Thursday, November 5, 2009
The U.S. Supreme Court heard oral argument Monday in Jones v. Harris Associates, a case that could impact the amount of managerial fees that millions of mutual fund investors pay fund advisers. The Court must decide what standard governs whether advisors' fees are excessive under the Investment Company Act (ICA) of 1940. Congress amended the ICA in 1970 to create a fiduciary duty for investment advisers “with respect to the receipt of compensation for services.” 15 U.S.C. § 80a-36(b). The 1970 amendment also granted a private right of action to fund holders to sue for breaches of this fiduciary duty.
In Jones, three Oakmark Funds shareholders brought suit against the fund’s adviser for charging double the amount of managerial fees that it charged institutional investors for purportedly similar services. The district court granted the advisor’s motion for summary judgment, holding that the Second Circuit’s 1982 decision in Gartenberg v. Merrill Lynch Asset Management, 694 F.2d 923, recognized a breach of duty under the ICA only where an adviser charges fees that are “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.” While affirming the result, a Seventh Circuit panel led by Chief Judge Easterbook criticized Gartenberg, finding that the decision ignored economic realities. As long as funds fully disclose managerial fees, market forces should keep mutual fund costs down in the face of industry competition. 527 F.3d 627. The Seventh Circuit denied rehearing en banc by a 5-5 vote, accompanied by a forceful dissent from Judge Posner assailing the panel decision. 537 F.3d 728.
The Seventh Circuit decision may not survive review. The Court signaled little enthusiasm for Judge Easterbrook’s analysis at oral argument on Monday, and even the litigants abandoned the panel’s position to revisit different aspects of the Gartenberg test. Chief Justice Roberts and Justice Scalia, however, touched on free market principles in questions to petitioner’s counsel. Chief Justice Roberts noted that technological developments now allow investors easy access to information about management fees at the click of a button. If investors find the fees excessive, they could move money to another fund in “thirty seconds.” Justice Scalia added that any fund experiencing investor exodus would clearly see the problem and recalibrate its adviser's compensation.
Most of the questioning revolved around different articulations of the Gartenberg test. Justice Kennedy inquired whether the ICA’s fiduciary duty language comported with other fiduciary duties, such as those applied to corporate officers and boards of directors. Petitioner’s counsel argued that Congress used fiduciary in a special sense to ensure the fairness of fees. Counsel offered a two-pronged fairness test a la Gartenberg. First, was there full disclosure and good faith negotiating between the mutual fund board (many of whose directors may have been appointed by the advisors) and the investment advisers? Second, was the fee fair when compared to the same or similar services charged to an outsider in an arms-length transaction (in this case, an institutional investor)?
Justice Breyer noted that the plain text of the Gartenberg test could be read different ways simply based on one’s tone of voice. The Court spent a good portion of argument grappling over the proper metric to measure excessive fees. Breyer posed that a workable standard may lie in petitioner’s argument that courts should evaluate what an adviser charges a mutual fund against its institutional clients.
It is difficult to predict what direction the Court will take. Without a clear majority in support of the Seventh Circuit market analysis decision, the Court may reverse the appellate panel and embellish the Gartenberg test to provide additional guidance to lower courts on how best to determine excessive managerial fees. (It should be noted that there is no reported case where fund holders have prevailed under the Gartenberg standard.)
(Aaron Bernay, Corporate Law Fellow and University of Cincinnati Law '10, prepared the above summary analysis of the Nov. 2 oral argument in Jones v. Harris Associates.)