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.