris Associates advises the Oakmark complex of mutual funds. Plaintiffs own shares in several of the Oakmark funds and contend that their fees are too high and in violation §36(b) of the Investment Company Act of 1940.
The Oakmark Fund paid Harris Associates 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 0.75% of anything over $5 billion. These fees are roughly the same as other funds of similar size and investment goal. Mutual funds are largely captive to their investment advisers. There is an ability to change advisers and there is a requirement for independent directors. In my view the market really controls the fees. If one fund charges less in fees than another fund with similar performance and investment goal, investors will put their money in the less expensive fund.
Plaintiffs’ claim that the fees are excessive because they far exceed those charged to independent clients. Like many investment advisers, Harris charges less for institutional clients that invest in funds similar to the Oakmark funds. The plaintiffs take the position that a fiduciary should not charge a different price to its controlled clients than it does to its independent clients.
Under §36(b) of the Investment Company Act of 1940 the “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company.”
The traditional standard was that a breach of fiduciary duty occurs when the adviser charges a fee that is “so disproportionately large” or “excessive” that it “bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982)
The district court concluded that Harris Associates had not violated the Act and granted summary judgment in its favor. The Court of Appeals for the Seventh Circuit upheld that ruling. But they rejected the traditional standard and crafted a new one. Instead, the court adopted a standard that an allegation that an adviser charged excessive fees for advisory services does not state a claim for breach of fiduciary duty under § 36(b), unless the adviser also misled the fund’s board of directors in obtaining their approval of the compensation. Section 36(b) does not say that fees must be “reasonable” in relation to a judicially created standard.
I find it funny that the plaintiffs had argued that the court should not follow the traditional standard in Gartenberg. They won on that point, but still lost with the new standard.
Since one part of the country is subject to the traditional standard in Gartenberg and another part is subject to this new standard, I assume the Supreme Court took the case to clean up this split. It will give the Court an opportunity to clarify the proper scope of the fiduciary duty that investment advisers owe to fund shareholders with respect to their compensation.
In the end, I do not think the ruling will have much impact on consumers. No plaintiff has succeeded on a § 36(b) claim against a fund advisor. But it is likely to have an impact on compliance and governance programs.
- The Supreme Court’s Review Of A Section 36(b) Fee Suit by Thomas O. Gorman of SEC Actions
- Seventh Circuit Rejects Gartenberg Standard in Adviser Fee Case and Fashions New Test by Thompson Hine
- Supreme Court to Hear Investment Adviser Fee Case (.pdf) by Sutherland
- A Fresh Look at Director “Independence”: Mutual Fund Fee Litigation and Gartenberg at Twenty-Five (.pdf) by Lyman Johnson 61 Vand. L. Rev. 497, 519 (2008).
- Section 36 of the Investment Company Act of 1940
- Seventh Circuit Court of Appeal Decision in Jones, et al., v. Harris Associates (.pdf)
- Petition for certiorari (.pdf)
- Brief in opposition in Jones, et al., v. Harris Associates(.pdf)
- Petitioner’s reply in Jones, et al., v. Harris Associates (.pdf)
- Brief amici curiae of AARP and Consumer Federation of America in Jones, et al., v. Harris Associates (.pdf) (in support of petitioner)
- Brief amici curiae of Law Professors in Jones, et al., v. Harris Associates (.pdf)