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High Court Review of Mutual Fund Case Likely

By Lea Anne Copenhefer, Steven R. Howard, Roger P. Joseph, and Joshua B. Sterling

On August 8, 2008, the U.S. Court of Appeals for the Seventh Circuit voted against rehearing en banc the panel decision in the Harris Associates case. [1] The panel opinion in that case, which was handed down on May 19, 2008, “disapproved” the long-standing Gartenberg case, which delineated the factors that most federal courts have applied to determine whether the advisory fees paid by mutual funds violate the fiduciary duty imposed on mutual fund advisers under Section 36(b) of the Investment Company Act of 1940 with respect to their receipt of compensation. [2] The significance of the panel’s decision did not pass unnoticed, however.


In a strongly worded dissent, Judge Richard Posner, joined by four other judges, disputed the panel’s conclusion that courts must only ascertain whether an adviser’s compensation was the product of honest and open bargaining, rather than perform the more detailed analysis applied under Gartenberg. [3] He argued that directors and advisers are often too cozy with one another, and that a court would be apt to miss evidence of a breach of fiduciary duty if it were only to assess whether an adviser had misled the board regarding the adviser’s compensation.


Summary of Dissent


Panel’s Analysis Inconsistent with Evidence
Judge Posner began his criticism of the panel opinion by placing advisory compensation in the broader context of the ongoing controversy surrounding executive compensation. “Mutual funds are a component of the financial services industry, where abuses on compensation matters ‘have been rampant . . . .’” [4] Because directors and advisers “hire each other preferentially based on past interactions,” directors tend to be less skeptical. This, in turn, leads to advisers “captur[ing] more rents” and being “monitored by the board less intensely.” [5]


In this context, Judge Posner reasoned that the standard advocated by the panel—that a court must ascertain only whether an adviser has “ma[d]e full disclosure and play[ed] no tricks”—would be an inadequate tool to determine whether an adviser had breached its fiduciary duty in connection with its receipt of compensation. [6] If directors have “feeble incentives . . . to police compensation,” then, in Judge Posner’s view, it would follow that a court should do more to discern whether Section 36(b) had been violated than assess whether the fee negotiations were open and honest. [7]


Panel Opinion Ignored Facts, Made Assumptions
Judge Posner tied his general concern about “less intense” monitoring of advisory fees to the funds at issue in Harris Associates. “A particular concern” was that the adviser had charged those “captive funds more than twice what it [had] charge[d] independent funds.” [8] Judge Posner complained that, instead of focusing on evidence, the panel had only “throw[n] out some suggestions on why this difference [in fees] may be justified . . .” [9] In supporting his assertion as to the captive nature of the funds at issue, Judge Posner observed that the adviser had set up the funds, had been approved each year since inception to manage the funds, advised the entire fund portfolio, and supplied the funds with office space, equipment, and management personnel.


Judge Posner also challenged the panel’s position that advisory fees paid by captive funds are subject to competition. The panel had asserted that “[a]n adviser can’t make money from its captive fund if high fees drive investors away.” [10] He questioned whether higher fees do, in fact, drive away investors. In this regard, he pointed to academic literature that compared the fees paid to equity pension fund portfolio managers with those paid to equity mutual fund portfolio managers. This comparison indicated, for the period studied, that pension funds paid much lower management fees than did mutual funds. [11]


Judge Posner did not explore whether the additional services that the adviser had provided to the captive funds warranted the larger fee, nor did he address whether any differences between services performed for pension funds and mutual funds could explain the lower management fees paid by pension funds. However, he did observe that “[t]he outcome in this case may be correct,” [12]which might indicate that the higher fee paid by the captive funds could have been justified based on these or other factors.


Panel Set Too High a Floor for Advisory Fees
Judge Posner criticized the panel for concluding that a court could infer a breach of fiduciary duty only from an advisory fee that was “unusual,” which would be “applied solely by comparing the adviser’s fee with the fees charged by other mutual fund advisers.” Because “[t]he governance structure that enables mutual fund advisers to charge exorbitant fees is industry-wide,” Judge Posner reasoned that the panel’s “comparability approach” would allow fees that have resulted from less-than-arm’s-length bargaining “to become the industry’s floor.” [13]


Judge Posner contrasted the Harris Associates standard with Gartenberg, under which a court could infer a breach of fiduciary duty from an advisory fee that was “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.” [14] He concluded that Gartenberg was a better standard because it was not limited to a simple fee comparison and, as a result, would not set a too-high floor. Judge Posner also suggested that the panel should have forgone creating a new standard and simply compared the fees paid by the captive funds against those paid by the independent funds. In addition, he observed that Gartenberg has been cited and supported by many federal courts over the decades since the Second Circuit’s ruling.


