Securities Law | Expert Legal Commentary
May 21, 2010
Jones v. Harris: Gartenberg Is the Proper Standard to Assess Whether Advisor Fees Are Excessive
Jones v. Harris Associates
Josh Lawler of Zuber Lawler & Del Duca and Joel Ginsberg
The Supreme Court of the United States has embraced the Gartenberg standard for analyzing claims of excessive fund advisory fees under section 36(b) of the Investment Company Act of 1940. The Court’s unanimous opinion in Jones v. Harris Associates, ___ U.S. _____, 130 S.Ct. 1418 (2010), ended a dispute among Circuit Courts as to the correct standard and conclusively adopted a standard relied upon by courts and the investment industry for more than 25 years. The Court indicated a need to show high deference to the thoughtful and educated decisions of independent mutual fund boards and cautioned the courts against making “inapt comparisons” in assessing excessive fee claims.
Defendant Harris Associates, L.P. serves as manager of the Oakmark Funds, open-end funds (typically mutual funds) without restrictions as to the amount of shares issued; the fund will buy back shares at current asset value whenever investors wish to sell. Open-end funds have grown in popularity because net returns have exceeded market average, and fund managers’ compensation has grown commensurately.
Plaintiffs Jerry N. Jones, Mary P. Jones, and Arline Winderman – all individual investors in several of the Oakmark funds – argued that Harris Associates breached its fiduciary duty by charging excessive management/ advisory fees in violation of section 36(b) of the Investment Company Act of 1940. That provision states that fund advisors owe a fiduciary duty to the fund with respect to the compensation they receive related to their advisory role, and that an investor in that fund can bring an action for breach of this duty.
The district court granted summary judgment in favor of Harris, following the long-time precedent of Gartenberg v. Merrill Lynch Asset Management Inc., 694 F.2d 923 (2nd Cir. 1982) and concluding that Harris Associates’ fees were “ordinary” under that standard. On appeal, the Seventh Circuit rejected Gartenberg as the applicable standard, stating that the market, not the courts, should decide whether advisor rates are excessive in all but the most extraordinary circumstances. Jerry N. Jones et al v. Harris Associates, L.P., 527 F.3d 627 (7th Cir. 2008).
Three months after the Seventh Circuit published it per curiam Jones opinion, Seventh Circuit judge Richard Posner drafted a dissenting opinion to the court’s denial of a request to re-hear the Jones case en banc. In the dissenting opinion, Posner defended the Gartenberg standard, noting that rampant abuse in the financial services industry precludes the ability for the “market to decide” and obligates the courts to take a more proactive approach. Jones v. Harris Associates L.P., 537 F.3d 728 (7th Cir. 2008).
To review LawUpdates.com’s commentary on the majority opinion, authored by Judge Frank Easterbrook, go to: Jones v. Harris Associates: The Market (Not the Courts) Should Set Fund Advisor Fees
To review LawUpdates.com’s commentary on Judge Posner’s dissent, go to: The Dissent in Jones v. Harris Associates – Defending Gartenberg, Requesting Review (Re: The August 8, 2008 Opinion)
Gartenberg is the proper standard
At issue in Jones is the proper standard to apply when assessing claims that a management/advisory fee is excessive in violation of the fiduciary duty set forth in section 36(b) of the Investment Company Act of 1940 (the “ICA”). That provision states that fund advisors owe a fiduciary duty to the fund with respect to the compensation they receive related to their advisory role.
Since the Second Circuit decided Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F. 2d 923 (2nd Cir. 1982), federal courts have followed that case in assessing claims of excessive advisory fees. Gartenberg held that a violation of section 36(b) may be present where “a 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.” 694 F.2d at 928.
In a unanimous opinion, the U.S. Supreme Court vacated the Seventh Circuit’s majority opinion rejecting Gartenberg and confirmed that Gartenberg is, in fact, the proper standard to apply in determining when an investment advisor has breached the fiduciary duty owed to captive mutual fund shareholders under section 36(b) of the ICA. The Court concluded that although Gartenberg “may lack sharp analytical clarity,” it has “provided a workable standard for nearly three decades.” 130 S.Ct. at 1430.
The Court focused on the statutory role of the independent and informed mutual fund board, the “cornerstone” of the ICA’s regulatory approach to fees. Under the ICA, this board plays a central role in reviewing and approving advisory fees; the Court stated that courts should afford deference to such board decisions. “[T]he standard for fiduciary breach under section 36(b) does not call for judicial second-guessing of informed board decisions.” Id. The Court should not “supplant the judgment of disinterested directors apprised of all relevant information, without additional evidence that the fee exceeds the arm’s-length range.” Id.
The Court also responded to the plaintiff’s effort to compare the rates they were charged with the much lower rates paid by institutional clients. The Seventh Circuit Court had rejected the argument, finding that institutional funds are not appropriate comparisons for the plaintiff’s funds, since institutional funds require a lower time commitment. 527 F.2d at 634.
The Supreme Court did not prohibit the introduction of fee comparisons and rejected making a “categorical rule” that would dictate how to evaluate such comparisons, but it did encourage judicial caution in comparing fees. Id. at 1428. The Court warned that courts “must be wary of inapt comparisons” because there may be “significant differences between the services provided by an investment advisor” to different funds due to a variety of fund-specific factors. Id. at In reliance on comparisons, plaintiffs may only be entitled to trial where they have “shown a large disparity in fees that cannot be explained by the different services in addition to other evidence that the fee is outside the arm’s-length range.” Id. at n.8.
Both sides of the Jones debate have claimed victory. Investment funds have lauded the Supreme Court’s affirmation of Gartenberg as the predictable, established standard. The financial institutions have similarly triumphed over the High Court’s requirement that deference be afforded mutual fund board decisions, and acknowledgement that different funds may require different rates.
On the other hand, investor groups have celebrated the aspect of the decision that allows them to use fee comparisons to prove claims of excessive fees. That shared victory lap may foreshadow more litigation in the future over alleged excessive fees charged by investment advisors.
Ultimately, Gartenberg is likely far better news for investment funds than for the investors who challenge fees. So long as fee decisions are made by independent boards who undertake a rigorous, impartial and thoughtful review of the relevant factors before approving a fee, those fee decisions are likely to be upheld. Indeed, the Court’s emphasis on the need to show deference to “independent,” “disinterested,” “informed,” and transparent board member decisions suggests that decisions lacking those qualities will not warrant such deference. A board that rubber-stamps fee requests or conducts fee reviews in secret is more likely to be challenged.
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