On April 8, 2009, in Gallus v. Ameriprise Financial, Inc., the U.S. Court of Appeals for the Eighth Circuit weighed in on the ongoing debate regarding the evaluation of advisory fees and the corresponding fiduciary duty set forth in Section 36(b) of the 1940 Act and, in doing so, added yet another wrinkle to a debate which has worked its way up to the U.S. Supreme Court.
Much like Jones v. Harris Associates, for which the Supreme Court granted certiorari in March 2009, the dispute in Gallus arose out of the plaintiffs’ allegation that the advisory fees paid to the investment adviser by a group of mutual funds managed and distributed by Ameriprise Financial Inc. and its affiliates were excessive and constituted a breach of Ameriprise’s fiduciary duty as set forth in Section 36(b) of the 1940 Act. However, in contrast to Jones, the plaintiffs in Gallus also alleged that Ameriprise breached its fiduciary duty by misleading the Board, thereby tainting the advisory fee review process. Based on a traditional analysis under Gartenberg v. Merrill Lynch Asset Mgmt., Inc., the district court found that the advisory fees paid to Ameriprise did not run afoul of Section 36(b) of the 1940 Act, and thus granted summary judgment in favor of Ameriprise. The Eighth Circuit reversed the lower court’s grant of summary judgment and remanded the case to the district court for further proceedings. In doing so, the Eighth Circuit articulated a new standard for the review of excessive fee cases arising under Section 36(b) of the 1940 Act. The Eighth Circuit adopted portions of and diverged from both the Second Circuit’s standard as set forth in Gartenberg and the Seventh Circuit’s standard articulated in Jones.
In partially adopting the Gartenberg standard, the Eighth Circuit concluded that “the Gartenberg factors provide a useful framework for resolving claims of excessive fees….” However, the Eighth Circuit went on to state that the Jones case highlights a flaw in the way many courts have applied Gartenberg, and noted that the size of the advisory fee is one factor to consider in evaluating claims arising under Section 36(b) of the 1940 Act. According to the Eighth Circuit, “the Gartenberg case demonstrates one way in which a fund adviser can breach its fiduciary duty; but it is not the only way…. [T]he [Gartenberg standard] should not be construed to create a safe harbor of exorbitance, for under such a view an adviser’s fiduciary duty would be diluted to a simple and easily satisfiable requirement not to charge a fee that is egregiously out of line with industry norms.”
The Eighth Circuit also took issue with the Jones approach in that it does not allow for the comparison between the fees an investment adviser charges its captive funds and the fees it charges its institutional clients, but adopted the Jones approach to the extent it imposes upon investment advisers a “duty to be honest and transparent throughout the negotiation process” in relation to the approval of advisory fees.
According to the Eighth Circuit, with respect to claims arising under Section 36(b) of the 1940 Act, a court’s review should include the evaluation of an investment adviser’s conduct throughout the negotiation process relating to the approval of advisory fees and the end result of such negotiation. “Unscrupulous behavior with respect to either can constitute a breach of fiduciary duty.” Furthermore, the Eighth Circuit noted there was a particularly strong argument in the Gallus case for comparing the fees Ameriprise charged its mutual fund clients to those it charged its institutional clients because the investment advice may have been essentially the same for both clients.
In shaping its new, hybrid, Section 36(b) standard of review, the Eighth Circuit reaffirmed the notion that “Section 36(b) does not allow a court ‘to substitute its business judgment for that of a mutual fund’s board of directors in the areas of management fees’ [and, furthermore, that] candid, transparent negotiation does not require discussion of every issue that a plaintiff might find relevant; and it does not require the adoption of a particular negotiation strategy.” Despite the plaintiffs’ contention, the Eighth Circuit was also careful to observe that a fee negotiation’s focus on advisory fees charged throughout the industry is not a per se breach of fiduciary duty. “[W]hile tethering fees to an industry median will not provide sure-fire protection from Section 36(b) liability, [neither is it] necessarily suspect.” In fact, “it is common business strategy to attempt to meet or surpass the value offered by one’s primary competitors … and there is no reason to assume it indicates bad faith.”
Prospectively, it is hard to assess the impact of the Gallus decision, as any standard articulated by the Supreme Court would trump the diverging standards of review under Section 36(b). That said, the Gallus standard, to the extent it is applied, may render it more difficult for a defendant to secure dismissal on the pleadings in cases arising under Section 36(b), as plaintiffs will seek to discover more extensive materials concerning the fee review process and will seek to exploit any apparent contradiction or variation therein. It also bears mentioning that, assuming certiorari is sought in Gallus, it is quite possible the Supreme Court will hear the case because of its substantial overlap with Jones.
