Adopting the position argued by all of the parties, the Supreme Court unanimously rejected the Seventh Circuit’s disclosure approach to the question of adviser fees under Section 36(b) of the Investment Company Act. Rather, the Court embraced the approach initially crafted by the Second Circuit in Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982) – with perhaps a slightly different emphasis, according to the concurring opinion by Justice Thomas. Jones v. Harris Associates, L.P., Case No. 08-586 (March 30, 2010).

Petitioners in this case are shareholders in three mutual funds managed by respondent Harris Associates, an investment adviser. Their complaint, based on Section 36(b), challenged the fees under advisory agreements between Harris and the mutual funds. It claimed those fees were “disproportionate to the services rendered” and not within the range of what would have been negotiated at arm’s length. The district court granted summary judgment in favor of respondent. The Seventh Circuit affirmed, but adopted a different rational. Rejecting Gartenberg as essentially out of date, the court adopted what in essence is a disclosure standard – as long as there is full disclosure and no deceit the fees could not be challenged as discussed here.

The Supreme Court vacated the circuit court’s decision and remanded. A consensus has developed around Gartenberg, the Court noted. Under the Second Circuit ruling, the test is whether the fee schedule represents a charge within the range of what would have been negotiated at arms length in view of all the facts and circumstances. Accordingly, to violate Section 36(b), the adviser would have to charge a fee that is so disproportionately large that “’it bears no reasonable relationship to the services rendered and could not be the product of arm’s-length bargaining’” the Court noted, quoting Gartenberg. This standard rejects the notion that the principal factor to be considered is the price charged by other similar advisers because there may be no competition.

Against this backdrop, the High Court began its analysis, focusing as usual on the language of Section 36(b). That section is based on the undefined phrase “fiduciary duty.” Citing its seminal decision in Pepper v. Litton, 308 U.S. 295 (1939), the Court stressed that the essence of the standard is whether the transaction carries the earmarks of an arm’s length transaction under all the circumstances. While at common law the fiduciary had the burden to establish this, the statute reverses the burden. Gartenberg incorporates this approach.

The Second Circuit standard is also fully consistent with the statutory structure. The cornerstone of the Act’s effort to control conflicts is a fully informed mutual fund board. To provide those directors with the necessary information, the Act requires the adviser to furnish all information reasonably necessary to evaluate the terms of the adviser’s contract. The SEC is given authority to enforce this requirement. This structure suggests “a measure of deference” to the board’s judgment which depends on the circumstances. Again, Gartenberg adopts this approach.

Justice Alito concluded his opinion for the Court by discussing other important questions which are, in effect, the Gartenberg-plus portion of the opinion. First, the Court stressed that the Act requires consideration of all the relevant information. Accordingly, the Court rejected any categorical rule regarding the comparison of the fees charged different clients. Rather, courts can give various comparisons the weight they merit in view of the similarities and differences. In this regard, plaintiffs bear the burden of showing that the fees are beyond the range of arm’s length bargaining. “Only where plaintiffs have shown a large disparity in fees that cannot be explained by the different services in addition to other evidence that the fee is outside the arm’s-length range will trial be appropriate,” the Court held.

Furthermore, the court’s evaluation of an investment adviser’s fiduciary duty must take into account both procedure and substance. Where the board’s procedures are robust, appropriate deference should be given. This contrasts with the situation where the process is deficient. As the same time the Court cautioned that Congress did not adopt a reasonableness standard and the courts should not attempt to engage in “precise calculation of fees . . .,” a job for which they are ill-suited the Court concluded.

In a brief concurring opinion, Justice Thomas stressed that the Court was not simply adopting Gartenberg. That decision can be read as emphasizing fairness and proportionality. Here, the burden of proof is on the plaintiff and Section 36(b) does not call for a judicial second-guessing of the decision by the board. Justice Thomas concluded noting that “[w]hatever else might be said about today’s decision, it does not countenance the free-ranging judicial “fairness” review of fees that Gartenberg could be read to authorize . . .”