On March 30, 2010, the United States Supreme Court decided Jones v. Harris Associates, L.P., No. 08-586, 556 U.S. ___ (2010), addressing the appropriate legal standard for assessing claims against mutual fund investment advisers and their affiliates under Section 36(b) of the Investment Company Act of 1940 ("Section 36(b)"). In reversing the United States Court of Appeals for the Seventh Circuit's affirmance of the trial court's grant of summary judgment in favor of the investment adviser of the Oakmark complex of mutual funds, the court rejected the Seventh Circuit's common law fiduciary duty standard in favor of the long-standing Gartenberg standard.

Background

Under Section 36(b), a mutual fund investment adviser is "deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature," paid by the mutual fund (or the shareholders of a mutual fund) to the adviser or any affiliate of the adviser. Section 36(b) further provides shareholders with a right to bring a derivative action on behalf of the fund for an alleged breach of this fiduciary duty, subject to a number of limitations.

For more than 25 years, most courts followed the standard announced in Gartenberg v. Merrill Lynch Asset Management, 694 F.2d 923 (2d Cir. 1982) when assessing Section 36(b) claims. In Gartenberg, the Second Circuit held that, for purposes of Section 36(b), a plaintiff-shareholder must show that the fund adviser and its affiliates charged a fee "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 Gartenberg and its progeny, courts typically examine six factors as being relevant to this determination: (1) the nature and quality of services provided to the fund; (2) the profitability of the fund to the adviser-manager; (3) "fall-out" (i.e., indirect) benefits received from the funds; (4) the realization of economies of scale in fund operations; (5) comparative fee structures; and (6) the independence and conscientiousness of the directors/ trustees governing the fund.

The continued application of the Gartenberg standard was called into question by the Seventh Circuit's adoption of a more traditional fiduciary duty standard in Jones. Specifically, in Jones, the Seventh Circuit rejected the Gartenberg standard in favor of a fiduciary duty standard that looked to the common law of trusts for the applicable standard under Section 36(b). In Jones, the Seventh Circuit held that competition in the mutual fund industry acts to deter excessive fees and, absent a failure to disclose material information to the mutual fund's board or directors, the adviser "is not subject to a cap on compensation."

This split between the United States Courts of Appeals with respect to the applicable standard to asses a Section 36(b) claim was the primary factor in the Supreme Court granting the Writ of Certiorari in Jones.

The United States Supreme Court Reverses the Seventh Circuit's Affirmance of the Trial Court's Granting of Defendant's Motion for Summary Judgment, and Endorses the Gartenberg Standard

The Supreme Court reversed and remanded the Seventh Circuit's affirmance of the trial court's granting of defendant's motion for summary judgment in Jones because the Seventh Circuit's decision was based on the incorrect standard for evaluating a Section 36(b) claim. Specifically, the Court rejected the common law fiduciary duty approach adopted by the Seventh Circuit in favor of the Gartenberg formulation, which requires that to face liability under Section 36(b), "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 found it unnecessary to wade into the dispute as to which common law trust standard was incorporated into Section 36(b). Rather, the Court held that its previous decision in Pepper v. Linton, 308 U.S. 295 (1939), addressed the concept of fiduciary duty in a context analogous to that presented under Section 36(b) in Jones. In Pepper, the Court stated that "[t]he 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." In Jones, the Court held that in Section 36(b), the Pepper fiduciary duty standard is modified by shifting the burden of proof from the fiduciary to the party claiming breach, 15, U.S.C. § 80a-35(b)(1), to show that the adviser's fee was outside the range that would be produced by arm's-length bargaining. The Court held that the Gartenberg standard fully incorporates the duty announced in Pepper in conjunction with Section 36(b)'s shifting the burden of proof to the plaintiff. Additionally, the Court held that the Gartenberg standard reflects the Investment Company Act's placement of a mutual fund's disinterested directors in the role of "independent watchdogs" of the relationship between a mutual fund and its adviser, and shows appropriate deference to the judgment of those disinterested directors. Specifically, the Court stated that "Gartenberg advises that 'the expertise of the independent trustees of a fund, whether they are fully informed about all facts bearing on the [investment adviser's] service and fee, and the extent of care and conscientiousness with which they perform their duties are important factors to be considered in deciding whether they and the [investment adviser] are guilty of a breach of fiduciary duty in violation of § 36(b).'"

After endorsing Gartenberg as the appropriate standard to assess a Section 36(b) claim, the Court next addressed two issues contested by the parties: (1) the comparison between the fees that an adviser charges a mutual fund and the fees that it charges institutional accounts; and (2) whether a court's evaluation of an investment adviser's fiduciary duty should consider both procedure and substance.


With respect to the comparison between mutual fund fees and institutional account fees, the Court held that there is not a categorical rule regarding the fees charged to different types of clients by an investment adviser. Instead, courts should give such comparisons the weight that they merit after considering the similarities and differences between the services that the clients require. However, the Court warned that courts should be "wary of inapt comparisons" because there may be significant differences between the services provided by an adviser to the two clients. Moreover, even if the services provided to institutional accounts are relevant, the Court stated that the Investment Company Act "does not necessarily ensure fee parity between mutual funds and institutional clients...."

As to the consideration of procedure and substance, the Court held that courts must consider both procedure and substance when examining a Section 36(b) claim. Specifically, the Court held that where a mutual fund board's process for approving investment advisory fees is robust, a court should afford appropriate deference to the approval rendered by the disinterested directors. In contrast, if the board's process is deficient or if the adviser withheld important information, a court must engage in a more thorough analysis of the fee generated by the board's fee approval process.

Reed Smith regularly represents mutual fund advisers and their affiliates in a wide variety of matters, including litigation under ICA Section 36(b). The firm did not serve as counsel in Jones.

This article is presented for informational purposes only and is not intended to constitute legal advice.