US Supreme Court Affirms Gartenberg Approach to Fiduciary Duty in Fund Fee Cases
The US Supreme Court has affirmed the use of the Gartenberg standards for assessing the fiduciary duty under Section 36(b) of the Investment Company Act with with regard to investment adviser compensation. The SEC had defended the venerable 1982 Gartenberg ruling in an amicus brief filed with the Court in this case, which involves the fiduciary duty imposed on mutual fund advisers under Section 36(b). The case was 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 appeals 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.
Writing for the Court, Justice Alito said that, based on §36(b)’s terms and the role that a shareholder action for breach of the investment adviser’s fiduciary duty plays in the 1940 Act’s overall structure, Gartenberg applied the correct standard. The Court also noted that a consensus has developed regarding the standard the Gartenberg court set forth over 25 years ago: The standard has been adopted by other federal courts, and SEC regulations have recognized, and formalized, "Gartenberg-like" factors.
While conceding that the Gartenberg standard may lack sharp analytical clarity, the Court said that it accurately reflects the compromise that is embodied in §36(b), and has provided a workable standard for nearly three decades.
The Court reached back to its 1939 ruling in Pepper v. Litton to find the right formulation for the phrase fiduciary duty in Section 36(b), whose essence is whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain. The Investment Company Act modifies this duty in a significant way by shifting the burden of proof from the fiduciary to the party claiming breach, to show that the fee is outside the range that arm’s-length bargaining would produce.
In the Court’s view, the Gartenberg approach fully incorporates this understanding of the fiduciary duty as set out in the Pepper ruling and reflects §36(b)'s imposition of the burden on the plaintiff. The Gartenberg approach also reflects §36(b)’s place in the statutory scheme and, in particular, its relationship to the other protections that the Act affords investors.
In recognition of the role of the disinterested directors, the 1940 Act instructs courts to give board approval of an adviser’s compensation such consideration as is deemed appropriate under all the circumstances. From this formulation, the Court drew two inferences. First, a measure of deference to a board’s judgment may be appropriate in some instances, and, second, the appropriate measure of deference varies depending on the circumstances.
In the Court's view, the Gartenberg doctrine heeds these precepts by advising that the expertise of the independent trustees of a fund, whether they are fully informed about all facts bearing on the investment adviser’s service and fee, and the extent of care and conscientiousness with which they perform their duties are important factors to be considered in deciding whether they and the investment adviser are guilty of a breach of fiduciary duty in violation of §36(b).