On March 9, 2009, the U.S. Supreme Court granted certiorari in Jones v. Harris Associates,1 a Seventh Circuit case that rejected the “reasonableness” standard, as articulated in Gartenberg v. Merrill Lynch Asset Management, Inc.,2 and set forth a new market and disclosure based standard for evaluating excessive fee claims under § 36(b) of the Investment Company Act of 1940 (“1940 Act”).
The Second Circuit held in Gartenberg that a § 36(b) violation occurs when the adviser “charge[s] a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered” and the fee is outside “the range of what would have been negotiated at arm’s-length in light of all the surrounding circumstances.”3 Judge Easterbrook, writing for a three-judge panel of the Seventh Circuit, opined that the Gartenberg “reasonableness” standard requires a form of judicial rate regulation that is neither mandated by the statute nor an effective means for protecting investors. Instead, the Harris decision instructed that, when evaluating a § 36(b) claim, a court should ask “whether the client made a voluntary choice ex ante with the benefit of adequate information.”4 The Court held that, while there should be proper disclosure, the level of fees should be regulated by the market and not the courts.5 Please see Sutherland’s legal alert on the Harris decision for more detail.
The Harris panel denied requests for rehearing and rehearing en banc.6 Judge Posner, who did not serve on the Harris panel, published a dissent to the denial of rehearing en banc. The dissent cited the overwhelming authority supporting the Gartenberg approach for calculating excessive fee claims and questioned the prudence of contradicting that authority without review by the full Seventh Circuit.7 Judge Posner further opined that “[c]ompetition in product and capital markets can’t be counted on to solve the problem [of excessive fees] because the same structure of incentives operates on all large corporations and similar entities, including mutual funds. Mutual funds are a component of the financial services industry, where abuses have been rampant.”8
The Supreme Court will hear the case in its October 2009 term and likely resolve the split in the circuits on the appropriate standard for reviewing excessive fee claims. Gartenberg focuses a court’s inquiry on the reasonableness of the fee charged and whether the fund’s board of directors conducted a proper inquiry into the reasonableness of the fee; whereas, Harris focuses on the sufficiency of an adviser’s disclosure. However, even under the Harris standard, it is within a court’s discretion to determine that the fee charged is unreasonably high.9
Despite the differences in the Gartenberg and Harris approaches, the effect of the Supreme Court adopting one over the other may not be significant in practice. The Harris standard poses a greater hurdle for plaintiffs than does Gartenberg since Harris requires plaintiffs to prove that the adviser’s disclosure was deceptive, inadequate or “otherwise hindered their ability to negotiate a favorable price for advisory services.”10 But, even under the more easily satisfied Gartenberg standard, no plaintiff has succeeded on a § 36(b) claim against a fund advisor.11 Furthermore, fund boards are likely to continue using the factors for review articulated in Gartenberg as part of their advisory contract renewal process regardless of the Supreme Court’s decision. This is because the Securities and Exchange Commission requires fund boards to disclose information in shareholder reports that essentially follows these Gartenberg factors.12 Fund boards also often rely on the Gartenberg factors to meet their state law obligations to exercise a duty of care.13