Observations


Advisory Fee Decisions Will Remain under Microscope
One may question whether Judge Posner was on target in his criticism of the mutual fund industry and whether he was correct in including mutual funds in his attack on excessive executive compensation for public companies. As noted above, he even states that the mutual fund “governance structure . . . enables mutual fund advisers to charge exorbitant fees . . . .” [15] Of course, however, that governance structure was established by Congress, and it is not up to the courts to remedy perceived deficiencies in that structure. Still, the dissent in Harris Associates is a reminder that courts and other observers continue to be skeptical of whether directors are effective watchdogs for mutual fund shareholders. As a result, mutual fund directors should read the dissent as a reminder to ask the hard questions at annual contract reviews.


It Will Remain Important to Compare Advisory Fees
Judge Posner argues that there is more for a court to do in assessing Section 36(b) claims than to compare fees and flag only the “unusual” ones as evidence of a possible breach of fiduciary duty. This is altogether consistent with Gartenberg and its progeny, which call for a fee comparison as one of many factors involved in assessing Section 36(b) claims. We believe that it remains advisable for directors to consider advisory fees paid by comparable funds as part of a broader analysis that encompasses all of the Gartenberg factors.


More than Semantics Distinguishes the Two Decisions
We agree with Judge Posner that there are real differences between the approach taken by the court in Harris Associates and that taken by the courts in the Gartenberg line of cases. The Gartenberg case and its progeny have outlined several factors for boards and courts to consider, and Harris Associates focuses mainly on comparative fees and, to a lesser extent, fund performance.


Referring to our May 27, 2008, article on the panel decision, Judge Posner states that “although one industry commentator has suggested that ‘courts may … conclude that in fact what the court of appeals has done [in Harris Associates] is merely articulate the Gartenberg standard in a different way,’ this misses an important difference between the Gartenberg approach and the panel’s approach.” [16] Indeed, in a previous article we clearly recognized those distinctions and therefore recommended that boards and advisers “stay the course” and continue to apply the Gartenberg factors.


As we observed in May, a standard under which a court evaluates only the probity of an adviser in the negotiation of its fee overlooks some of the statutory language. Congress drafted Section 36(a) to address breaches of fiduciary duty involving personal misconduct, and stated in Section 36(b) that a plaintiff need not prove personal misconduct, so Section 36(b) must mean something more than what the Harris Associates panel opinion suggests.


On the other hand, it could be argued that Gartenberg goes too far the other way by having courts dictate the factors that boards should consider. It remains for the courts to consider the differences between the Gartenberg and Harris Associates approaches and strike a new balance.


Other Courts Will Likely Address Panel Opinion
We think that the dissent has raised the intensity of the debate that the panel opinion initiated over Gartenberg. It is quite clear that Chief Judge Frank H. Easterbrook, who wrote the panel opinion, holds Gartenberg in low esteem, calling it a form of federal rate regulation. As we noted in our earlier article, this is not an accurate characterization of Gartenberg and its progeny. Judge Posner is equally dismissive of his colleague’s opinion, regarding it as an academic exercise that ignores certain inherent problems in the mutual fund industry and misapplies an economics of law analysis. [17] It is striking to us that, while the panel decision in Harris Associates concludes that competition would prevent an adviser from imposing unduly high fees, Judge Posner is just as convinced that neither competition nor the fund governance structure can be counted on to do so.


The fireworks aside, we think that each opinion highlights legitimate issues that need to be addressed on appeal. First, there is the question, raised by Chief Judge Easterbrook, of whether the far-reaching “reasonableness” test of Gartenberg has a legally sufficient basis in Section 36(b). While Judge Posner endorses Gartenberg, he does not directly address this question (as is his prerogative in dissent). Second, there is the question of what test the courts should apply in hearing Section 36(b) cases. Chief Judge Easterbrook contends that mutual fund investors effectively check advisory compensation by voting with their feet, so that courts no longer need to undertake the Gartenberg analysis. Judge Posner replies, based on a selection of academic literature and lay opinion, that this market is not perfect and therefore merits close judicial supervision of the sort set forth in Gartenberg. His criticism of the fund governance structure, moreover, suggests he would be less likely than other judges have been to give weight to a board’s approval of advisory fees.


