Mutual Fund Advisory Fees

This post is by James Morphy’s colleagues Bruce Clark and Aisling O’Shea.

The United States Court of Appeals for the Eighth Circuit has ruled that the size of a mutual fund investment adviser’s fee is only one factor to be considered in reviewing a claim under Section 36(b) of the Investment Company Act of 1940. Gallus v. Ameriprise Financial, Inc., No. 07-2945 (8th Cir. April 8, 2009). The decision purports to affirm 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, requires courts to consider those deliberations in light of multiple factors in determining whether investment adviser fees are excessive. However, the decision notes that Gartenberg demonstrates one way in which a fund adviser can breach its fiduciary duty, but not the only way. According to the Eighth Circuit, the proper approach to Section 36(b) looks both to the adviser’s conduct during negotiations and the end result. To that end, the Eighth Circuit ruled that the district court erred in failing to compare the fees charged to an adviser’s institutional clients and mutual fund clients. As more fully discussed below, Gallus also departs from the Seventh Circuit’s opinion in Jones v. Harris Associates, 527 F.3d 627 (7th Cir. 2008).

The United States Supreme Court recently announced that it will hear an appeal in Jones v. Harris Associates, where the Seventh Circuit disagreed with the Second Circuit’s decision in Gartenberg, and held 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).

Separately, the Eighth Circuit also held that Section 36(b)’s statutory damages period does not end with the filing of a lawsuit because the plain language of the statute yields only a retrospective limitations period. Accordingly, plaintiffs may recover damages incurred after the filing date.

Section 36(b) of the Investment Company Act
Section 36(b) of the Investment Company Act governs the compensation or payments made to investment advisers of registered investment companies and imposes a fiduciary duty on those advisers in connection with their receipt of fees from the funds they manage. 15 U.S.C. § 80a 35(b). Specifically, Section 36(b) provides that “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services” and provides that claims for excessive fees may be brought by the SEC or by shareholders.

The Second Circuit’s Decision in Gartenberg
In 1982, the Second Circuit considered whether fees paid to a money market fund manager were “so disproportionately large as to constitute a breach of fiduciary duty in violation of § 36(b).” Gartenberg, 694 F.2d at 925. After analyzing the legislative history, Gartenberg concluded that a court should scrutinize the fee itself using a variety of factors. As articulated in Gartenberg, the test is “whether the fee schedule represents a charge within the range of what would have been negotiated at arm’s-length in the light of all the surrounding circumstances.” Id. at 928. Put another way, “[t]o be guilty of a violation of § 36(b) . . . the adviser-manager must charge a fee that 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.” Id. In evaluating the reasonableness of adviser fees, Gartenberg found that the fees paid to other fund advisers were not dispositive because there was insufficient competition in the adviser marketplace. Id. at 929.

Gartenberg identified a number of factors that courts should consider in evaluating “whether a fee is so excessive as to constitute a ‘breach of fiduciary duty’” under Section 36(b), including, among others: (i) the cost to the adviser-manager of providing the service, (ii) the nature and quality of the service, (iii) “the extent to which the adviser-manager realizes economies of scale as the fund grows larger” and (iv) the volume of orders being processed by the adviser-manager. Id. at 930. In other words, in assessing the adviser’s fee, a court should rely on its own business judgment to determine whether the fee is inconsistent with the investment adviser’s fiduciary duty under Section 36(b) rather than recognizing that the inherent competition of the marketplace sets an appropriate fee.

The Seventh Circuit Rejects Gartenberg
In 2008, the Seventh Circuit rejected the Gartenberg approach that has long been followed as the proper standard for reviewing fees under Section 36(b).[1] In Jones v. Harris Associates, shareholders of various funds advised by Harris Associates L.P. (“Harris”) alleged that the fees paid to Harris were excessive and therefore in violation of Section 36(b). While the Seventh Circuit affirmed the ruling below, which followed Gartenberg and held that Harris had not violated the Act because its fees were ordinary, the Seventh Circuit explicitly rejected the approach used in Gartenberg “because it relies too little on markets.” Jones, 527 F.3d at 632.

