Supreme Court Upholds Arm’s Length Standard for Setting Fees for Mutual Fund


Our Chicago business law lawyers were very interested in a recent Supreme Court decision upholding an established standard for determining when a mutual fund’s investment advisor has breached his or her fiduciary duty to shareholders. In Jones et al. v. Harris Associates L.P., No. 08-586 (March 30, 2010), three shareholders in the Oakmark family of mutual funds sued the funds’ investment manager, Harris Associates. They alleged that Harris charged the Oakmark funds twice as much as it did other funds, but did the same work. The situation was not challenged by the funds’ board members because they were all appointed by Harris Associates, the shareholders claimed. As a result, they said, the Oakmark funds paid $37 million to $58 million more than other funds for the services of Harris Associates in just one year.

Mutual funds typically use outside investment advisors to manage all of their affairs, including picking board members. Because this creates the potential for abuse, Congress enacted the Investment Company Act of 1940 to protect mutual fund shareholders. Among other things, that act creates a fiduciary duty for investment advisors with respect to their compensation, and allows shareholders to sue if that duty was breached. The plaintiff shareholders in this case sued Harris Associates in Chicago federal court for a breach of that fiduciary duty, alleging that it charged fees disproportionate to the services rendered and that were not equivalent to fees negotiated at arm’s length. Harris Associates successfully moved for summary judgment. The trial court, applying the standard laid down in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F. 2d 923 (CA2 1982), held that there was no evidence that the fees were outside a range that could have been produced by arm’s length negotiations.

Plaintiffs appealed to the Seventh Circuit, where their claim still failed, but for different reasons. The Seventh rejected the Gartenberg standard, saying it relied too little on markets. Instead, the panel applied a standard from trust law, saying a trustee is free to negotiate any compensation that the trust is willing to pay. Similarly, a fiduciary’s compensation need not be limited by an arbitrary cap, the panel wrote. It suggested that market forces would help keep fees reasonable and noted that comparing fees for other Harris Associates clients is unfair because different clients require different amounts of work. An investment advisor’s compensation would only be subject to interference, the Seventh wrote, if the amount was so out of the ordinary that observers might think “that deceit must have occurred, or that the persons responsible for decision have abdicated.”
After the Seventh denied an en banc rehearing, with a dissent by Judge Posner, the Supreme Court took up the case to resolve a split in the circuits over the standards used to judge breaches of the Investment Company Act. In its unanimous opinion, the court found that Gartenberg was indeed the correct standard, reversing the Seventh Circuit. That standard has been adopted by other federal appeals courts, the high court noted, as well as by the SEC. The opinion, authored by Justice Alito, quoted at length from the Second Circuit’s decision in Gartenberg, which among other things said that “[t]o be guilty of a violation of [the Act], … the adviser-manager must charge 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 approach is consistent with other protections in the Act and the Act’s role in federal regulations.

The Seventh Circuit erred by focusing almost entirely on full disclosure to determine a breach of fiduciary duty, the Supreme Court wrote. Courts should take a more nuanced look, giving deference to well-informed, independent board decisions and avoiding over-reliance on market comparisons. Thus, the court vacated the Seventh Circuit’s decision and sent the case back to trial court.

The Joilet, Ill. shareholder litigation attorneys at Lubin Austermuehle are pleased to have been named to Illinois Super Lawyers. We frequently handle litigation, arbitration and other legal disputes for Illinois businesses and investors. Our clients include parties of all sizes, including individual shareholders as well as businesses, public or private, from small concerns to major Fortune 500 corporations. In addition to breach of fiduciary duty claims brought under specific statutes, our Chicago business dispute lawyers also litigate common-law breach of fiduciary duty, breach of contract, fraud and other claims that commonly arise when business agreements go sour. Our goal is always to meet our clients’ goals with a minimum of time and expense.

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