These are weighty issues, and ultimately they may need to be resolved by the Supreme Court. We believe the dissent in Harris Associates makes it more likely that, in this or some future case, the U.S. Supreme Court will address Section 36(b).


Conclusion
The dissent in Harris Associates underscores that the panel opinion was out of kilter with the established case law under Section 36(b)—an area in which there otherwise has been general agreement among the circuits for over 25 years. The dissent may therefore lead other courts to continue to adhere to Gartenberg. It will bear watching how other courts—and perhaps the Supreme Court—address the issues the dissent has raised.


In our view, the right answer may be for courts to give full effect to the language used by Congress in the 1940 act, but not to expand that language. Harris Associates arguably failed to give full effect to the statutory language of the 1940 act. Gartenberg and the cases that followed it arguably have gone beyond the statute by mandating that boards consider specific factors, not identified in the statute, in approving an advisory contract. Under Section 15(c) of the 1940 act, it is “the duty of the directors of a registered investment company to request and evaluate, and the duty of an investment adviser to such company to furnish, such information as may reasonably be necessary to evaluate the terms” of any advisory agreement. Section 36(b) provides that it shall not be necessary to allege or prove that any defendant engaged in “personal misconduct,” but also states that in any action under Section 36(b) “approval by the board of directors … shall be given such consideration by the court as is deemed appropriate under all the circumstances.” We believe that if a board does its duty carefully and conscientiously under Section 15(c), its decision should carry great weight, whether or not the board has considered all of the factors enumerated in Gartenberg.


But, we hasten to add, no court has yet taken the middle ground we suggest, and it is therefore wise for boards and advisers to continue to apply the Gartenberg factors in connection with review of advisory agreements.


This article appears in the forthcoming Fall 2008 issue of the Securities Litigation Journal, the journal of the Securities Litigation Committee. The committee’s website includes a full archive of the newsletter and other online resources.

 

End Notes


  1. Jones v. Harris Assoc., 2008 U.S. App. LEXIS 16857 (7th Cir. Aug. 8, 2008).
  2. Jones v. Harris Assoc., 527 F.3d 627 (7th Cir. 2008).
  3. Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923 (2d Cir. 1982). The factors that courts consider under Gartenberg include: fees charged by other similar advisers to other similar funds; the adviser’s cost in providing services to the fund; the nature and quality of those services; the extent to which the adviser realizes economies of scale in providing those services as the fund grows larger; the volume of orders or transactions the adviser must process; and whether a fund’s directors have carefully considered and approved an advisory fee.
  4. Jones v. Harris Assoc., 2008 U.S. App. LEXIS 16857 at *6.
  5. Id. at *7; quoting Camelia M. Kuhnen, Social Networks, Corporate Governance and Contracting in the Mutual Fund Industry (Mar. 1, 2007) (available at http://ssrn.com/abstract=849705).
  6. Jones v. Harris Assoc., 527 F.3d at 632.
  7. Jones v. Harris Assoc., 2008 U.S. App. LEXIS 16857 at *5.
  8. Id. at *8.
  9. Id. at *8. Those suggestions included that, in general, mutual funds may pay higher fees because of costs associated with redemptions and that, with respect to the funds at issue, they had “grown more than the norm for comparable pools,” which would imply that the adviser had “delivered value for the money.”  See Jones v. Harris Assoc., 527 F.3d at 631, 634.
  10. Jones v. Harris Assoc., 527 F.3d at 632.
  11. Jones v. Harris Assoc., 2008 U.S. App. LEXIS 16857 at *9–*10.
  12. Id. at *13.
  13. Id. at *11.
  14. Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d at 928.
  15. Jones v. Harris Assoc., 2008 U.S. App. LEXIS 16857 at *11.
  16. Id. at *11 (quoting Bingham McCutchen LLP Client Alert of May 27, 2008).
  17. Judge Posner also points out that the panel failed to have its opinion reviewed by the entire Seventh Circuit Court of Appeals before publication, as required by the court’s local rules in the case of opinions that will cause a circuit split.  See Seventh Circuit Court of Appeals Local Rule of Appellate Procedure 40(e).

 

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