Citing what it called “wholly inadequate” oversight of a faraway subadviser, the Securities and Exchange Commission fined and ordered repayment of advisory fees by Morgan Stanley Investment Management. According to the settlement, Morgan Stanley will repay its client, the Malaysia Fund, $1.8 million for fees it paid from 1996-2007 for “research, intelligence, and advice” that  AMMB Consultant Sendirian Berhad of Malaysia, was to provide as subadviser.

AMMB served as a sub-adviser to the Fund from inception until it was terminated at the end of 2007. The Research and Advisory Agreement specified that AMMB would register with the SEC as an investment adviser under the Investment Advisers Act and furnish Morgan Stanley “such investment advice, research and assistance, as [Morgan Stanley] shall from time to time reasonably request.” AMMB did not exercise investment discretion or authority over any of the assets in the Fund. Morgan Stanley took responsibility for monitoring AMMB’s performance of services. The Fund would pay AMMB an escalating fee based on the fund’s assets. During the relevant time period, the Fund paid AMMB advisory fees totaling $1,845,000. As the fund administrator, Morgan Stanley facilitated the Fund’s payment of AMMB’s advisory fees.

Section 15(c) of the Investment Company Act requires an investment adviser of a registered investment company to furnish such information as may reasonably be necessary for such company’s directors to evaluate the terms of any contract whereby a person undertakes regularly to serve or act as investment adviser of the company.

It was an OCIE exam in 2008 that first questioned the arrangement between AMMB and Morgan Stanley. AMMB did not provide any of the services it and Morgan Stanley represented to the Fund’s Board. Instead, AMMB provided two monthly reports that Morgan Stanley neither requested nor used in its management of the Fund. The first was a two-page list of the market capitalization of the Kuala Lumpur Composite Index. The second was a two-page comparison of the monthly performance of the Fund against other Malaysian equity trusts. For twelve years, the fund’s Board relied on Morgan Stanley’s representations and submissions of information regarding AMMB’s services when it unanimously approved the continuation of AMMB’s advisory contracts. The SEC stated that even though Morgan Stanley took responsibility for monitoring AMMB’s services, its oversight and involvement with AMMB during the relevant time period were wholly inadequate.

The settlement calls on the RIA to devise written procedures, reimburse the fund and pay a fine of $1.5 million.

If you are charging a fund for services provided by a third, then there is an obligation to make sure the third party is providing those services.  The SEC stated a violation of Section 206(2) of the Investment Advisers Act that prohibits an investment adviser from engaging “in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client”. It also imposes on investment advisers a fiduciary duty to act in “utmost good faith,” to fully and fairly disclose all material facts, and to use reasonable care to avoid misleading clients. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191, 194 (1963). Morgan Stanley willfully violated Section 206(2) of the Investment Advisers Act by representing and providing information to the Fund’s Board that AMMB was providing advisory services for the benefit of the Fund, which it was not.

Sources:

• SEC Order Against MSIM
• SEC Charges Morgan Stanley Investment Management for Improper Fee Arrangement – SEC Press Release
• Over $3.3 Million Charges Against Morgan Stanley Investment Management for Improper Fee Arrangement by Jay Gould in Pillsbury’s Investment Fund Law Blog

Traditionally, private fund managers have looked at the section 3(c)(1) or section 3(c)(7) exemptions from the definition of “investment company” to avoid the restrictions of being regulated under the Investment Company Act. Dodd-Frank defined a “private fund” as being “issuer that would be an investment company as defined in Section 3 of the Investment Company Act, but for section 3(c)(1) and section 3(c)(7) of that Act.”

If you want to avoid being a “private fund” you need to look at the other exemptions under the Investment Company Act. Section 3(c)(5) is available for real estate funds:

Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses: …  (C) purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.

The SEC has issued some guidance on what is meant by that exemption.

