SEC Defends Gartenberg Ruling in Amicus Brief Filed with Supreme Court

The SEC defended the venerable 1982 Gartenberg ruling in an amicus brief filed with the US Supreme Court in a case involving the fiduciary duty imposed on mutual fund advisers under Section 36(b) of the Investment Company Act. The case is on appeal from a Seventh Circuit panel ruling that expressly disapproved the Gartenberg approach based on its view that a fidu­ciary duty differs from rate regulation. The SEC said that the panel’s focus on whether an adviser has made full disclosure and played no tricks on the investment company’s board is inconsis­tent with the plain text of Section 36(b), the structure of the 1940 Act, and the purposes and legislative history of the statute. The court of appeals denied rehearing en banc, with five judges dissenting. The Supreme Court granted certiorari. (Jones v. Harris Associates L.P., Dkt. No. 08-586).

Section 36(b) gives mutual fund shareholders and the SEC an inde­pendent check on excessive fees by imposing a fiduciary duty on investment advisers with respect to the receipt of compensation for services. In Gartenberg v. Merrill Lynch Asset Management, Inc. (CA-2 1982), the court ruled that, in order to violate Section 36(b), the adviser must charge a fee that is so disproportionately large that it bears no relationship to the services rendered and could not have been the product of arms-length bargaining.

In this action, the Seventh Circuit panel held that an investment ad­viser’s fiduciary duty to a mutual fund is satisfied when­ever the adviser has made full disclosure and played no tricks on the board. The panel indi­cated that, so long as such disclosure occurs, the board’s approval is conclusive and Section 36(b) imposes no cap on the amount of compensation that the adviser may receive.

According to the government’s brief, the panel committed two fundamental errors in applying Section 36(b) to the record in this case. First, the court viewed the investment ad­viser’s fiduciary duty under the statute as limited to the provision of full and accurate information to the mu­tual fund’s board. Second, the court indicated that, as­suming Section 36(b) contemplates an inquiry into the substantive reasonableness of an adviser’s fee in ex­treme cases, the fees paid by comparable mutual funds provide the only suitable benchmark for evaluating the fee. Because both of those propositions are wrong, said the SEC, the judgment of the court of appeals should be vacated, and the case should be remanded for further proceedings under the appropriate legal standards.

The SEC also contended that the disclosure only stance taken by the appeals panel reflects an unduly limited view of the fiduciary duty created by Section 36(b). According to the brief, the text of Section 36(b) and complementary statutory provisions strongly indicates that a fully informed board’s approval of compensation does not guarantee against a fiduciary breach. The statute’s trust-law background, purposes, and legislative history reinforce that conclusion.

For purposes of any suit enforce the fiduciary duty, Section 36(b)(2) specifies that approval by the fund’s board of directors of such compensation must be given such consideration by the court as is deemed appropriate under all the circum­stances. Thus, the SEC reasoned that, when invest­ment advisers are alleged to have breached their fiduciary duty to the fund by receiving a particular fee, the court should consider all the circum­stances in determining whether a fiduciary breach has occurred. The panel’s approach here contradicts the statute, said the Commission, by making conclusive the presence of a single circumstance, namely that the board was apprised of all relevant information before it ap­proved the adviser’s fee. The text of Section 36(b) makes clear that Congress intended courts to engage in a fuller inquiry.

The court of appeals remarked that a lot has happened in the mutual-fund market since Section 36(b) was enacted in 1970. But, said the SEC, one thing that has not happened is any change in Section 36(b)’s statement of fiduciary duty. Congress’s imposition of that duty was largely predicated on the assumption that disclosure and the pressures of the marketplace were not fully adequate to protect investors from the potential for abuse inherent in the structure of investment companies.

Another amicus brief filed by a consortium of law professors said that, in discarding Gartenberg, the Seventh Circuit panel discarded more than a quarter-century of jurisprudence and substituted in its place an imaginative economic reinterpretation of Section 36(b) that undercuts a critical provision of the statute and at the same time creates a harmful split among the circuits. In addition, the law professors said that the Seventh Circuit’s reasoning overlooks the substantial value of the Gartenberg factors, which are: rates charged by other advisers of similar funds; the adviser’s cost in providing the service; the nature and quality of the service; the extent to which the adviser realizes economies of scale as the fund grows larger; and the volume of orders which must be processed.

In the view of the law professors, the Gartenberg factors have a healthy impact on the behavior of the fund’s trustees in their mandated annual review of the advisory contract. Gartenberg has positively stimulated procedural protection for shareholders during the renewal of investment advisory contracts. The board, with its independent counsel, systematically reviews the advisory contract through the lens of the Gartenberg factors, noted the professors.