The court held that the analysis does not turn on whether the fees paid are “reasonable” based on the Gartenberg considerations. Rather, the court held that a “fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth.” Id. Drawing from the law of trusts, the court continued: “A trustee owes an obligation of candor in negotiation, and honesty in performance, but may negotiate in his own interest and accept what the settlor or governance institution agrees to pay.” Id. (citing Restatement (Second) of Trusts § 242 & cmt. f).

The Seventh Circuit held that if an unaffiliated board of directors sets the fee for an investment adviser after candid negotiations, this fee is not subject to “judicial review for ‘reasonableness.’” Id. at 633. The hallmark of Jones’ analysis is that market competition, rather than “a ‘just price’ system administered by the judiciary,” is both appropriate and just. Id. The court concluded with a discussion of how the feesetting market will regulate itself – if a fee is “excessive” investors will respond by moving their money elsewhere. Id. at 634. In sum, the Investment Company Act works “by requiring disclosure and then allowing price to be set by competition in which investors make their own choices.” Id. at 635.

The plaintiffs in Jones petitioned the Seventh Circuit for rehearing en banc. Although the court ultimately denied rehearing, Judge Posner, joined by four other judges, issued a dissent from the denial of rehearing en banc. Jones v. Harris Assocs., 537 F.3d 728, 729 (7th Cir. 2008) (Posner, J., dissenting from denial of rehearing en banc). In his dissent, Judge Posner chides the panel opinion for rejecting the well-settled law in Gartenberg, noting that no other court has declined to follow the case.

The Supreme Court Grants Certiorari in Jones
Subsequently, the shareholders petitioned the Supreme Court for a writ of certiorari. On March 9, 2009, the Supreme Court granted certiorari, agreeing to hear the case. Jones v. Harris Assocs., No. 08-586, 2009 WL 578699 (U.S. Mar. 9, 2009). At issue before the Court is the proper standard to be applied when reviewing the compensation of an investment adviser under a Section 36(b) challenge. The shareholders’ merits brief is due June 10, 2009. The case is likely to be heard in the Court’s October 2009 term.

The Eighth Circuit rejects Jones
On April 8, 2009, the Eighth Circuit issued Gallus v. Ameriprise Financial, Inc. In Gallus, shareholders of eleven mutual funds, advised and distributed by affiliates of the various defendants (“Ameriprise”), asserted a claim for Section 36(b) violations. Primarily at issue was the proper standard to be applied and whether the district court erred in declining to consider a comparison between the fees Ameriprise charged to institutional clients and to mutual fund clients. The shareholders presented evidence indicating that the fees charged by the adviser to mutual funds were nearly double those charged to institutional investors and alleged that the adviser had misled the funds’ board in the fee-setting process.

The Eighth Circuit noted the split between the approaches in Gartenberg and Jones, and concluded “the Gartenberg factors provide a useful framework for resolving claims of excessive fees, notwithstanding the substantial changes in the mutual fund industry that have occurred in the intervening years.” Gallus, No. 07-2945, slip op. at 11. The court held: “Fund advisers do not have a duty in merely an abstract sense. Rather, the duty is imposed ‘with respect to the receipt of compensation.’” Id. However, the court stated that Jones “highlights a flaw in the way many courts have applied Gartenberg.” Id. Although the court agreed with the Seventh Circuit that the plain language of Section 36(b) “impose[s] on advisers a duty to be honest and transparent throughout the negotiation process,” it found this conclusion to be consistent with Gartenberg because there the Second Circuit was concerned with “only the question of whether the fee itself was so high that it violated [Section] 36(b).” Id. (Emphasis in original).

