Online Exclusive: Anatomy of a Circuit Split

The battle to define excessive investment adviser fees in Jones v. Harris Associates has grabbed attention ever since it led the 7th Circuit to toss out a 25-year-old legal standard following a showdown between superstar appellate judges Frank Easterbrook and Richard Posner.

The case involved mutual fund shareholders who were suing their investment adviser, Harris Associates, for charging them excessive fees. It would lead to a reassessment of the Gartenberg standard of determining when investment adviser fees for mutual funds are excessive.

Courts and regulators have applied that standard for years, so when the Supreme Court rejected the 7th Circuit’s new standard March 30, in some ways it rejected the questioning of a decades-long deference to investment advisers.

“You could say the 7th Circuit was solving a problem that no one thought existed,” says Fulbright & Jaworski Partner Darryl Anderson.

On appeal the Supreme Court disagreed, however, readopting the Gartenberg standard that grants deference to mutual fund boards by stating investment adviser fees are excessive only if they are “so disproportionately large that they could not have been the result of arm’s-length bargaining.”

For in-house counsel working with investment advisers or mutual fund boards, the ruling provides the comfort of knowing the longstanding standard is definitely the law, experts say.

“People are comfortable with how it came down, because it essentially puts them back in the position where they were comfortable before,” Anderson says.

Circuit Showdown

The Gartenberg standard clarifies Section 36(b) of the Investment Company Act of 1940 and came out of the 2nd Circuit’s 1982 ruling in Gartenberg v. Merrill Lynch Asset Management Inc. The standard remained generally accepted for more than 25 years–until Chief Judge Easterbrook and a 7th Circuit panel threw it out on the basis that its reasoning “relies too little on markets” to control mutual fund fees.

“An adviser can’t make money from its captive fund if high fees drive investors away … A fiduciary duty differs from rate regulation,” Easterbrook wrote in that decision. “Publicly traded corporations use the same basic procedures as mutual funds: a committee of independent directors sets the top managers’ compensation. No court has held that this procedure implies judicial review for ‘reasonableness.’”

He concluded that fee challenges should only succeed in cases of insufficient disclosure or outright deception, making it far more difficult for excessive fee claims to survive summary judgment.

After the 7th Circuit declined to hear the case en banc, Judge Posner wrote a dissent blasting Easterbrook’s reasoning. Posner, who was not part of the original 7th Circuit panel that heard Jones, argued that the ruling Easterbrook authored was based “mainly on an economic analysis that is ripe for re-examination.”

With a circuit split and conflicting opinions from two of the most respected appellate judges in the country at play, no one was surprised when the Supreme Court granted the case certiorari, says John Baker, of counsel at Stradley Ronon Stevens & Young.

When it finally weighed in on Jones, a unanimous Supreme Court firmly re-established Gartenberg, adding a new layer of guidance but generally adhering to the old standard’s deference to the boards that set mutual fund fees.

Sound Process

The justices pointed to Section 36(b) of the Investment Company Act, which sets up the standard of fiduciary duty of mutual funds to shareholders. It was specifically created to prevent any government body from having ratemaking power over investment adviser fees.

By updating Gartenberg, the Supreme Court wanted to ensure that the judicial system would not be overinvolved with–or second-guess–boards that considered all the necessary and relevant factors to make their decisions.

“The Supreme Court is making clear that they are reticent to second-guess boards of trustees that are doing what they should be doing,” says Thomas Harman, a partner at Morgan, Lewis & Bockius.

The Supreme Court emphasized this deference by stating that if a mutual fund board can show it had a sound process for determining fees, courts generally should apply less scrutiny when shareholders claim excessive fees than if it is found to have a weak process.

“[I]f the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently,” Justice Samuel Alito wrote for the majority.

The board must show that it considered factors including the profitability of the fund to the adviser and the fees charged for other funds that provide similar services. A percentage of the board of directors must also be disinterested in the investment adviser and the directors must have full disclosure for their deliberations.

“They’re not new factors, necessarily,” says Grace Carter, a partner at Paul Hastings. “[The justices] specifically say Gartenberg has stood the test of time for 25 years, and it’s worked pretty well overall.”

The ruling will continue to make it very difficult for plaintiffs to make it to trial, as long as the investment advisers can defend their processes, Baker says. The consideration is in line with Gartenberg‘s deference to the board.

Cautious Comparisons

A robust process is crucial because fee disputes often arise when shareholders learn that other, allegedly similar funds charge disparate fees. The Jones plaintiffs wanted to compare their mutual fund fees to the lower fees that Harris Associates charged institutional clients.

Easterbrook wrote that although Harris Associates charged the Jones plaintiffs higher fees than investors in other funds, that doesn’t necessarily mean the Jones plaintiffs’ fees were excessive.

But the Supreme Court refused to accept a concrete rule either allowing or disallowing comparisons.

Instead, Alito wrote that comparisons between separate mutual funds, or between mutual funds and institutional funds such as pensions, can be taken into account, but courts must do so with caution and discernment.

“Even if the services provided and fees charged to an independent fund are relevant, courts should be mindful that the [Investment Company] Act does not necessarily ensure fee parity between mutual funds and institutional clients,” Alito wrote.

He continued that comparisons of fees charged by other advisers can be “problematic because these fees, like those challenged, may not be a product of negotiations conducted at arm’s length.” Only plaintiffs who show a large disparity in fees not explainable by different services–in addition to other evidence–will be able to proceed to trial.

“The opinion really emphasizes that this comparison between various factors–including fees charged by other mutual fund advisers and fees charged to institutional clients–doesn’t doom cases to trial,” Carter says.

The high court’s ruling in Jones is a positive outcome for investment advisers. To avoid heightened judicial scrutiny, mutual fund boards should continue documenting their fee-setting process in case someone challenges it, and counsel should ensure the investment adviser discloses material information to the board.

Because of the high court’s deference to boards and the fact that plaintiffs bear the burden of proof, Baker expects Jones will make it “extremely difficult” for plaintiffs to overcome the pleading phase.

That said, counsel should realize the resolution to this case maintains the status quo that has worked just fine for several decades, Anderson says. It doesn’t shake things up.

“The court is trying to say, ‘We’re readopting this standard. Don’t read into this too much. We believe there are ways to grant summary judgment,’” he says.