On March 30, the U.S. Supreme Court unanimously upheld the traditionally high barrier to lawsuits against mutual fund advisers for imposing allegedly excessive fees. In Jones v. Harris Associates, the Supreme Court held that a mutual fund shareholder must show that the adviser charged "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." This high burden is already in place in most federal courts and, in the wake of the Supreme Court's ruling, will continue to govern in cases seeking to challenge mutual fund advisory fees.
In the case before the Supreme Court, a group of mutual fund shareholders alleged that the manager of the funds violated Section 36(b) of the Investment Company Act of 1940 ("Act") by charging fees that were "disproportionate to the services rendered" and "not within the range of what would have been negotiated at arm's length in light of all the surrounding circumstances." In assessing this claim, the district court applied the test first established in 1982 in the case of Gartenberg v. Merrill Lynch Asset Management, Inc. This test set a high barrier to shareholder suits challenging fees, requiring a showing that, under all surrounding circumstances, a fee 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."
On appeal, the Seventh Circuit disapproved this traditional approach because it "relies too little on markets." The Seventh Circuit instead focused on whether the investment adviser made full disclosure. Under the Seventh Circuit's approach, the amount of compensation would be subject to challenge only if it were "so unusual" as to give rise to an inference "that deceit must have occurred, or that the persons responsible for decision have abdicated."
In an opinion written by Justice Alito, the Supreme Court vacated the Seventh Circuit's opinion and said that the traditional Gartenberg standard "was correct in its basic formulation of what Section 36(b) requires" and that the standard "may lack sharp analytical clarity, but we believe that it accurately reflects the compromise that is embodied in Section 36(b) and it has provided a workable standard for nearly three decades."
The Supreme Court held that "all relevant circumstances" must be considered in determining whether a fund manager's compensation is lawful. Among the factors that may be relevant in a particular case are "comparisons between the fees that an adviser charges a captive mutual fund and the fees that it charges its independent clients." "By the same token," the Supreme Court added, "courts should not rely too heavily on comparisons with fees charged to mutual funds by other advisers." Furthermore, "a court's evaluation of an investment adviser's fiduciary duty must take into account both procedure and substance." Fees resulting from robust negotiation and review procedures are more likely to be upheld than fees resulting from a deficient process.
The Supreme Court reaffirmed the principle that the Act "does not call for judicial second-guessing of informed board decisions." According to the Supreme Court, it is not the role of courts to "supplant the judgment of disinterested directors apprised of all relevant information," nor is it their place to "engage in a precise calculation of fees representative of arm's-length bargaining." The proper standard thus relies heavily on informed and independent directors to protect the interests of shareholders.
Notably, in affirming the traditional Gartenberg test, the Supreme Court presumably could have affirmed summary judgment for the adviser on the basis of the district court's ruling. Instead, however, the Supreme Court remanded the case for further proceedings consistent with its own opinion. This may suggest some difference between the district court's application of Gartenberg and the application that the Supreme Court envisioned.
More generally, time will tell how the lower courts apply the Supreme Court's opinion. To be sure, the Supreme Court has clearly stated that a mutual fund board's decisions on adviser compensation are entitled to significant deference. Where a board maintains robust negotiation and review procedures, plaintiffs will continue to find it extremely difficult to challenge adviser compensation decisions. Nevertheless, the Supreme Court rejected the Seventh Circuit's test for imposing liability under Section 36(b), a test that had the potential to become even more restrictive than Gartenberg. It will be for the lower courts, in applying the Supreme Court's new opinion, to determine whether it is in the long run a victory for mutual fund advisers or for plaintiffs challenging adviser compensation.