Seventh Circuit Rejects Gartenberg’s Construction of Section 36(b) of the 1940 Act
Introduction
In a decision that is sure to impact fund fee litigation for the foreseeable future, the U.S. Court of Appeals for the Seventh Circuit dis- missed an allegation of violation of Section 36(b) of the Investment Company Act of 1940, as amended, against Harris Associates, L.P., the investment adviser to the Oakmark funds.1 In Jones v. Harris Associates, L.P., the Seventh Circuit explicitly rejected the approach of Gartenberg v. Merrill Lynch Asset Management, the seminal opinion of the U.S. Court of Appeals for the Second Circuit, which held that an invest- ment adviser’s fiduciary duty under Section 36(b) broadly prohibits charging a fee “so disproportionately large that it bears no reason- able relationship to the services rendered, and could not have been the product of arm’s-length bargaining.”2 Noting that “Section 36(b) does not say that fees must be ‘reasonable’ in relation to a judicially created standard,” the Seventh Circuit in Jones held that “[j]udicial price- setting does not accompany fiduciary duties,” and that “Section 36(b) does not call for a de- parture from this norm.”3
Discussion
Section 36(b) provides in part 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, or of payments of a material nature, paid by such registered investment company, or by the securityholders thereof, to such invest- ment adviser or any affiliated person of such investment adviser.”4 In Gartenberg, the Second Circuit interpreted an investment adviser’s fiduciary duty under Section 36(b) principally by focusing on the amount of fee charged by the investment adviser, noting that “[t]he test is essentially whether the fee schedule represents a charge within the range of what would have been negotiated at arm’s-length in light of all of the surrounding circumstances.”5
The Seventh Circuit in Jones explicitly “disap- prove[s] the Gartenberg approach,” observing that “[a] fiduciary duty differs from rate regulation.”6 The court held that “[a] fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trus- tees [of the fund] (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.”7 Citing the law of trusts in support of its view, the court stated that, like a trustee, a fiduciary “owes an obligation of candor in negotiation, and honesty in performance, but may negotiate in his own interest. . . .”8 The Seventh Circuit’s opinion in Jones does envisage the possibility of “compensation so unusual that a court will infer that deceit must have occurred, or that the persons re- sponsible for decision have abdicated,” but it implies that such instances would be rare.9 The court ob- served, in this regard, that the process for fund board approval of investment advisory fees is similar to the process for determining how much public-company executives are compensated—where a committee of independent directors sets the top managers’ com- pensation—and yet “[n]o court has held that this pro- cedure implies judicial review for ‘reasonableness’ of the resulting salary, bonus, and stock options.”10
In articulating this new standard for interpreting Sec- tion 36(b), the Seventh Circuit rejected the plaintiffs’ contention that Gartenberg should be disregarded because it relies too much on market prices and there is a lack of actual fee competition in the mutual fund industry. In return, the court stated that “just as plaintiffs are skeptical of Gartenberg because it relies too heavily on markets, we are skeptical about Gartenberg because it relies too little on markets.”11 The court observed that thousands of mutual funds today compete for investor assets. Although mutual funds rarely “fire” their investment advisers, the court noted that inves- tors themselves fire advisers “cheaply and easily by moving their money elsewhere.”12 Rejecting the notion that investors are too unsophisticated to pay attention to fund costs, the court noted that “the most substan- tial and sophisticated investors choose to pay substantially more for investment advice” through unreg- istered products (e.g., hedge funds) that oftentimespay higher fees than registered funds.13 The essence of the court’s competition theory is that investors are willing to pay higher fees for superior net investment performance, and that competition in the fund industry is strong on relative basis—“what is ‘excessive’ depends on the results available from other investment vehicles, rather than any absolute level of compensation.”14
The court also rejected the plaintiffs’ argument that a mutual fund’s fees are per se excessive if the investment adviser charges lower fees to “comparable” pension funds or other institutional products. Noting that “[d]ifferent clients call for different commitments of time,” the court observed that mutual funds need to account for daily redemptions and have higher turn- over than institutional products.15 In essence, the court stated that an adviser is free to charge different amounts to clients for similar services based on what the market will bear, observing that advisers apportion their own internal costs for services to customers “according to their elasticity of demand, not according to any rule of equal treatment.”16
Immediate Implications
The immediate impact of the Jones decision remains unclear. For now, the Jones court’s construction of Section 36(b) controls in cases heard in the Seventh Circuit, which includes the states of Illinois, Indiana, and Wisconsin. The Gartenberg construction of Section 36(b) continues to control in cases heard in the Second Circuit—Connecticut, New York, and Vermont—as well as in other circuits that have adopted Gartenberg.17 Due to the split among the circuit courts of appeal, it is more likely (but far from certain) that the Supreme Court would review Jones if petitioned to do so.
In our view, it is unlikely that Jones will have an im- mediate impact on how fund boards approach the annual investment advisory contract review process. The split in the circuits creates a degree of uncertainty about which interpretation of Section 36(b) would govern in a given case. Moreover, the Gartenberg standard has been enshrined by SEC rules requiring detailed disclosure of the factors considered, and conclusions reached, by fund boards in connection with the approval of investment advisory contracts.18 The considerations that must be addressed in this disclosure are informed significantly by the standards set forth in Gartenberg. Accordingly, fund boards may feel compelled by these SEC disclosure requirements tocontinue to follow a Gartenberg-style contract-review process, notwithstanding the court’s holding in Jones. The decision should prompt the SEC to rethink (and perhaps revise and simplify) its Gartenberg-based disclosure requirements in light of the Seventh Circuit’s interpretation of Section 36(b). In the meantime, a robust consideration of all the Gartenberg factors remains the most prudent course to follow unless and until a uniform standard is adopted by the courts, and the SEC makes conforming changes to its contract review disclosure requirements.
This update was authored by William K. Dodds (+1 212 698 3557; william.dodds@dechert.com), Robert A. Robertson (+1 949 442 6037; robert.robertson@dechert.com), Alan Rosenblat (+1 202 261 3332; alan.rosenblat@dechert.com), and Thomas C. Bogle (+1 202 261 3451; thomas.bogle@dechert.com).
Footnotes
1) Jones v. Harris Associates L.P., No. 07-1624, 2008 WL 2080753 (7th Cir. 2008).
2) Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923, 928 (2d Cir. 1982), cert. denied sub nom. Andre v. Merrill Lynch Ready Assets Trust, 461 U.S. 906 (1983).
3) Jones, 2008 WL 2080753, at *4 – *5.
4) 15 U.S.C. § 80a-35(b) (emphasis added).
5) Gartenberg, 694 F.2d at 928.
6) Jones, 2008 WL 2080753, at *4.
7) Id.
8) Id.
9) Id.
10) Id. Some may argue that this approach seems to place more emphasis on the fiduciary duty of fund directors than the fiduciary duty of the investment adviser specified in Section 36(b).
11) Id. (emphasis added).
12) Id., at *5.
13) Id., at *6.
14) Id., at *5.
15) Id., at *6.
16) Id.
17) See, e.g., Migdal v. Rowe Price-Fleming Intern., Inc., 248 F.3d 321 (4th Cir. 2001).
18) See Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, SEC Release No. IC-26486 (June 23, 2004), at n. 31 (noting that the factors enumerated in the disclosure rule are similar to factors considered by courts, and citing Gartenberg in particular).
