March 30, 2010

Supreme Court Decides Jones v. Harris Associates, L.P.

On March 30, the Supreme Court decided Jones v. Harris Associates, L.P., No. 08-586, holding that an investment adviser does not breach its "fiduciary duty" to a mutual fund under the Investment Company Act by charging an excessive fee unless a shareholder proves that the 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." This standard was first announced in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982) and now has been adopted by the Supreme court.

Mutual funds are established and managed by a separate entity called the fund's investment adviser. Congress enacted the Investment Company Act of 1940 to ensure the fair treatment of mutual funds and their shareholders by the funds' investment advisers. Among other matters, the Act and related rules require that a majority of a mutual fund's directors have no affiliation with the fund's investment adviser and that such directors review and annually reapprove the agreement between the fund and its investment adviser (including the adviser's compensation). The Act further imposes on advisers a "fiduciary" duty with respect to the amount of their fees and allows individual investors to sue for breach of that duty. 15 U.S.C. § 80a-35(b). Most federal courts have historically applied the Gartenberg standard to assess claims for excessive fees. The district court applied that standard in this case and granted summary judgment against an excessive-fees claim. The Seventh Circuit Court of Appeals affirmed, but it expressly disapproved the Gartenberg standard and based its holding instead on a finding that the adviser had disclosed the facts relevant to its fees to the fund's directors sufficiently to satisfy common-law trust principles.

The Supreme Court unanimously affirmed the claim's dismissal, but it rejected the Seventh Circuit's approach and instead adopted the Gartenberg standard as controlling. The Gartenberg standard, held the Court, is consistent both with the statute's language and with the limited role that shareholder suits play in regulating an adviser's fees. The "cornerstone" of the Act's regulatory approach is its requirement that a fully informed mutual fund board, including its disinterested directors, review and annually approve an investment adviser's fees. Because of the central role of the board in reviewing fees, courts should give a board's decision to approve an adviser's fees a degree of deference "commensurate" with the procedural rigor of the board's review and the degree to which it considered relevant factors. Courts may consider comparisons between the fees that an adviser charges a captive mutual fund and the fees that it charges its independent clients, but they should be wary of relying "too heavily" on inapt comparisons because the services provided may be different and the Act does not necessarily ensure fee parity. Finally, emphasized the Court, the Act does not authorize courts to second guess a board's decision or to apply the fiduciary duty requirement so as to regulate the "reasonableness" of advisers' fees.

Justice Alito delivered the opinion for a unanimous Court. Justice Thomas filed a concurring opinion.

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