The Supreme Court recently issued an important decision regarding the test for determining whether an investment adviser has violated its “fiduciary duty” to a mutual fund by charging excessive fees under §36(b) of the Investment Company Act of 1940. Jones v. Harris Associates L.P., 559 U.S. --- (Mar. 30, 2010). The Court upheld the test adopted by the Second Circuit 25 years ago in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982). Specifically: “To face liability under § 36(b), an investment adviser must 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.”
In Harris Associates, shareholders in a mutual fund sued the fund’s investment adviser for charging fees that were “disproportionately large,” citing the Gartenberg standard. The shareholders claimed that the fees that they were charged were disproportionately higher than those charged to the investment adviser's institutional client investors for the same fund strategies, management and advisory services. As a result, the shareholders claimed that the fees violated Section 36(b). The District Court applied the Gartenberg standard but found that the fees at issue were not disproportionately larger than the fees charged to other clients and by other investment advisers.
The Seventh Circuit affirmed, but based on different reasoning. The circuit court disapproved the Gartenberg test and adopted a test that was more deferential to the determination of the mutual fund’s board of directors. In short, the Seventh Circuit had held that while an investment adviser must make “full disclosure” to the board and “play no tricks,” it is permitted to “negotiate with the fund in its own interest.” The Seventh Circuit believed that the competitive pressures of the modern mutual fund market would preclude excessive fees. Thus, according to the Seventh Circuit, the end amount of the fees should not be evaluated, only the adviser’s satisfaction of its disclosure obligation.
The Supreme Court rejected the Seventh Circuit’s disclosure-based analysis, noting that the Investment Company Act requires a reviewing court to consider “all relevant factors.” (emphasis added). According to the Supreme Court, a court should thus take into account “both procedure and substance” in its Section 36(b) analysis. Where there was some deficiency in the trustees’ approval process or the investment adviser’s disclosure, a court must take a “rigorous look” at the outcome. On the other hand, where the trustees’ process for reviewing the investment adviser’s compensation was “robust,” the outcome should be accorded “commensurate deference.” Nevertheless, the Supreme Court held that the resulting fee may still be excessive if the plaintiff can produce evidence that the fee “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,” per Gartenberg.
The Court cautioned, however, that Section 36(b) “does not call for judicial second-guessing of informed board decisions,” observing that courts are “not well suited” to make “precise calculations” of proper “arm’s-length” fees. In other words, a court may not supplant a fully-informed determination by the trustees in the absence of evidence that the fee “exceeds the arm’s-length range.”