In a No Action Letter issued to Realex Capital Corporation in 1984, the Securities and Exchange Commission did not decline to take action. Realex was looking to invest as a limited partner in a limited partnership that would own and operate a building. The SEC took the position that the interests would be “investment contracts” and therefore securities, not real estate for purposes of section 3(c)(5). Realex would be relying on the efforts of the managing partners for the success of the enterprise. In this case, Reaex had only limited major decision rights. For example there was a limitation on sale, but Realex could only object if it did not receive net cash proceeds at least equal to its capital contributions.

In a pre-REMIC No Action Letter, the SEC agreed not to action against Premier Mortgage Corporation for a mortgage pooling fund. Premier would acquire whole mortgage loans secured by first liens on the property.

Getting closer to real estate funds, United States Property Investments NV asked for clarification from the SEC for their fund that would be investing in real estate and real estate interests. In 1989, the SEC said the fund’s investment strategy would allow it qualify for the exemption under 3(c)(5). The fund would invest only in fee interests in real estate, joint ventures formed to acquire real estate, mortgage loan secured by real estate, and interests in joint ventures formed to make mortgage loans secured by real estate. At least 55% of the investments would be exclusively backed by real estate. The remainder would mortgage loans secured primarily, but not exclusively, by real estate.  The fund’s joint venture interests would be exclusively general partnership interests and would be active in the management and operation, including consent for major decisions.

Following that letter, City Trust followed up with a similar investment fund that would established for buying commercial mortgage loans and equipment loans in the form of industrial development bonds. This letter request combined the real estate mortgages in clause (C) of 3(c)(5)  with the purchase money debt for merchandise, insurance, and services in clause (A).

The United States Property Investments NV letter is the most useful to real estate private equity funds looking for 3(c)(5) as an exemption to avoid being defined as a “private fund.” It’s not clear what lesser amounts of real estate would be acceptable. It’s also not clear whether a more complicated structure of ownership would change the analysis. Real estate funds often have lots of intervening entities to satisfy tax, ERISA, financing and management issues.

The other thing to keep in mind is that using the 3(c)(5) exemption may get you out from under the definition of a private fund, but does not necessarily mean that you are not an investment adviser. It just means that the management company is not an adviser to a private fund.

Sources:

• City Trust No Action Letter (December 12, 1990)
• Premier Mortgage No Action Letter (March 14, 1983)
• Realex Capital Corp No Action Letter(March 19, 1984)
• United States Property Investments NV No Action Letter (May 1, 1989)
• Are you an Investment Company? – prior post in Compliance Building

Image of Royal Exchange London is from the Library of Congress

Fund managers are dealing with Dodd-Frank and the requirements under the Investment Advisers Act made by the Securities and Exchange Commission. Of course, a fund manager needs to focus on other areas of financial regulation and enforcement by the Securities and Exchange Commission. Fund managers need to keep focused on how they comply with the Investment Company Act.

Section 3 of the Investment Company Act has this definition:

1. When used in this title, “investment company” means any issuer which–

A. is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities;

B. is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or

C. is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

This leaves you with the tricky analysis of whether your investments are securities. To avoid that mess, most private funds look to two exemptions from the definition of “investment company”: 3(c)1 and 3(c)7.

Under 3(c)(1), the main limitations are that you have one hundred or fewer holders of beneficial interest in the fund and that you propose to sell them in a public offering. Under 3(c)(7) you can go beyond the 100 owners, but they need to be “qualified purchasers.” That means they need to have a big wallet.

One challenge for private funds who do not want to register under the Investment Advisers Act is that private fund is defined as an “issuer that would be an investment company as defined in Section 3 of  the Investment Company Act, but for section 3(c)(1) and section 3(c)(7) of that Act.”

There are other exemption available, but they are harder to fit under. You may have a trail of paper work stating that you fall under the section 3(c)(1) or section 3(c)(7) exemption, even though you could claim to fit under one of the other exemptions.

For example, 3(c)(5) is available for real estate funds:

Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses: …  (C) purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.

