Gallus v. Ameriprise Financial: Deepening the Circuit Split on the Standard of Review on Fund Advisor Fees

The Eighth Circuit’s enhanced interpretation of Gartenberg cuts the divide among circuit courts even deeper on the issue of a court’s proper analysis of mutual fund advisory fees under Section 36(b). In John E. Gallus v. Ameriprise Financial, 561 F.3d 816 (8th Cir. 2009), the Court upheld the Gartenberg analysis, but added that a court can consider any discrepancy between the rates advisors charge institutional investors and the rates they charge ordinary retail investors to determine whether the advisor’s fees are excessive in violation of the Investment Company Act of 1940. The opinion clearly contradicts the holding of Jones v. Harris Associates, currently pending review before the U.S. Supreme Court, which held that, generally, the market, not the courts, should determine the reasonableness of rates. The Gallus opinion sounds similar to Judge Posner’s dissent from the Seventh Circuit’s denial of rehearing in Jones, leading some pundits to wonder whether it foreshadows the Supreme Court’s future decision on the issue.

BACKGROUND

Shareholders of eleven mutual funds that are advised and distributed by affiliates of Ameriprise, asserted a claim of Section 36(b) violations, claiming that they should not be charged higher fees than the firm’s institutional clients. The shareholders presented evidence indicating that the fees charged by the advisor to retail mutual fund investors were nearly double those charged to institutional investors. Advisers have claimed that such fee discrepancies are justified by the higher costs of advising retail investors. The shareholders also alleged that the advisor had misled the funds’ board about the fee discrepancy between the different types of clients in the fee-setting process.

Evidence indicated that the retail and institutional funds at issue “had identical investment objectives” and “very similar stock holdings,” and that the advisor admitted in internal emails that it did not have good reasons to justify the disparity.

The District Court applied the factors set forth in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2nd Cir. 1982) (discussed in more detail below) and granted summary judgment in favor of Ameriprise on the question of whether it had violated its Section 36(b) fiduciary duty by charging excessive fees.

On appeal, the Eighth Circuit found that, although the District Court had properly considered the Gartenberg factors, the District Court erred in failing to consider a comparison between the fees charged to retail versus institutional investors and in failing to determine whether Ameriprise misled the board. John E. Gallus v. Ameriprise Financial, 561 F.3d 816 (8th Cir. 2009).

Section 36(b) duties and the precedent before Gallus

Section 36(b) of the Investment Company Act of 1940 (the “Act”) governs the compensation made to investment advisors of registered investment companies and imposes a fiduciary duty on those advisors in connection with their receipt of fees from the funds they manage. 15 U.S.C. section 80a35(b). Section 36(b) in particular provides that “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services” and enables shareholders or the SEC to bring claims for excessive fees.

In 1982, the Second Circuit rendered a watershed case on the issue of whether fees paid to a money market fund manager were “so disproportionately large as to constitute a breach of fiduciary duty in violation of section 36(b).” Gartenberg, 694 F.2d at 925. The Gartenberg court determined that the Court should scrutinize fees to determine “whether the fee schedule represents a charge within the range of what would have been negotiated at arm’s-length in the light of all the surrounding circumstances.” Id. at 928. Gartenberg set forth factors for the court to consider in evaluating whether the fees are so excessive as to constitute a “breach of fiduciary duty” include, among others: (1) the cost to the adviser-manager of providing the service; (2) the nature and quality of the service; (3) “the extent to which the adviser-manager realizes economies of scale as the fund grows larger;” and (4) the volume of orders being processed by the adviser-manager. Id. at 930. The Gartenberg court specifically rejected the notion of comparing fees paid to other advisors and relying on the inherent competition in the marketplace to set appropriate fees, because the advisor marketplace had insufficient competition. Id. at 929.

In 2008, the Seventh Circuit flatly rejected the Gartenberg approach “because it relies too little on markets.” Jones v. Harris Associates, 527 F.3d 627, 632 (7th Cir. 2008). While the Seventh Circuit did affirm the ruling below, which had followed Gartenberg and held that the Harris had not violated the Act, the Circuit Court held that the analysis of reasonableness of the fees should not turn on Gartenberg factors. Rather, the Jones court determined that market competition, rather than “a ‘just price’ system administered by the judiciary.” 527 F.3d at 634. The Court stated that a “fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth.” Id. at 632. The court noted that if a fee is excessive, investors will respond by moving their money elsewhere. Id. at 634.

