March 30, 2010
On March 30, 2010, the Supreme Court issued its decision in Jones v. Harris Associates L.P., No. 08-586. The Court construed Section 36(b) of the Investment Company Act of 1940, which states that investment advisers to mutual funds are deemed to have a fiduciary duty with respect to the receipt of compensation for services and provides a private cause of action for breach of that duty.
The Supreme Court in Jones held that “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.” Slip op. 9.
Background. Mutual funds and their investment advisers are subject to a variety of federal and state securities and corporate laws, including the Investment Company Act of 1940. Investment advisers provide portfolio management and other services to mutual funds, for disclosed fees, pursuant to contracts that must be approved by the board of directors of the mutual funds.
Section 36(b) of the Investment Company Act, added in 1970, provides a private right of action against investment advisers that breach their “fiduciary duty” with respect to the receipt of “compensation.” 15 U.S.C. § 80a-35(b). Such an action may be brought by a shareholder in a mutual fund managed by the adviser, and the plaintiff has the burden of proving a fiduciary breach. The statute directs the court to give appropriate weight to the fund directors’ decision-making.
Section 36(b) suits often claim that the adviser’s fee is “excessive” in comparison to some internal or external benchmark. For many years, such claims were resolved under the framework articulated by the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982), which held that to violate Section 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. at 928. Gartenberg went on to provide a non-exclusive list of “factors” that courts should consider in making this determination. Id. at 930-31. The SEC also has required fund directors to consider similar factors during the contract-approval process. See Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, 69 Fed. Reg. 39,798, 39,801 & n.31 (June 30, 2004).
In Jones, the district court applied Gartenberg and entered summary judgment against the plaintiffs. On appeal, a Seventh Circuit panel affirmed on somewhat different grounds. In an opinion by Chief Judge Easterbrook, the panel expressed disagreement with the Gartenberg framework and suggested instead that Section 36(b) requires candor in negotiation and honesty in performance, but imposes no substantive “cap” on an adviser’s compensation. Instead, the panel stated that the amount of the fee should, subject to the requirements of full disclosure, be set by market forces. The full court denied rehearing, but Judge Posner wrote a dissenting opinion criticizing the panel for rejecting Gartenberg and relying too much on competition to check advisory fees.
The Jones plaintiffs successfully petitioned for Supreme Court review. In their merits brief, the plaintiffs argued that a variant of the Gartenberg standard should govern Section 36(b) claims. They further argued that, under their proposed standard, the disparity between the advisory fees charged to mutual funds and to (allegedly) similar separately managed accounts was sufficient to raise a triable issue about the adviser’s discharge of its fiduciary duty with respect to compensation. The plaintiffs were supported by a number of amici curiae, including the United States.
The investment adviser in Jones also advocated a variant of the Gartenberg standard. It argued that, under that standard, its conduct satisfied Section 36(b)–as the district court had found. The adviser was supported by a number of amici curiae, including the Investment Company Institute and the Independent Directors Council.
Supreme Court Opinion. In a unanimous decision, the Supreme Court vacated the Seventh Circuit’s decision and remanded for further proceedings. The Court’s opinion was authored by Justice Alito; Justice Thomas wrote a separate concurring opinion.
The Court began by noting that the 1970 amendments to the Investment Company Act had “bolstered shareholder protection in two primary ways.” Slip op. 2. First, the amendments strengthened the independence of fund directors, who scrutinize adviser compensation. Second, the amendments imposed a fiduciary duty on the adviser with respect to its compensation, and granted a private right of action to enforce that duty. “Board scrutiny of adviser compensation and shareholder suits under § 36(b),” the Court explained, “are mutually reinforcing but independent mechanisms for controlling conflicts.” Id. at 12.
Although “the standard for an investment adviser’s fiduciary duty has remained an open question in [the Supreme] Court,” the lower federal courts had developed “something of a consensus” regarding the Gartenberg standard. Slip op. 7. The Court adopted that consensus view:
The meaning of § 36(b)’s reference to “a fiduciary duty with respect to the receipt of compensation for services” is hardly pellucid, but based on the terms of that provision and the role that a shareholder action for breach of that duty plays in the overall structure of the Act, we conclude that Gartenberg was correct in its basic formulation of what § 36(b) requires: 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.
Id. at 9 (footnote omitted; emphasis added). In making this determination, “all relevant circumstances [must] be taken into account”–including, presumably, the non-exclusive “factors” identified in Gartenberg itself. Id. at 11.
