The Supreme Court’s Review Of A Section 36(b) Fee Suit

The Supreme Court on Monday agreed to hear Jones v. Harris Associates, L.P., No. 08-586 (S. Ct. Filed Nov. 3, 2008), which raises a significant question for the mutual fund industry. Specifically, the High Court will consider what shareholders must established when bringing suit under Section 36(b) of the Investment Company Act claiming that the fees paid the investment adviser are excessive. Currently there is a split in the circuits between the standard adopted by the Seventh Circuit in Jones and earlier decisions by the Second, Third and Fourth Circuits.

Section 36(b), added to the Act in the 1970 Amendments, provides in pertinent part: “For the purposes of this subsection, 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. … An action may be brought under this subsection by … a security holder. … With respect to any such action the following provisions shall apply: (1) It shall not be necessary to allege or prove that any defendant engaged in personal misconduct … (2) In any such action approval by the board of directors … of such compensation or payments, or of contracts … and ratification or approval of such compensation or payments … by the shareholders … shall be given such consideration by the court as is deemed appropriate under all the circumstances … .”

Prior to the decision in Jones, the key decision on this question was the Second Circuit’s ruling in Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982). There, the Court held that the concept of a fiduciary duty under Section 36(b) reflects the reality of the situation involving an investment company and its adviser. In that context, 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 has been followed by the Third and Fourth Circuits. Krantz v. Prudential Investments Fund Management LLC, 305 F.3d 140 (3rd. Cir. 2002); Migdal v. Rowe Price-Fleming International, Inc., 248 F.3d 321 (4th Cir. 2001).

The Seventh Circuit rejected Gartenberg in Jones, fashioning a new standard grounded in economics and keyed to deception. In Jones, the Petitioners are shareholders in the Oakmark funds. Their complaint challenges as excessive, and a breach of Section 36(b), the fees paid to Respondent Harris, the investment adviser. According to Petitioners, Harris created the funds, manages their daily operations and even furnishes them office space. In short, Petitioners note, they are “captive” mutual funds.

Harris charges Oakmark fees for investment advisory services based on a percentage of each fund’s net assets. Those fees were properly approved. Plaintiffs’ claim that the fees are excessive because they far exceed those charged to independent clients. Respondent counters, noting that the fees charged to Oakmark are comparable to those paid by similar funds and, in any event, Harris’ performance has been extraordinary.

The district court granted summary judgment in favor of Harris. Following Gartenberg, the court held that the key question is whether the fees charged were “so disproportionately large that they could not have been the result of arm’s-length bargaining.” On the record here, the court concluded that there was no dispute that the fees charged by Harris were comparable to those paid by other similar funds. Accordingly, plaintiffs failed to establish a breach of Section 36(b).

The Seventh Circuit affirmed, but adopted a different rationale. In a panel decision written by Judge Easterbrook, the court began by rejecting Gartenberg as the wrong standard. Rather, the basic economics of the market place suggest that the fees charged reflect competition. Section 36(b), the Court noted, does not put the courts in the rate setting business: “A fiduciary duty differs from rate regulation. A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.” Rather, the federal securities laws rely primarily on disclosure and “then allowing price to be set by competition in which investors make their won choices.” Those investor choices can be made by switching funds.

Here, plaintiffs do not contend that Harris “pulled the wool over the eyes” of the disinterested trustees or otherwise hindered the negotiations to obtain a favorable fee contract. Accordingly, they have not alleged a violation of Section 26(b). Jones v. Harris Associates L.P., 2007 WL 627640 (7th Cir. May 19, 2008). The Seventh Circuit declined to rehear the case en banc, splitting five to five with Judge Posner writing a dissent noting that the economics of the panel decision were ripe for review.

The issue to be resolved by the Supreme Court presents a clear conflict among the circuits. The question is one of importance to funds, their advisers and shareholders. At the same time, the case may hold more significance since it involves the rights of shareholders to bring suits and litigate difficult issues.

The High Court’s decision may also further the recently decided Wyeth v. Levine, No. 06-1249 (Decided March 4, 2009). There, the Court rejected a key argument advanced by business groups, claiming that FDA approval could, in view of the regulatory scheme, effectively immunize complying drug companies from damage suits. In some ways the decision of the Seventh Circuit in Jones invokes a similar notion. Judge Easterbrook’s opinion essentially relies on the approval process for the fees coupled with the notion that shareholder who are unhappy with the results can, absent fraud, follow the Wall Street Rule of “voting with your feet” by leaving. Jones may thus present another version of the arguments advanced but rejected in Wyeth.