There are some additional limitations that come with this based on some SEC No Action letters. I’ll put some information together on that later.

Sources:

• Real Estate Programs – Avoiding the Scope of the Investment Company Act by Richard P. Cunningham, Jr. , Esq. and Thomas G. Voekler, Esq.
• Section 3 of the Investment Company Act
• What is a Security? Is Real Estate a Security? – prior post on Compliance Building
• Private Fund Exemptions under the Investment Company Act – prior post on Compliance Building
• Qualified Purchasers under the Investment Company Act – prior post on Compliance Building

Image is Exchange hall, Copenhagen, Denmark, between ca. 1890 and ca. 1900, published by The Library of Congress

When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employees.

Its unlikely that your key employees will have the $5 million in investments needed to qualify as an investor. (Each investor in a 3(c)(7) private investment fund must be Qualified Purchaser.)

The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act.

You will still need to determine if the employee’s acquisition of the interest is exempt from the registration requirements of the Securities Act. Most likely that will mean that the knowledgeable employee will need to be an accredited investor. Meeting that $200,000 per year / $300,000 per year if married income (and a reasonable expectation of that income continuing) threshold may be the biggest impediment to offering equity interests further down the company ladder.

The first category of “knowledgeable employees” is the management of the covered company, which covers these positions:

• director [see Section 2(a)(12)]
• trustee
• general partner
• advisory board member [see Section 2(a)(1)]
• “executive officer”

Executive Officer is defined in Rule 3C-5 as:

• president
• vice president in charge of a principal business unit, division or function
• any other officer who performs a policy-making function
• any other person who performs a similar policy-making function

The second group of knowledgeable employees are those who participate in the investment activities. Those employees need to meet these requirements:

• Participate in the investment activities in connection with his or her regular functions or duties,
• has been performing such functions and duties for at least 12 months, and
• is not performing solely clerical, secretarial or administrative functions.

The 12 month limit is not limited to 12 months at the employee’s current company. The SEC concluded that it is not necessary to require that an employee work for the particular fund or management affiliate for the entire 12-month period as long as the employee has the requisite experience to appreciate the risks of investing in the fund and performed substantially similar functions or duties for another company during that 12 month period.

Whether an employee actively “participates in the investment activities” of a private fund will be a factual determination made on a case-by-case basis.  In a 1999 No Action letter sent to the ABA the SEC said the following would NOT be knowledge employees:

• Marketing and investor relations professionals who explain potential and actual portfolio investments of a fund and the investment decision-making process and strategy being followed to clients and prospective investors and interface among the fund, the portfolio mangers and the fund’s clients.
• Attorneys who
  • provide advice in the preparation of offering documents and the negotiation of related agreements,
  • who also are familiar with investment company management issues, and
  • respond to questions or give advice concerning ongoing fund investments, operations and compliance matters.
• Brokers and traders of a broker-dealer related to the Fund who are Series 7 registered.
• Financial, compliance, operational and accounting officers of a fund who have management responsibilities for compliance, accounting and auditing functions of funds.

The SEC also said that research analysts who investigate the potential investments for the fund may not be knowledgeable employees unless they research all potential portfolio investments and provide recommendations to the portfolio manager.

Sources:

• Section 3(c)(7) of the Investment Company Act
• Rule 3c-5 under the Investment Company Act(17 CFR 270.3c-5)
• American Bar Association SEC No Action Letter, April 22, 1999
• SEC Release IC-22597 on Privately Offered Investment Companies
• Some Considerations for Private Investment Partnerships by Arthur S. Ainsberg and Steven J. Fredman in the CPA Journal
• Employee Investment in Private Funds By Igor Panshensky of Paul, Hastings, Janofsky & Walker LLP
• Private Fund Exemptions under the Investment Company Act – prior post
• Qualified Purchasers under the Investment Company Act – prior post

Photo is of the Board of Directors and Officers of the Industrial Exhibition Association of Toronto 1930 used under Creative Commons License from the Toronto Public Library Special Collections

In a private fund exempt under 3(c)(1) investors only generally need to be accredited investors (and “qualified clients” if the fund manager is SEC registered. If you have more than 100 investors in the fund you will need to fall under the 3(c)(7) exemption. That means all of your investors must be “qualified purchasers.” A qualified purchaser is a much greater requirement than an accredited investor and a qualified client.