The Court held that Congress’s use of the term “fiduciary duty” invoked the law of trusts, and particularly a historical standard under which “[t]he essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain.” Slip op. 10-11 (quoting Pepper v. Litton, 308 U.S. 295, 306-07 (1939)). The Court adopted this formulation for Section 36(b) purposes, while noting that the statute “modifies this duty in a significant way: it shifts the burden of proof from the fiduciary to the party claiming breach, to show that the fee is outside the range that arm’s-length bargaining would produce.” Id. at 11 (internal citation omitted). Accordingly, “the range of fees that might result from arm’s length bargaining” constitutes “the benchmark for reviewing challenged fees.” Id.
The Court recognized that a fully informed fund board is the “cornerstone” of congressional efforts to control conflicts of interest, and that independent directors serve as “watchdogs” for the shareholders. Slip op. 11. A court hearing a Section 36(b) case must give the board’s approval of adviser compensation “such consideration … as is deemed appropriate under all the circumstances.” 15 U.S.C. § 80a-35(b)(2). “From this formulation,” the Jones Court explained, “two inferences may be drawn. First, a measure of deference to a board’s judgment may be appropriate in some instances. Second, the appropriate measure of deference varies depending on the circumstances.” Slip op. 12.
After articulating these overarching standards, the Court turned to “several important questions” that were presented in this particular case.
First, the Court held that comparisons between mutual fund fees and advisory fees charged to other clients might be appropriate. “Since the Act requires consideration of all relevant factors,” the Court said, “we do not think that there can be any categorical rule regarding the comparisons of the fees charged different types of clients.” Slip op. 13. “Instead, courts may give such comparisons the weight that they merit in light of the similarities and differences that the clients in question require, but courts must be wary of inapt comparisons.” Id. The Court observed that the services provided may be sufficiently different as to render a fee comparison irrelevant. And even where a fee comparison can be made, “the Act does not necessarily ensure fee parity between mutual funds and institutional clients.” Id. at 14. The Court further admonished that this comparison would not require a trial in every Section 36(b) case: “Only where plaintiffs 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 will trial be appropriate.” Id. at 14 n.8.
Second, the Court said that “courts should not rely too heavily on comparisons with fees charged to mutual funds by other advisers.” Slip op. 14. Such fees, the Court reasoned, might not reflect the requisite arm’s-length bargaining.
Third, the Court elaborated on the deference to be afforded director decision-making in particular circumstances. “Where a board’s process for negotiating and reviewing investment-adviser compensation is robust, a reviewing court should afford commensurate deference to the outcome of the bargaining process. Thus, if the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently.” Slip op. 15. (This formulation is similar to the familiar abuse-of-discretion standard of judicial review.) “In contrast,” the Court continued, “where the board’s process was deficient or the adviser withheld important information, the court must take a more rigorous look at the outcome.” Id.
The Court cautioned that “a fee may be excessive even if it was negotiated by a board in possession of all relevant information.” Slip op. 14. In the next breath, however, the Court explained that Section 36(b) “does not call for judicial second-guessing of informed board decisions”; a court may 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. at 16. The Court did not elaborate, however, on what form such “additional evidence” might take.
Justice Thomas wrote a brief concurrence emphasizing that the Court’s standard “defers to the informed conclusions of disinterested boards and holds plaintiffs to their heavy burden of proof.” Slip op. 1 (Thomas, J., concurring).
Conclusion. In Jones, the Supreme Court stressed that “a court’s evaluation of an investment adviser’s fiduciary duty must take into account both procedure and substance.” Slip op. 15. The judicial role is not, the Court stressed, to independently evaluate the “reasonableness” of the advisory fee. Id. Rather, Jones teaches that:
The Supreme Court’s clarification of the standards for Section 36(b) litigation should benefit all participants in the mutual fund industry–including investment advisers, fund directors, and investors–as well as lawyers and judges faced with resolving fee disputes under the Investment Company Act. Whether it will encourage or discourage additional fee litigation remains to be seen.
This Alert was prepared by Mark A. Perry, who co-authored the amicus brief for the Independent Directors Council in Jones. Any questions about Jones or other litigation involving investment advisers may be directed to Mr. Perry (202-887-3667; firstname.lastname@example.org) or his partners Mark Kirsch (212-351-2662; email@example.com) and Gareth T. Evans (213-229-7734; firstname.lastname@example.org).
© 2010 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.