The SEC Should Return To Its Roots: Disclosure

As the new Commission struggles to revive an agency which has been badly battered during the current market crisis, it is essential that it return to basics. Disclosure is the central theme of the federal securities laws. If investors are furnished the material facts, they can make an informed investment decision. If material information is available, the efficient market theory posits that it will be reflected in the market price. Investing, price discovery and trading are keyed to the full, fair and timely disclosure of material information.

As the current market crisis has unfolded with huge scandals, there have been repeated calls for reform, continued criticism of actions and inactions by the SEC and multiple charges of failure. Reforms are necessary according to many, because the regulatory structure is outdated and has not keep up with ever changing markets. Additional authority for the SEC and other regulators is necessary to supervise unregulated segments of the market such as credit default swaps. The critics have repeatedly charged that the SEC’s performance during the market crisis has been lackluster at best. There have been repeated charges of failure on the part of the enforcement program for not discovering at an earlier point giant frauds such as the Madoff Ponzi scheme.

Disclosure however is seldom mentioned in these comments and discussions. Also seldom mentioned is a report by the SEC’s Inspector General dated September 25, 2008. The report, discussed here, is titled “SEC’s Oversight of Bear Stearns and Related Entities,” Report No. 446.

In the report, the Inspector General carefully reviews the events surrounding the collapse of Bear Stearns. In part, it details the failure of the Division of Corporation Finance to complete a timely analysis of Bear Stearns’ then most recent 10-K filing. That failure, the Inspector General charges, “deprived investors of material information that they could have used to make well-informed investment decisions. … the information [about the firm’s exposure to the sub-prime market] could have been potentially beneficial to dispel the rumors that lead to Bear Stearns’ collapse.”

In the aftermath of Bear Stearns’ collapse many on Wall Street claimed the firm’s demise came in part from a bear raid — short sellers’ swirling rumors that put increasing downward pressure on the stock price until it collapsed. SEC enforcement is reportedly investigating the prospect of insider trading. Whatever the validity of these theories, they all begin with inadequate disclosure. As the inspector general’s report makes clear, Corp Fin’s review and comment process on Bear Stearns’ 10-K was much delayed and not completed until after the collapse of the firm. Critical information about the exposure of the firm to the sub-prime market was not available to the market because of this failure. A lack of information can lead to rumors, speculation and panic trading — the kind that surrounded the downward spiral of Bear Stearns’ share price as it collapsed.

This is not an isolated instance. A thoughtful article by Joe Nocera in the New York Times on Saturday March 7, 2009 (here, registration required) details potential a “Bear Stearns” spiral which is going on now. According to Mr. Nocera “G.E. spent the week fending off rumors that it was the second coming of Citigroup. G.E. has billions of dollars of unacknowledged losses in GE Capital, its huge finance unit, the bears claimed. G.E. is about to lose its prized AAA. Its debt is immense. GE Capital is going to need to shore up its capital base. And on, and on.” The company reportedly is doing everything it can to shore up its share price and dispel the rumors. Day after day the company is reaching out to investors in every way possible to try and dispel the rumors.

Nevertheless, traders continue to batter the share price of G.E. This, according to Mr. Nocera, is a predicament of its own making: “For many years, G.E. was one of the more impenetrable companies for investors. There was a kind of arrogance to its disclosures; even the most diligent analysts didn’t truly understand where its numbers came from.”

Previously G.E. benefited from its lack of disclosure by almost magically making quarterly numbers. The ability to somehow do this reassured traders and the markets despite a lack of disclosure. In the midst of the current market crisis however, G.E. apparently is not getting the benefit of the doubt. Rumors and speculation about possible losses at GE Capital are driving down the share price of G.E. just as similar rumors spiraled down the share price of Bear Stearns. The lack of information is battering G.E. despite its protests.

Bear Stearns, G.E. and no doubt others should remind the SEC and those searching for the causes of the market crisis, solutions to the collapse of the credit markets and answers on how to remake the system that it all begins with disclosure. While the rejuvenation of SEC enforcement is a popular topic, that alone will not be sufficient. Enforcement is, by definition a somewhat backward looking process. At best enforcement may be able to halt a fraud in mid-stream. The best preventative medicine for bear raids, rumors and speculation is the facts. Full, fair and timely disclosure arms investors with the facts and helps ensure that price discovery and trading is based on material information rather than rumors, guesses and speculation. As the SEC is rejuvenated, it is essential that the agency return to the basics — timely, full disclosure of material information.