On March 30, 2010, in Jones v. Harris Associates L.P., the United States Supreme Court handed down its much-anticipated decision reviewing Gartenberg. The Court concluded that “Gartenberg was correct in its basic formulation.” With the decision in Jones, the previously influential Gartenberg approach now becomes the authoritative test nationwide.
The decision is notable in several respects:
(1) Gartenberg is the Correct Approach Under the Gartenberg formulation, to impose liability for breach of fiduciary duty under Section 36(b) of the Investment Company Act, “an investment adviser 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.” In Jones v. Harris, the Supreme Court adopted this standard, noting that, although it “may lack sharp analytical clarity,” it nonetheless “accurately reflects the compromise that is embodied in Section 36(b), and it has provided a workable standard for nearly three decades.” The Court rejected outright the notion urged by the petitioners that Section 36(b) mandates that advisers must charge, and that boards must approve, “fair” or “reasonable” advisory fees.1 The Court notes both that Congress rejected such a standard when it adopted Section 36(b) and “courts are not well suited” to determine what constitutes a fair or reasonable fee in particular cases.
(2) Deference to a Well-Informed Board The decision emphasizes that where a board’s process for negotiating and reviewing adviser compensation is “robust” and an informed board considers the “relevant factors,” a reviewing court should afford commensurate deference to the outcome of the bargaining process, even if the court might weigh the factors differently. Where the decision reflects the considered judgment of a fully informed board: “[i]t is important to note” that the standard for breach of fiduciary duty under Section 36(b) “does not call for judicial second-guessing of informed board decisions.” If, on the other hand, the board’s process is deficient, or the adviser withheld information, a court must take a harder look at the outcome. One fair question raised by the decision is the continuing validity of each of the well-known Gartenberg factors — the decision mentions, but does not specifically approve them. However, the Court’s clear mandate to consider “all relevant circumstances” will likely mean, in practice, that boards would be well-advised to continue to consider the Gartenberg factors, as well as any other relevant information.
(3) No Categorical Bar on Consideration of Institutional Fees The Court declined to adopt a categorical rule stating that comparisons of fees charged by an adviser to institutional clients are irrelevant. Lower courts must be “wary of inapt comparisons,” but may give such comparisons the weight they deserve in light of the similarities or differences in services. The Court specifically noted differences in levels of services, frequency of redemptions, rate of asset turnover, and greater regulatory and legal obligations, and boards would be well-advised to consider and rely on these differences.
(4) Fees Charged by Advisers of Comparable Funds Deserve No Undue Weight The Court said, echoing Gartenberg, that courts should not place undue weight on comparisons to fees charged by advisers of other funds, since such fees may, themselves, not result from arm’s length bargaining.
We describe the decision in more detail below.
First, the Court encouraged judicial restraint in reviewing fees set between an informed mutual fund board and an adviser. The “fiduciary duty” standard in Section 36(b) represents a “delicate compromise” that, while more favorable to shareholders than previously available remedies for allegedly excessive fees under common law standards for corporate waste, does not permit a court to review compensation for reasonableness. Looking to its own decision in Pepper v. Litton,2 the Court observed that “[t]he essence of the test” for a breach of fiduciary duty “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.” The Court found this formulation to express the substantive meaning of the phrase fiduciary duty in Section 36(b). For suits under Section 36(b), however, the Investment Company Act modified this duty procedurally, “in a significant way” by shifting the burden of proof from the fiduciary to the party claiming the breach. The Gartenberg approach correctly reflects both the application of Pepper v. Litton’s “earmarks of an arm’s length bargain” standard and the statutory burden-shifting.
Second, the Court emphasized that the Gartenberg approach appropriately reflects Section 36(b)’s “place in the statutory scheme and, in particular, its relationship to the other protections that the Act affords investors,” most notably the requirement that disinterested directors sit on the fund board. The Investment Company Act thus “interposes independent directors as ‘independent watch dogs’ of the relationship between a mutual fund and its adviser.” Board scrutiny of adviser compensation and shareholder suits under Section 36(b) are “mutually reinforcing but independent mechanisms for controlling conflicts.”