To paraphrase the requirements under Section 2(a)(51) of the Investment Company Act, a “qualified purchaser” means:

• a person with more than $5 million in investments
• a company with more than $5 million in investments owned by close family members
• a trust, not formed for the investment, with more than $5 million in investments
• an investment manager with more than $25 million under management
• a company with more than $25 million of investments

To that list you can also add:

• A company (regardless of the amount of such company’s Investments) beneficially owned exclusively by Qualified Purchasers.
• A “Qualified Institutional Buyer” under Rule 144A of the 33 Act (except that “dealers” under Rule 144 must meet the $25 million standard of the 1940 Act, rather than the $10 million standard of Rule 144A). Rule 144A generally defines a “Qualified Institutional Buyer” as institutions, including registered Investment Companies, that own and invest on a discretionary basis $100 million of securities that are affiliated with the institution, banks that own and invest on a discretionary basis $100 million in  securities and have an audited net worth of $25 million, and certain registered dealers.

“Investments” generally means the following:

1. Securities, including stocks, bonds and notes, other than securities of an issuer that  is under common control with the qualified purchaser.
2. Real estate held for investment purposes.
3. Commodity futures contracts, options or commodity futures and options on physical commodities traded on a contract market or board of trade, held for investment purposes.
4. Physical commodities (e.g., gold and silver), with respect to which futures contracts are traded on a contract market or board of trade, held for investment purposes.
5. Financial contracts (e.g., swaps and similar individually negotiated financial transactions), other than securities, held for investment purposes.
6. For an investment company or a commodity pool, any binding capital commitments.
7. Cash and cash equivalents held for investment purposes. Neither cash used by an individual to meet everyday expenses nor working capital used by a business is considered cash held for investment purposes.

Sources:

• Section 2(a)(51) of the Investment Company Act
• Rule 144A (17 C.F.R. 230.144A) (.pdf)
• What is a qualified purchaser in Hedge Fund Law Blog
• Rule 144A Offerings May Supplant IPOs from Bowne
• Private Fund Exemptions under the Investment Company Act – prior post

Image of Coin Stacks is by Darren Hester under a creative commons license.

Private investment funds primarily use two exemptions to avoid being defined as an “investment company” under the Investment Company Act of 1940: Section 3(c)(1) or Section 3(c)(7).

Less than 100 Investors

Section 3(c)(1) of the Investment Company Act excludes from being an investment company any issuer whose outstanding securities are beneficially owned by not more than 100 persons and that is not making and does not presently propose to make a public offering of its securities. The benefit of Section 3(c)(1) is that there is no additional status requirement for the investor, such as net worth, total assets, or total investments owned beyond the “accredited investor” standard.

There are some catches in trying to count the number of investors. There are several types of investors that result in a look through their ownership.

More than 100 Investors

If your private fund will have more than 100 investors, either directly or because of a look-through, then the fund will need to fit under the Section 3(c)(7) exemption. As with Section 3(c)(1) you cannot anticipate making a public offering. Investors in 3(c)(1) fund need only be accredited investors, but investors in a 3(c)(7) fund must be “qualified purchasers.”

The higher standard of qualified purchaser limits potential investors to institutional investors, investment managers and high net worth individuals. (More on the “qualified purchaser” definition in my next post.)

Contacting lots of investors may be viewed as general solicitation so you need to pay attention to the prohibition on general solicitation or advertisement under Regulation D.

