Seventh Circuit Rules on Mutual Fund Advisory Fees in Jones v. Harris Associates

As noted in an article by Floyd Norris of the New York Times, a panel of the Seventh Circuit Court of Appeals unanimously ruled in Jones v. Harris Associates that courts should play a limited role in reviewing fees charged by mutual fund advisors. In an opinion by Judge Frank Easterbrook, the court relied on what it called a “careful study” by Harvard Law School Professor John C. Coates IV and Columbia Business School Dean R. Glenn Hubbard that found that market forces and existing regulations provide powerful constrains on mutual fund fees, as well as an article by Ohio State Finance Professor René M. Stulz showing that hedge fund compensation regularly exceeds mutual fund fees.

The following summary and memorandum concerning the decision is by John Baumgardner of Sullivan & Cromwell LLP.

In Harris Assocs. v. Jones, No. 07-1624 (7th Cir. May 19, 2008), the United States Court of Appeals for the Seventh Circuit ruled that as long as a mutual fund investment adviser does not breach the fiduciary duty owed to shareholders by failing to disclose all of the pertinent facts or otherwise hindering the fund’s directors from negotiating a favorable price, no judicial review of the reasonableness of the adviser’s fee is required to dismiss a claim under Section 36(b) of the Investment Company Act of 1940. This decision rejects the long-followed Second Circuit decision in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982), which, while respecting the deliberations of independent directors, required courts to consider those deliberations in light of multiple factors in determining whether investment adviser fees were excessive. The Seventh Circuit examined the definition of fiduciary duty, rather than the amount of the fee itself, to evaluate whether the adviser complied with the duty created under Section 36(b), and held that a court should not substitute its judgment of what is “reasonable” for a fee determined by marketplace competition, absent lack of disclosure, deceit or some other breach of a fiduciary duty. (c) Sullivan & Cromwell LLP

A memorandum summarizing the decision is available here.