Section 36(b) instructs a court to give board approval of an adviser’s compensation “such consideration as is appropriate under all the circumstances.” That “formulation” compels the inferences that, first, a measure of deference board’s judgment may be appropriate in certain circumstances, and, second, the amount of deference to be accorded depends on the circumstances. The approach requires, as Gartenberg said, consideration of the independent trustees’ expertise, whether they are fully informed about services and fees, and the extent of their care and conscientiousness. It also requires courts to consider “an adviser’s compliance or non-compliance with its disclosure obligations” under Section 36(b) “in calibrating the degree of deference that is due a board’s decision to approve an adviser’s fees.” In this regard, the Court made clear that “‘Section 36(b) is sharply focused on the question of whether the fees themselves were excessive.’” As a result, while the Court explained that lower courts “must take into account both procedure and substance” in Section 36(b) cases, the Court did not suggest that this analysis begin anywhere else but with a focus on the fees paid.
The Gartenberg approach comports with each of the foregoing policies: it reflects the concept of fiduciary duty enunciated by the Court and the burden shift to the party claiming the breach; it requires that a court take all relevant circumstances into account, including approval by the board; and it uses the range of fees that might result from arm’s length bargaining as the benchmark for reviewing challenged fees. While the Gartenberg standard “may lack sharp analytical clarity,” the Court found that it “accurately reflects the compromise that is embodied in Section 36(b), and it has provided a workable standard for nearly three decades.”
In confirming the Gartenberg approach, the Court addressed several issues debated by the parties, including the relevance of, first, the fees charged by the investment adviser to its institutional clients and, second, fees charged by advisers of competitive mutual funds. As to the former, the Court declined to adopt “any categorical rule regarding the comparison of fees charged different types of clients.” The Court cautioned that, “in light of the different markets for advisory services,” lower courts must be “wary of inapt comparisons” and recognized that “there may be significant differences between the services provided by an investment adviser to a mutual fund and those it provides to a pension fund which are attributable to the greater frequency of shareholder redemptions in a mutual fund, the higher turnover of mutual fund assets, the more burdensome regulatory and legal obligations, and higher marketing costs.” In this regard, the Court appears to have acknowledged, as did the recent Gallus decision by the Eighth Circuit Court of Appeals that, while some comparisons are altogether inapt — such as the comparison of fees paid by money market funds and pension funds raised in Gartenberg — not all fee comparisons should be dismissed out of hand.3 Although this ruling may make it harder to dispose of the cases on preliminary motions than would a categorical rule against comparisons to institutional fees, future plaintiffs may still be hard-pressed to muster sufficiently specific allegations that services are similar to withstand such motions.
The relevance of fees charged by competing mutual funds had been a subject of lively recent debate, between the Seventh Circuit Judges Easterbrook (writing for the panel below) and Posner (dissenting from denial of rehearing en banc), in the amicus briefs and elsewhere. Particularly in light of the plethora of fee options now available to fund shareholders, numerous parties had asked the Court to affirm the relative importance of such fee comparisons. As had the Gartenberg court, however, the Supreme Court cautioned against over-reliance on fees charged to mutual funds by other advisers: “[t]hese comparisons are problematic because these fees, like those challenged, may not be the product of negotiations conducted at arm’s length.” Certainly, however, the well-informed board will want to continue to consider such comparisons among other factors.
As a procedural matter, the Supreme Court decision may provide a sufficient basis to dismiss the Jones plaintiffs’ claims as a matter of law. On remand, the lower court may well conclude that since it decided the case on Gartenberg grounds, and considered evidence relating to institutional fees, that nothing remains but to reinstate the dismissal without further proceedings.
The Supreme Court thus leaves intact a standard that, as the Court acknowledged, has provided a workable test for many years. The decision leaves a clear mandate for fund trustees to ask questions and for fund advisers to be sure that boards are well-informed. Indeed, the decision recognizes that shareholder suits under Section 36(b) are only one of the shareholder protections provided by the Investment Company Act; the companion bulwark is the well-informed board.
We will work with our clients on the practical effects of the ruling. Certainly, proponents of a vigorous advisory review process that emphasizes full disclosure by the adviser will find much in the opinion to support their position.
For assistance, please contact the following lawyers in the Financial Services Area:
David C. Boch, Partner, Broker-Dealer
david.boch@bingham.com, 617.951.8485
Amy Kroll, Partner, Broker-Dealer Group
amy.kroll@bingham.com, 202.373.6118
David Boch, Partner, Broker-Dealer Group
david.boch@bingham.com, 617.951.8485
Lea Anne Copenhefer, Partner, Investment Management
leaanne.copenhefer@bingham.com, 617.951.8515
Toby R. Serkin, Partner, Investment Management
toby.serkin@bingham.com, 617.951.8760
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615
This article was originally published by Bingham McCutchen LLP.