Jones v. Harris Argued

The Supreme Court heard argument today in Jones v. Harris, a case in which a mutual fund investor challenged allegedly excessive advisory fees.

Regulatory Background

• Congress enacted Investment Company Act of 1940 to mitigate conflicts of interest inherent in relationship between investment advisers and the mutual funds they create
• Section 36(b) imposes on investment advisers a fiduciary duty with respect to the receipt of compensation for services
• Authorizes fund shareholders to bring claims for breach of fiduciary duties
• Approval by the board of directors is not conclusive…shall be given consideration by the courts as deemed appropriate under all circumstances

The Second Circuit decision in Gartenberg v. Merrill Lynch Asset Management, Inc. set prevailing standard for more than 25 years:

• Does the fee schedule represent a charge within the range of what would have been negotiated at arm's-length; or
• Are the fees so disportionately large that it bears no reasonable relationship to the services rendered
• Gartenberg found that fees paid to other fund advisers were not dispositive
• A court should rely on its own business judgment to determine whether the fee is inconsistent with the investment advisers fiduciary duty under Section 36(b)

Courts should consider six factors:

• Nature, extent and quality of services provided to fund shareholders
• The profitability of the fund’s fees to the adviser
• Fallout benefits to the adviser
• Whether fee levels reflect economies of scale as the fund grows
• Fee structure of comparative funds
• The independence and conscientiousness of the trustees

The Seventh Circuit Opinion in Jones v. Harris Associates

• Easterbrook's majority opinion held that Harris had not violated the Act because the fees were ordinary
• Rejects Gartenberg approach ("because it relies too little on markets")
• Disclosure plus fee-setting market will regulate itself
• Investors vote with their feet and dollars
• Market competition rather than a "just price" administered by the courts is appropriate
• Judge Posner issued dissent and chided the panel for rejecting Gartenberg

The SCOTUS

Prompted by the Circuit split and, one suspects, the split between Easterbrook and Posner--whom one normally thinks of as ideological soulmates--the SCOTUS took cert.

According to Bloomberg, which reported on the oral argument held today:

U.S. Supreme Court justices signaled they are split over the role judges should play in reviewing the compensation of mutual fund advisers in a case that might force reductions in the $90 billion in annual fees advisers collect.

Hearing arguments today in Washington, Chief Justice John Roberts and Justice Antonin Scalia emerged as the industry’s strongest defenders, questioning whether courts should second- guess the fund boards that approve the fees. The justices are considering the impact of the federal law that governs the mutual fund industry and its $10 trillion in assets.

An investor who objects to a fee “can go look at another fund,” Roberts said. “It takes 30 seconds.”

Other justices, including Stephen Breyer, suggested that judges should compare the fees paid by mutual fund shareholders to those the same investment advisers charge institutional clients that have similar investment objectives. Breyer said that, for fund directors, that would be a “normal question to ask.”

The WSJ opines that:

The U.S. Supreme Court seemed reluctant to intervene significantly in how mutual funds charge their customers, but indicated during arguments on Monday that it may request a more clearly defined standard for the fees.

The Journal also reports a rather curious comment by Justice Scalia:

And the justices noted that although the U.S. Securities and Exchange Commission backed the petitioners in the case, the agency has not filed any actions enforcing the relevant statute since 1980.

Assistant Solicitor General Curtis Gannon said the commission has focused instead on encouraging mutual funds to disclose more information.

Justice Antonin Scalia suggested the commission could more easily take on a larger role policing the industry than the courts. "It makes a lot more sense to have the SEC regulate rates than to have the courts do it, doesn't it?" he asked.

If Scalia's suggesting substantive fee regulation, that would be a really dramatic change. Certainly, it's true that courts should not be in the business of setting fees (as opposed to policing conflicts of interest).

As the Delaware Chancery Court has observed (In re Infousa, Inc.,2007 WL 3325920):

Sensational allegations may be grist for the mill of business journalists, but a Court cannot declare a grant of executive compensation to be excessive without immediately inviting the subsequent question: “How much is too much?” The answer to that question depends greatly upon context. The acumen of the business executive, the competitive environment in the industry, and the recruitment and retention challenges faced by the hiring corporation all bear heavily on an appropriate level of compensation. “How much is too much?” is a question far better suited to the boardroom than the courtroom.

That question is equally poorly suited for the administrative office rather than the board room. The SEC's track record from the days of regulating fixed broker-dealer commissions, for example, holds out little reason to think it could do a very good job of setting salaries.

Fionally, the Conglomerate Blog has a sort of mini-symposium of blog posts on the case for your edification.