SEC Commissioner Troy Paredes is rapidly filling the shoes of former Commissioner Paul Atkins as the leading intellectual voice on the Commission. As larry Ribstein observed last week, Paredes "has quietly been doing a great job speaking up against a looming tide of financial regulation."
Paredes' recent remarks on investment company regulation are a case in point. Do read the whole thing, but I'll excerpt here the passage on Jones v. Harris, which is a pending SCOTUS case we'be veen following here at PB.com:
The Supreme Court soon will hear oral argument in the case of Jones v. Harris Associates L.P. [8] The Supreme Court is set to decide the appropriate level of scrutiny courts should bring to bear in reviewing investment advisory fees under section 36(b) of the Investment Company Act. Given the significance of this case to many in the audience, I would be remiss if I did not share some observations on it. [9]
As you know, in the 1982 Gartenberg case, [10] the Second Circuit found that for an adviser of a mutual fund to violate the section 36(b) fiduciary duty, the adviser’s fee must be “so disproportionately large that it bears no reasonable relationship to the services rendered and could not be the product of arm’s length bargaining.” [11]
In Jones, the Seventh Circuit took a different approach, placing greater emphasis on the extent to which competition keeps advisory fees in check. In the Jones opinion, Judge Easterbrook streamlined the test for a section 36(b) violation as follows: So long as an adviser “make[s] full disclosure and plays no tricks,” according to the Seventh Circuit, the adviser meets its fiduciary responsibilities. [12]Much could be said about the case. Indeed, the briefs are extensive. I will limit myself to highlighting two core points, leaving the details to others.
First, adequate market discipline can obviate the need for more exacting and burdensome regulation, including demanding judicial scrutiny of advisory fees. One can conceive of the section 36(b) fiduciary duty as compensating for a lack of competition in the mutual fund industry. Put differently, the legal accountability of section 36(b) can be thought of as substituting for a lack of market-based accountability. The industry, however, has changed since section 36(b) was adopted in 1970 and Gartenberg was decided in 1982. To the extent the industry has become more competitive, it may argue for greater judicial deference to the bargain the adviser and the fund strike. In the face of sufficient market forces that constrain advisory fees, the need for courts to monitor as strictly the adviser/board fee negotiations is mitigated.
Second, courts are not well-positioned to second-guess the business decisions that boards and others in business make in good faith. Judges may exercise expert legal judgment, but not expert business judgment. A judge may be equipped to monitor a board’s decision-making process, but should steer clear of the temptation to override substantive outcomes. These sensibilities cut against reading section 36(b) as implementing a sort of substantive limit on fees and instead recommend that courts focus on the process by which the fees were determined.
An especially large advisory fee that appears to be “disproportionate” would seem to evidence that the decision-making process that produced the fee was inexcusably tainted, giving rise to a section 36(b) fiduciary duty breach. However, if on further scrutiny a court determines that careful, conscientious, and disinterested mutual fund directors agreed to the fee, little, if any, room is left for the court to declare that the fee is nonetheless so large that it could not be the result of an arm’s-length bargain. To the contrary, if a faithful, diligent board decided that the fee was appropriate, it would seem to rebut any preliminary determination that the fee ran afoul of section 36(b). The prospect that perhaps a better bargain could have been driven is a slim justification for allowing judges — who have no comparative expertise negotiating or setting advisory fees — to substitute their judgment for the collective judgment of independent directors acting in good faith.
Like you, I look forward to hearing the argument in Jones and reading the Court’s opinion. Whatever the outcome, I hope that the Court speaks with sufficient clarity so that mutual fund boards and advisers understand what is required of them and can organize their affairs accordingly. Such predictability is unlikely to result if a new approach to section 36(b) is adopted that allows courts meaningful discretion to second-guess good faith business decisions.
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[8] 527 F.3d 627 (7th Cir. 2008).
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[9] See also Commissioner Troy A. Paredes, “Remarks Before the Mutual Fund Directors Forum Ninth Annual Policy Conference” (May 4, 2009), available here.
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[10] Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923 (2d Cir. 1982).
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[11] Id. at 928. Gartenberg provided important industry guidance by highlighting a number of specific factors for mutual fund advisers and boards to mind in negotiating the advisory fee. Id. at 930.
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[12] 527 F.3d 627, 632 (7th Cir. 2008).
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