You will also need to be careful in limiting future transfers of interest in the private investment funds. With more than 100 investors, you will no longer be in the safe harbor exemption from being a publicly traded partnership.

500 or more Investors

Once you have 500 or more investors and more than $10 million in assets you are subject to the reporting requirements of the Exchange Act. Effectively you are no longer a private fund.

I believe something analogous happened to Google. They had gotten so big and their shares ended up in the hands of more than 500 people. Since they would have to begin complying with the reporting requirements, they may as well let the shares trade publicly.

So if you are going to end up with more than 500 investors in a private fund, you are better off having several smaller funds to avoid the public reporting requirements under the Exchange Act.

Sources:

• Section 3 of the Investment Company Act – Definition of Investment Company
• Section 12(g) of the Exchange Act of 1934
• Fund Raising Publicity – prior post
• Advertising or Solicitation to Offer or Sell Securities Under Rule 502(c) – prior post
• Classification of Private Funds as Publicly Traded Partnerships – prior post

Image of the Twenty Dollar Bill is by Darren Hester under a Creative Commons License.

The Supreme Court issued its opinion in Jones v. Harris Associates, addressing the standard for when mutual fund fees are too high.

Background

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.

Decision

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.”

Sources:

• Jones et al. v. Harris Associates L. P. (08-586)
• Jones v. Harris decided — unanimously by William Birdthistle in The Conglomerate

Much has been made about FINRA’s Regulatory Notice 10-06 and how that will affect the social media use by registered representatives. Looking beyond the broker/dealers, I thought it would be interesting to see what mutual fund companies are doing with social media. I’ve started seeing some mutual fund companies starting to dip their toes into web 2.0.

Key Regulations Governing Advertising of Mutual Funds

Mutual funds are highly regulated under the Investment Company Act and the Securities Act. The interests in the funds themselves are securities and are governed by the Securities Act. As a security, that means under Section 5.(b)2 of the Securities Act you can only use a prospectus to advertise it.

Under Rule 482, the SEC allows mutual funds some additional flexibility is advertising their products. If an advertisement meets the disclosure requirements of the rule, then the advertisement will be deemed a “prospectus.” (Which means you won’t be illegally selling securities.)

Required Disclosure under Rule 482

There is long list of requirements in the advertisement. Here are just some of them:

• Point out that investors need to consider the investment objectives, risks, and charges and expenses of the investment company carefully before investing.
• Explains that the prospectus and, if available, the summary prospectus contain this and other information.
  identifies a source from which an investor may obtain a prospectus and, if available, a summary prospectus;
• You should read the prospectus carefully before investing.
• Advertisements that includes performance data have to point out that past performance does not guarantee future results (along with extensive limitations on how you can disclose performance)
• Money market funds must point that they are not federally insured and you can lose money. (Hello Reserve Fund!)
• Disclosure statements can’t be in fine print

Filings

Advertisements then need to be filed with the SEC under Rule 497 or with FINRA. (Most do the FINRA filing.) You have to file the advertisement with  FINRA within 10 days of first use or publication [FINRA Rule 2210(c)].

How can you do all of this with web 2.0?

You can’t.

One key aspect of web 2.0 is that it allows anyone to be a publisher. But now you’re a publisher without any training on how to be a publisher. In the case of mutual fund companies, publishing will have to go through a long process of review and approval before content can be published. Failure to comply has serious consequences.

That doesn’t mean that mutual fund companies cannot use social media. It just means they can only use is it certain ways.

Syndicate Content

If you’ve gone through the trouble and expense of creating compliant content, you should make it available in as many ways as possible. You obviously can’t push all of the required disclosures through the 140 characters of Twitter. But you can send links back to your website where you can make all of the disclosures. If you have video, you can publish the video on Facebook and YouTube.

If you want to have a good day fishing, you need to go where the fish are. (See the picture above.) Push your content to potential customers in the places where they are. Some of them (many of them?) may be spending time on Web 2.0 sites.

