Jones v. Harris Decided

The Supreme Court today issued a unanimous decision 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

SCOTUS Opinion (per Alito)

The syllabus of the SCOTUS decision informs us that:

Based on §36(b)’s terms and the role that a shareholder action for breach of the investment adviser’s fiduciary duty plays in the Act’s overall structure, Gartenberg applied the correct standard.

(a) A consensus has developed regarding the standard Gartenberg set forth over 25 years ago: The standard has been adopted by other federal courts, and the Securities and Exchange Commission’s regulations have recognized, and formalized, Gartenberg-like factors. ...

(b) Section 36(b)’s “fiduciary duty” phrase finds ts meaning in Pepper v. Linton, 308 U. S. 295, 306–307, where the Court discussed the concept in the analogous bankruptcy context: “The essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain. If it does not, equity will set it aside.” Gartenberg’s approach fully incorporates this understanding, insisting that all relevant circumstances be taken into account and using the range of fees that might result from arm’s-length bargaining as the benchmark for reviewing challenged fees. ...

(c) Gartenberg’s approach also reflects §36(b)’s place in the statutory scheme and, in particular, its relationship to the other protections the Act affords investors. Under the Act, scrutiny of investment adviser compensation by a fully informed mutual fund board, see Burks v. Lasker, 441 U. S. 471, 482, and shareholder suits under §36(b) are mutually reinforcing but independent mechanisms for con-trolling adviser conflicts of interest, see Daily Income Fund, Inc. v. Fox, 464 U. S. 523, 541. In recognition of the disinterested directors’ role, the Act instructs courts to give board approval of an adviser’s compensation “such consideration . . . as is deemed appropriate under all the circumstances.” §80a–35(b)(1). It may be inferred from this formulation that (1) a measure of deference to a board’s judgment may be appropriate in some instances, and (2) the appropriate measure of deference varies depending on the circumstances. Gartenberg heeds these precepts.

(d) First, since the Act requires consideration of all relevant factors, §80a–35(b)(2), courts must give comparisons between the fees an investment adviser charges a captive mutual fund and the fees it charges its independent clients the weight they merit in light of the similarities and differences between the services the clients in question require. In doing so, the Court must be wary of in-apt comparisons based on significant differences between those services and must be mindful that the Act does not necessarily ensure fee parity between the two types of clients. However, courts should not rely too heavily on comparisons with fees charged mutual funds by other advisers, which may not result from arm’s-length negotiations. Finally, a court’s evaluation of an investment adviser’s fiduciary duty must take into account both procedure and substance.Where disinterested directors consider all of the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if the court might weigh the factors differently. Cf. Lasker, 441 U. S., at 486. In contrast, 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., at 484. Gartenberg’s “so disproportionately large” standard, reflects Congress’ choice to “rely largely upon [independent] ‘watchdogs’ to protect shareholders interests,” Lasker, supra, at 482.

So Easterbrook's opinion is reversed. Posner's position (more or less) prevails. As for the debate between the two, however, the bottom line expressed by Justice Alito's unanimous decision was that "The debate between the Seventh Circuit panel and the dissent from the denial of rehearing regarding today’s mutual fund market is a matter for Congress, not the courts."

As for Alito's relegation of the economic debate to Congress, Larry Ribstein opinedthat it might be true, but was "unfortunate given where Congress is headed these days." Ribstein further opined that:

The Court applied an under-all-the-circumstances substance-plus-procedure test, the implications of which will be keeping mutual funds and their lawyers busy for some time. The Court thereby sided with Judge Posner's dissent and rejected Judge Easterbrook's emphasis on disclosure, market competition and easy exit by investors which, as I have argued, support analogizing mutual funds to the sale of products rather than fiduciary relationships.

Professor William Birdthistle of the Chicago-Kent College of Law was actively involved in the case as an amicus. His initial reaction is to "characterize this decision as a decidedly Gartenberg-plus ruling."

Comments

[Lawrence Cunningham]

The lower court opinion was vacated, not reversed. The Court's opinion also contains a misleading error about which I've blogged over at Concurring Opinions.