In an opinion issued today in Jones v. Harris Associates L.P., 559 U.S. ___ (2010) (Alito, J.), the Supreme Court resolved a circuit split by unanimously affirming the standard set nearly three decades ago in Gartenberg v. Merrill Lynch Asset Management, Inc.,1 for courts to assess claims by mutual fund shareholders under § 36(b) of the Investment Company Act of 1940.
Plaintiffs filed suit on behalf of three mutual funds against their investment adviser, Harris Associates L.P. ("Harris"), for allegedly violating § 36(b) by charging excessive advisory fees. The district court granted summary judgment for Harris. Applying the Gartenberg standard, the court held that the challenged fees were not "so disproportionately large that they could not have been the result of arm's-length bargaining."2 Plaintiffs appealed.
Writing for the Seventh Circuit, Judge Easterbrook affirmed the lower court ruling, but only after disapproving the Gartenberg standard because it relied too little on the ability of market forces to police fees.3 The court created a new disclosure-based standard that turned on whether the adviser provided the mutual fund's board with sufficient and accurate information during the board's annual fee review. Under this standard, an adviser breached its fiduciary duty under § 36(b) only when its disclosures were inadequate or the fees were so unusually high "that deceit must have occurred, or that the persons responsible for decision have abdicated."4
The Supreme Court vacated the Seventh Circuit's ruling and held that district courts should apply the Gartenberg standard, which permits § 36(b) liability only when an adviser's 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."5 Stating that § 36(b) "does not call for judicial second-guessing of informed board decisions,"6 Justice Alito's opinion clarified the following three issues relevant to the Gartenberg analysis:
- Fees Charged to Other Clients: Courts may compare the fees that an adviser charges the mutual fund with what it charges its independent clients. The weight given to this comparison depends on the similarities and differences between the services required by the clients in question, and courts should be wary of inapt comparisons. If such a comparison is relevant, the fact that an adviser charges its mutual fund client a higher fee for similar services will not defeat a summary judgment motion unless the plaintiff can show that the fee is "outside the arm's-length range" and its disparity cannot be explained by the different services or other evidence.7
- Fees Charged to Comparable Mutual Funds by Other Advisers: Courts are cautioned not to rely overly on comparisons to fees other investment advisors charge peer funds.8
- The Board's Fee-Review Process Determines the Level of Deference: Where the directors are given adequate information and they consider all relevant factors before approving an adviser's fees, that decision is entitled to "considerable weight," even if a court might weigh the factors differently. But if the board's process is deficient or the advisor failed to disclose material information, a court must "take a more rigorous look" at the board's decision to approve the fees at issue.9
In sum, Jones confirmed that where the independent directors of a mutual fund act with appropriate information and consider the relevant factors governing advisory fees, that judgment is entitled to significant deference from the court. The Supreme Court reaffirmed prior decisions implementing Gartenberg over the past 25 years that have concluded that, absent a showing of a deficient process or a result so far from the norm that it could not have been the result of arms-length bargaining, a court should not reweigh the fees approved by a fund's board.10
O'Melveny & Myers LLP has an active mutual fund practice that includes defending mutual fund advisers against § 36(b) lawsuits.
Footnotes
1. 694 F.2d 923 (2d Cir. 1982).
2. Jones v. Harris Assocs. L.P., No. 04 C 8305, 2007 WL 627640, at *7–*9 (N.D. Ill. Feb. 27, 2007).
3. 527 F.3d 627, 632 (7th Cir. 2008). The Seventh Circuit reasoned that given the thousands of mutual funds competing in today's market, competitive pressure will generally keep fees low because sophisticated investors will "mov[e] their money elsewhere" when fees are "excessive in relation to the results[.]" Id. at 633–34.
4. Id. at 632.
5. 559 U.S. ___ (slip op. at 9).
6. Id. at 16.
7. Id. at 13–14, 14 n.8.
8. Id. at 14–15.
9. Id. at 15–16.
10. See In re American Mutual Funds, No. CV 04-5593 GAF (RNBx), 2009 WL 5215755, at *2 n.1 (C.D. Cal. Dec. 28, 2009) (granting defense verdict following a bench trial).
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