The Eighth Circuit noted that Gartenberg “demonstrates one way in which a fund adviser can breach its fiduciary duty, but it is not the only way.” Id. The court made it clear that Gartenberg “should not be construed to create a safe harbor of exorbitance.” Id. Rather, “the proper approach to [Section] 36(b) is one that looks to both the adviser’s conduct during negotiation and the end result.” Id. at 12. Accordingly, the court held that although the district court properly applied the Gartenberg factors in evaluating whether the size of the fee itself violated Section 36(b), it erred in holding that no Section 36(b) violation had occurred “simply because Ameriprise’s fee passed muster under the Gartenberg standard.” Id. Instead, the fund adviser’s conduct “must be evaluated independent from the result of the negotiation.” Id. at 13. The Eighth Circuit went on to note that the district court had also erred in declining to consider a comparison of the fees charged to Ameriprise’s institutional clients and in failing to determine whether Ameriprise had misled the board about the fee discrepancy between different types of clients. As a result, the case was remanded to the district court for, inter alia, consideration of the disputed issues of fact concerning the similarities and differences between mutual funds and institutional clients. This holding is inconsistent with the few opinions that have addressed whether such a fee comparison may be the basis for contradicting the reasonableness of the fee under Gartenberg and concluded it is not. See, e.g., Strougo v. BEA Assocs., 188 F. Supp. 2d 373, 384 (S.D.N.Y. 2002).

Finally, the court addressed whether Section 36(b)’s statutory damages period ends with the filing of the lawsuit or continues throughout litigation. Prior courts have held that mutual fund shareholders were limited to the one-year period before filing the complaint and could not recover damages incurred after a complaint was filed. Relying on “[t]he plain language of the statute,” the Eighth Circuit held that “a straightforward reading of the damages limitation yields only a retrospective limitation” on damages. Gallus, No. 07-2945, slip op. at 15 (emphasis added). Accordingly, plaintiffs may recover damages incurred after the filing date. Id. at 14.

The Eighth Circuit’s interpretation of Gartenberg further deepens the split among circuits regarding a court’s proper analysis of mutual fund advisory fees under Section 36(b). Gartenberg will continue to be controlling in the Second Circuit (which includes Connecticut, New York and Vermont), but Gallus means that, for cases brought in the Eighth Circuit (which includes Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota), that court’s interpretation will control. It should also be noted that the Third Circuit (which includes New Jersey, Pennsylvania and Delaware) has disagreed with Gartenberg and is closer to Jones in the requirements imposed on advisers. Green v. Fund Asset Mgmt., L.P., 286 F.3d 682 (3d Cir. 2002). The Fourth Circuit (which includes Maryland, North Carolina, South Carolina, Virginia and West Virginia) adopted the Gartenberg analysis for Section 36(b) claims in Migdal v. Rowe Price-Fleming International, Inc., 248 F.3d 321, 326-27 (4th Cir. 2001).

In short, in a majority of states, a mutual fund advisory fee will be scrutinized using a variety of factors. However, in the Eighth Circuit, such an analysis will look at both the adviser’s conduct during negotiation and the end result. Therefore, courts may compare, as part of this analysis, the fees an adviser charges to institutional clients and its mutual fund clients. The Eighth Circuit is the first court of appeals to posit this comparison as a factor in the analysis. Because advisory fees charged to mutual fund investors are often higher than fees charged to institutional investors, allowing such a comparison may open a new avenue for plaintiffs/shareholders asserting claims under Section 36(b).

The Seventh Circuit’s opinion in Jones remains the minority view for analyzing Section 36(b), but continues as the law in that circuit (which includes Illinois, Indiana and Wisconsin). However, the Supreme Court’s recent grant of certiorari in Jones means that it has the opportunity to clarify the standard courts should apply in analyzing Section 36(b). As the Eighth Circuit noted, some observers have “suggest[ed] that the [Supreme] Court may establish a standard of review that may result in lower management fees.” Gallus, No. 07-2945, slip op. at 10 (citing Sam Mamudi, “Decision Could Set Standard on Fees,” Wall St. J., March 19, 2009, at C9).

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