The Supreme Court issued its opinion in Jones v. Harris Associates, addressing the standard for when mutual fund fees are too high.
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 Jones v. Harris case starts with the 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 its 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.
Judge Easterbrook in the Seventh Circuit rejected the Gartenberg standard and crafted a new one. 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.
The Supreme Court concludes that
“Gartenberg was correct in its basic formulation of what §36(b) requires: to face liability under §36(b), an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship tothe services rendered and could not have been the product of arm’s length bargaining.”
They also make it clear that the burden of proof is on the party claiming the breach, not the fiduciary.
The Supreme Court found fault is looking almost entirely at the element of disclosure. The result is that the Supreme Court overturned the Seventh Circuit and remanded it back for further proceedings.
What does the standard mean?
The Investment Company Act does not necessarily ensure fee parity between mutual funds and institutional clients. Courts need to look at the similarities and differences in the the services being provided to different clients.
Courts should not rely too heavily on comparing fees charged by other advisers. Fees may not be the product of arm’s length negotiations.
A court should give greater deference to fund fees when a board’s process for negotiating and reviewing compensation is robust. “[I]f the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently.” If a fund adviser fails to disclose material information to the board, the court should use greater scrutiny.
“[A]n adviser’s compliance or non-compliance with its disclosure obligations is a factor that must be considered in calibrating the degree of deference that is due a board’s decision to approve an adviser’s fees.”
The result is that courts should defer to the “defers to the informed conclusions of disinterested boards” and hold “plaintiffs to their heavy burden of proof.”