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Circuit Court Turns Down Appeal against Harris Associates, Refusing to Put a Cap on Mutual Fund Advisory Fees
Jerry N. Jones, et al. v. Harris Associates, L.P.
No. 07-1624, U.S. Court of Appeals for the Seventh Circuit, 05/19/2008
Companies Mentioned: Harris Associates, L.P.
Holding
The U.S. District Court for the Seventh Circuit affirmed a district court’s ruling that mutual fund adviser fees should not be determined by the judiciary. In refusing to put a limit on adviser’s fees, the Seventh Circuit declared that Section 36(b) of the Investment Company Act does not say that fees must be “reasonable” in relation to a judicially created standard. Federal securities laws, such as the Investment Company Act, work largely by requiring disclosure and then allowing price to be set by competition in which investors make their own choices. In this case, the fees were not hidden from investors—and the mutual fund's net return has attracted new investments rather than drive investors away. Section 36(b) does not make the federal judiciary a rate regulator, similar to that performed by the Federal Energy Regulatory Commission. Regulating advisory fees through litigation is unlikely to do more good than harm.
Detailed Summary
Defendant Harris Associates, L.P. advised the Oakmark complex of mutual funds. These open-end funds (an open-end fund is one that buys back its shares at current asset value) have grown in recent years as a result of their net returns exceeding the market average, and the compensation for investment adviser’s has grown apace. Plaintiffs Jerry N. Jones, Mary P. Jones, and Arline Winderman, who owned shares in several of the Oakmark funds, argued that the adviser’s fees were too high and thus violated §36(b) of the Investment Company Act of 1940.
The U.S. District Court for the Northern District of Illinois, Eastern Division, found that defendant’s fees did not violate the Act, and granted summary judgment in favor of defendant. Hence, they filed this appeal where they argued that the adviser’s fees were excessive based on §36(b), which provides: “For the purposes of this subsection, 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, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser. An action may be brought under this subsection by the Commission, or by a security holder of such registered investment company on behalf of such company, against such investment adviser . . . “
In ruling in favor of defendant, the district court followed Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982), concluding that Defendant’s fees were “ordinary.” Opinion, p. 5.
Gartenberg articulated two variations on a theme: “(T)he test is essentially 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 of the surrounding circumstances. Opinion, p. 5, quoting Gartenberg at 928. And “(t)o be guilty of a violation of §36(b) . . . the adviser-manager 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.” Id.
Plaintiffs argued that Gartenberg should not be followed for two reasons: “first, that the second circuit in that case relies too much on market prices as the benchmark of reasonable fees, which plaintiffs insist is inappropriate because fees are set incestuously rather than by competition; second, that if any market should be used as the benchmark, it is the market for advisory services to unaffiliated institutional clients. The first argument stems from the fact that investment advisers create mutual funds, which they dominate notwithstanding the statutory requirement that 40% of trustees be disinterested. Few mutual funds ever change advisers, and plaintiffs conclude from this that the market for advisers is not competitive. The second argument relied on the fact that Harris Associates, like many other investment advisers, has institutional clients (such as pension funds) that pay less. For a client with investment goals similar to Oakmark Fund, Harris Associates charges 0.75% of the first $15 million under management and 0.35% of the amount over $500 million, with intermediate break.” Opinion, p. 6.
In response to these arguments, the Seventh Circuit rejected the principle laid down in Gartenberg, but for a different reason. It wrote that it was skeptical about Gartenberg because “it relie(d) too little on markets.” Opinion, p. 7. Further, a fiduciary duty differs from rate regulation. A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trustees, rather than a judge or jury, determine how much advisory services are worth. Opinion, p. 8.
In refusing to put a limit on adviser’s fees, the Seventh Circuit declared that Section 36(b) does not say that fees must be “reasonable” in relation to a judicially created standard. This statute merely states that an adviser has a fiduciary duty. And the rule in trust law provides that a trustee owes an obligation of candor in negotiation, and honesty in performance, but may negotiate in his own interest and accept what the settlor or governance institution agrees to pay. Opinion, p. 8, citing Restatement (Second) of Trusts §242 & comment f. When the trust instrument is silent about compensation, the trustee may petition a court for an award, and then the court will ask what is “reasonable”; but when the settlor or the persons charged with the trust’s administration make a decision, it is conclusive. Id. pp. 8-9, citing John H. Langbein, The Contractarian Basis of the Law of Trusts, 105 Yale L. J. 625 (1995).
The Federal Circuit even cited a study that concluded that thousands of mutual funds are plenty, that investors can and do protect their interests by shopping, and that regulating advisory fees through litigation is unlikely to do more good than harm. Opinion, p. 12, citing John C. Coates & R. Glenn Hubbard, Competition in the Mutual Fund Industry: Evidence and Implications for Policy, 33 Iowa J. Corp. L. 151 (2007).
Federal securities laws, such as the Investment Company Act, work largely by requiring disclosure and then allowing price to be set by competition in which investors make their own choices. In this case, the fees were not hidden from investors—and the Oakmark Funds’ net return has attracted new investment rather than drove investors away. §36(b) does not make the federal judiciary a rate regulator, similar to the function performed by the Federal Energy Regulatory Commission. Opinion, pp. 13-14.
On the basis of the foregoing analysis, the Seventh Circuit affirmed the judgment of the district court.
View a PDF of the judicial opinion.Law Commentary
Read the related Law commentary: The Dissent in Jones v. Harris Associates – Defending Gartenberg, Requesting Review, by Joel B. Ginsberg, Esq.
Law Commentary
Read the related Law commentary: Jones v. Harris Associates: The Market (Not the Courts) Should Set Fund Advisor Fees, by Joel B. Ginsberg, Esq.
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