The Jones plaintiffs petitioned the Seventh Circuit for a rehearing en banc, which was denied. However, Judge Richard Posner and four other judges filed a dissent from the denial of the rehearing en banc, criticizing the original panel for rejecting the well-settled law of Gartenberg and noting that no other court had followed the Jones opinion’s lead. Jones v. Harris Assoc., 537 F.3d 728, 729 (7th Cir. 2008).

On March 9, 2009, the U.S. Supreme Court granted certiorari to hear Jones – the issue before the Court is the proper standard to apply when reviewing the compensation of an investment advisor under a Section 36(b) challenge. The case will likely be heard in October 2009. Notably, the Eighth Circuit chose not to stay its decision in Gallus pending the Supreme Court’s decision in Jones.

Gallus: Rejecting Jones and adding to Gartenberg

In the Gallus opinion, the Eighth Circuit acknowledge the split between the Gartenberg and Jones approaches, determining that “the Gartenberg factors provide a useful framework for resolving claims of excessive fees, notwithstanding the substantial changes in the mutual fund industry that have occurred in the intervening years.” 561 F.3d at 822.  The court said that Jones ”highlights a flaw in the way many courts have applied Gartenberg” even though Jones was correct in emphasizing the duty advisors have under Section 36(b) “to be honest and transparent throughout the negotiation process.” Id. at 823.

But the Eighth Circuit took Gartenberg one step further, finding that Gartenberg “demonstrates one way in which a fund advisor can breach its fiduciary duty, but it isnot the only way.” Id. at 823. The Court determined that “the proper approach to [Section] 36(b) is one that looks to both the adviser’s conduct during negotiation and the end result.” Id. As a result, even though the district court properly applied the Gartenberg factors, it erred by determining that those factors alone indicated that Ameriprise’s fee “passed muster.” Id.

Specifically, the Circuit Court held that the District Court erred in failing to consider the comparison of fees charged to the different type of clients, and in failing to determine whether Ameriprise had misled the board during the fee-setting process. Accordingly, the Circuit Court remanded the case for consideration of the disparate fees charged to independent mutual fund and institutional clients. Notably, other courts faced with this issue have determined that this type of fee comparison should not be the basis for contradicting a fee that may otherwise be deemed reasonable under Gartenberg. (See, e.g. Strougo v. BEA Assocs., 188 F. Supp. 2d 373, 384 (S.D.N.Y. 2002)).

The Gallus court also addressed the question of whether Section 36(b)’s statutory damages period ends with the filing of a lawsuit – the decision reached by prior courts—or whether damages may continue through litigation. The Eighth Circuit relied on a “straightforward reading of the damages limitation” to decide that the plaintiffs may recover damages incurred after the filing date, such that plaintiffs may obtain all redress “in a single action.” 561 F.3d at 825

CONCLUSION

A majority of states follow the Gartenberg analysis to scrutinize mutual fund advisory fees under Section 36(b). The Eighth Circuit is the first Court to consider the adviser’s conduct during negotiation as well as the end result of those negotiations, including a comparison of the fees the advisor charges to retail versus institutional clients. Jones remains the minority view; in its review of Jones, the Supreme Court has the opportunity to set forth and clarify a unified standard for analysis under Section 36(b). Some pundits wonder whether Gallus and Judge Posner’s Jones dissent were written at least in part with an eye toward influencing the Supreme Court in its Jones review – or whether the Gallus court has predicted that its opinion will be in line with the Supreme Court’s decision.

In the meantime, because the fees charged to institutional investors are frequently lower than those charged to mutual fund investors, Gallus may open up new doors for shareholders to challenge fees under Section 36(b). In any event, recent decisions like Gallus indicate an increasing level of judicial skepticism of advisory fees and the competitiveness of that marketplace.

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Josh Lawler

Joel B. Ginsberg

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