On March 30, 2010, the Supreme Court of the United States determined the standard for private investors to establish a breach of fiduciary duty claim under the Investment Company Act of 1940, 15 U.S.C. § 80a-1 et seq. (the “Act”) in Jones v. Harris Assocs. L.P., No. 08-586, 559 U.S. __ (2010). The Jones decision reaffirms the key role of a board of directors in setting advisory fees and, more generally, the importance of robust board oversight of compensation schemes. Nevertheless, the Supreme Court’s decision does not address what evidence investors can use to upset an informed board of directors’ approval of an investment adviser’s compensation. In particular, investors may continue to challenge a board’s determination based upon lower fees charged by the investment adviser to other clients.
Section 36(b) of the Act, 15 U.S.C. §80a-35(b), provides that an investment adviser of a registered investment company “shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser.” Private investors can bring suit under Section 36(b) on behalf of the investment company.
The Supreme Court granted certiorari in Jones to resolve a split among the Seventh Circuit and Second Circuit Court of Appeals as to the proper standard under Section 36(b). The Seventh Circuit ruled in Jones that mutual funds’ investment advisers were not subject to a cap on compensation since there had been full disclosure of their compensation to the mutual funds’ boards of directors, and the compensation had been approved by a majority of the funds’ independent directors as required by the Act. As the Supreme Court noted, the Seventh Circuit’s ruling directly conflicted with that of the Second Circuit in Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923 (2d Cir. 1982), under which an investor could prevail if it established that fees were “disproportionally large” or could not have been the result of “arm’s-length bargaining.” The Seventh Circuit’s view was that competition among mutual funds operated to keep fees low and that Gartenberg placed insufficient faith in the free market.
In a unanimous opinion, the Supreme Court held that the Gartenberg standard was the correct one and “to face liability under Section 36(b) of the 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.” The Court eschewed the Seventh Circuit’s economic analysis of the mutual fund market, instructing that district courts should instead look both to procedure and substance of an investment adviser’s compensation. Where a board of directors’ process for negotiating and reviewing the adviser’s compensation is robust, a reviewing court should defer to the board’s determination unless there was sufficient evidence to otherwise indicate that the fee was excessive and bore no relation to the services rendered. However, if the board’s process is deficient or the adviser withholds information, the court should take a “more rigorous look at the outcome.” The Supreme Court held that the Seventh Circuit had erred in focusing almost entirely on the element of disclosure to the mutual funds’ boards of directors.
The Supreme Court also cautioned that neither comparisons between fees charged by other mutual funds nor comparisons to fees charged by investment advisers to their institutional clients were particularly useful in determining whether a particular fee is reasonable, although it did not rule that such comparisons could never be used as evidence that a fee was excessive.
Jones provides a clear framework for courts to assess whether an investor has stated a viable breach of fiduciary duty claim under Section 36(b). Courts will first assess the procedure under which an investment adviser’s compensation was approved. If a board of directors carefully considers the adviser’s compensation and approves of it, courts should not second guess that decision. A cursory review of the compensation will result in a reviewing court applying greater scrutiny. Nevertheless, even with full board review, investors may offer other evidence to suggest that the adviser’s compensation is “disproportionately large,” including fees that the adviser charged other clients for the same services. Had the Supreme Court adopted the Seventh Circuit’s view of the standard, courts would have been largely precluded from considering the reasonableness of a fee where it had been approved by a properly informed board of directors.
Consequently, investment companies should work closely with outside counsel to examine fee structures in light of the services provided and to determine if such fees are warranted. A particularly important consideration is whether it is appropriate for different clients of the investment adviser to be charged different fees based on the specific services offered. Higher fees may be justified where the investment adviser provides a greater variety of services for a particular client.
For more information regarding this decision, please contact any member of Baker Hostetler’s Securities Litigation and Regulatory Enforcement Team.
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