Examples

• Putnam Investments
  • Putnam Today on Twitter
  • Putnam Investments on Facebook
  • Roth IRA Blog
  • Putnam’s YouTube Channel
• Vanguard
  • Vanguard Blog
  • Vanguard on Facebook
• Fidelity
  • Fidelity on Twitter
  • Fidelity on Facebook
• Legg Mason
  • Legg Mason on Twitter
• American Century Investments
  • American Century Investments on Twitter
  • American Century Investments on Facebook

Sources:

• Rule 482 under the Securities Act of 1933
• Putnam Social Media Strategy Rooted In Content Syndication in Rock the Boat Marketing
• Webcast on how Putnam Investments uses social media – hosted on BrightTalk
  

Photo © Adrian van Leen for openphoto.net CC:PublicDomain

OpenCongress allows you to create custom widgets for the status of bills in Congress. I decided to play around and create one for the House version of the Private Fund Investment Advisers Registration Act.

I’ll create one for the Senate version once they formally introduce the Restoring American Financial Stability Act of 2009.

On Monday, the Supreme Court heard the arguments on a case involving mutual fund fees. The case is trying to reconcile 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.

The parties argued their positions Monday in front of the Supreme Court. I was not there, but I thought I could collect some coverage and Tuesday Morning Quaterbacking of the arguments.

According to the coverage, neither party supported Chief Judge Easterbrook’s ruling in the Seventh Circuit. He had found that the marketplace may be trusted to curb excessive fees and that mutual fund investors unhappy with the fees they are charged could withdraw their money and invest it elsewhere.

The mutual fund side argued for the Gartenberg standard: Fees must be “within the range of what would have been negotiated at arm’s length in the light of all of the surrounding circumstances.”

The plaintiff side argued:

“It surely cannot be the case that where you are dealing with a fiduciary duty — which is a higher standard recognized in the law — that you can charge twice as much as what you are obtaining at arm’s length for services that you are providing.”

William Birdthistle thinks:

“If, as some of today’s questions seem to indicate, the eventual decision from the Court in Jones v. Harris will read like Gartenberg with just one additional factor included in an already long and nebulous evaluation, we might have to wait for the next wave of litigation in trial courts to see whether the new Jones standard makes any practical difference on fees. If, on the other hand, the justices highlight and strongly emphasize the institutional/individual fee comparison in an opinion that reads like Posner’s dissent or Ameriprise v. Gallus, the pressure upon the industry to lower fees could be more acute and immediate.”

Anna Christensen thinks:

There did not seem to be five votes for adopting the Seventh Circuit’s market-based approach. The Court may reject that standard and decide little else, perhaps adopting the basic Gartenberg test with some degree of explication, and sending the case back to the court of appeals for application of the test. On the other hand, the Court may decide that as the argument in this case demonstrates, the terms of Gartenberg test do not provide significant guidance on how to identify an unfairly large fee, and use the facts of this case to provide an object lesson to lower courts.

It sounds like the Supreme Court is unlikely to come out with a ruling that dramatically affects the industry. Inevitably, it will require additional work for compliance.

References:

• Jones v. Harris: Early Reaction to Today’s Argument by William Birdthistle for The Conglomerate
• Will the Court Reject a Market-Based Approach for Advisory Fees? by Anna Christensen for SCOTUSblog
• Justices Scrutinize Adviser Pay by Adam Liptak for The New York Times
• Jones v. Harris Associates: Let 8,000 Lawsuits Bloom, Part 1 by Jennifer S. Taub for The Race to the Bottom
• Jones v. Harris Associates: Let 8,000 Lawsuits Bloom, Part 2 by Jennifer S. Taub for The Race to the Bottom
• Status Quo on Mutual-Fund Fees? Postgaming the Harris Arguments by Ashby Jones for The Wall Street Journal’s Law Blog
• A Flurry of Stories on Mutual Fund Fees – Prior Post