A recent opinion by the U.S. Court of Appeals for the Eighth Circuit reinforces the importance of good process surrounding board decision making, as well as a good faith effort by the investment adviser to provide accurate and complete information to the board during the contract review process. In Gallus v. Ameriprise Financial, Inc., the Eighth Circuit unanimously ruled that the proper approach to Section 36(b) of the Investment Company Act of 1940 (1940 Act) is one that looks at both the adviser’s conduct during negotiation and the end result. According to the court, unscrupulous behavior with respect to either may result in a breach of Section 36(b).
Section 36(b) of the 1940 Act provides that an investment company’s investment adviser and sub-adviser have a fiduciary duty with respect to the receipt of compensation for services. Section 36(b) also provides an express cause of action for recovery of excessive compensation. Most boards of directors rely on the factors and analysis used in a widely known case from the U.S. Court of Appeals for the Second Circuit, Gartenberg v. Merrill Lynch Asset Management, Inc. In that case, the plaintiffs claimed that the adviser-manager, which provided both advisory and administrative services to the fund, made “too much” money and thereby breached the fiduciary duty imposed upon investment advisers by Section 36(b) of the 1940 Act. The district court held that the plaintiffs failed to prove a breach of fiduciary duty. In affirming the district court’s decision, the Second Circuit stated that to be guilty of a violation of Section 36(b), the adviser-manager would have to charge a fee “that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.” The court in Gartenberg also noted that a determination of whether a breach of fiduciary duty has occurred can be made only after reviewing all of the facts.
The Gallus court stated that “the Gartenberg factors provide a useful framework for resolving claims of excessive fees,” but that courts subsequent to Gartenberg have applied the Gartenberg standard incorrectly to excessive fee cases because they may have overlooked the investment adviser’s conduct during fee negotiations. In other words, the Gallus court said that the Gartenberg court looked only at whether the fee itself was so high that it violated Section 36(b). The Gallus court said that a high fee in and of itself is only one way that an investment adviser can violate Section 36(b). According to the court, an investment adviser may also violate Section 36(b) if it engages in any misconduct or lack of candor during fee discussions with a mutual fund’s board.
The Gallus court further held that the lower court erred in rejecting as irrelevant a comparison of fees charged to Ameriprise’s institutional clients and to its mutual fund clients, noting that the lower court had relied on dicta from the Gartenberg case in a section where the Second Circuit disregarded a comparison of advisory fees charged by the investment adviser to different investment vehicles. In Gallus, the court held that the comparison among Ameriprise’s different investment vehicles was relevant, because of the greater similarity between the investment vehicles being compared. The court added that, unlike the Gartenberg case, where the comparison of fees involved a money market fund and an equity institutional account, “the argument for comparing mutual fund advisory fees charged to institutional accounts is particularly strong in this case because the investment advice may have been essentially the same for both accounts.” The appeals court in Gallus concluded that the lower court’s review was too narrow because it did not evaluate the adviser’s conduct during the fee negotiations and, specifically, whether the adviser “omitted, disguised or obfuscated” information about the fee comparisons.
The Gallus court acknowledged that investment advisers commonly use fee comparisons with external primary competitors that establish that their investment advisory fees are within the industry median to demonstrate reasonableness of those fees for purposes of Section 36(b). The court added that such a strategy is a “common business” practice and does not necessarily indicate bad faith. However, the court stated that such a strategy alone will not shield an investment adviser from a breach of fiduciary duty claim under Section 36(b) if the adviser has engaged in dishonesty or a lack of candor with regard to other relevant aspects of the fee negotiation.