Fund Industry Defends Gartenberg Ruling on Advisory Fees as US Supreme Court Test Looms

With a case challenging the 1982 Gartenberg ruling involving the fiduciary duty imposed on mutual fund advisers under Section 36(b) of the Investment Company Act set for oral argument before the U.S. Supreme Court on November 2, a flurry of amicus briefs defending Gartenberg have been filed. The briefs herald a strong defense of Gartenberg as a pillar of the modern mutual fund industry. For example, the Investment Company Institute notes that, during almost three decades of experience with Gartenberg, fund directors and federal courts have found that a central part of their analysis focuses on the nature and quality of the services investors are receiving and the price that investors could be expected to pay to other advisers that manage similar mutual funds providing comparable services. Moreover, according to the brief, the Gartenberg ruling has worked its way into the fabric of SEC rulemaking.

The ICI observed that the SEC has incorporated “Gartenberg-like” factors into its regulations requiring disclosure in fund shareholder reports and proxy statements of the basis for the directors’ decision to approve the fund’s advisory contract and the adviser’s fee. The Gartenberg holding, as implemented through these SEC disclosure requirements, establishes a framework that provides directors with useful guidance about the categories of information that they should request and scrutinize when reviewing the fund’s advisory contract and has led to meaningful improvements in that review process.

The case is on appeal from a Seventh Circuit panel ruling that expressly disapproved the Gartenberg approach based on the panel’s view that a fiduciary duty differs from rate regulation. 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).

The ICI asks the Court to reject the effort to replace Gartenberg’s flexible approach with what the ICI calls a ``simplistic comparison’’ of the fees an adviser receives from a mutual fund with those received from its non-fund institutional clients. Instead, the ICI urges the Court to find that Gartenberg articulates the appropriate standard for assessing claims under Section 36(b).

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.

In an earlier amicus brief filed with the Court, 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 Investment Company Institute mounted a strong defense of Gartenberg in its brief, arguing that the proper standard for evaluating claims for a breach of fiduciary duty under Section 36(b) is the one articulated in Gartenberg. This standard has been consistently applied by the lower federal courts, said the ICI, and provides that a court should determine whether the fee received by an investment adviser 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.

The Gartenberg holding has proved useful to the federal courts and the SEC for almost 30 years, said the ICI. The Gartenberg court identified several factors to assist in determining whether a fee is so excessive as to constitute a breach of fiduciary duty, but also made clear that those factors were not exclusive, and that some might be more significant than others.

The salient point about the Gartenberg framework is that it is sensitive to context, noted the ICI, and thus allows a court hearing a Section 36(b) claim to decide which factors are most relevant to the case before it. As the courts have gained experience with Section 36(b) claims over the decades, they have generally concluded that certain factors identified in Gartenberg are more likely to be relevant than others, while not closing the door as a matter of law to considering other factors, whether listed in Gartenberg or not. The result has been the development of a remarkably stable and cohesive body of law that has provided welcome guidance, in particular, to advisers and to fund boards tasked with evaluating advisory fee proposals.

The Gartenberg standard also allows courts to weed out meritless claims before trial, said the ICI, while providing substantial protection to investors by reinforcing and clarifying boards’ obligations to review advisory fee proposals thoroughly, and by holding open the prospect of a judicial recovery should a plaintiff be able to show that the advisory fee bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining. That standard is demanding, said the ICI, and it should be, especially when the fund’s board has properly carried out its obligations of reviewing the fee proposal.

In its brief, the Mutual Fund Directors Forum said that the Second Circuit, in Gartenberg, recognized the central role of a fund’s board of directors in approving advisory contracts and adopted a standard that defers to and protects that function when exercised reasonably. The Gartenberg decision gets it right on the role of a fund’s board, said the forum.

The history of Section 36(b) reveals three predominant themes. First, Congress entrusted a fund’s board with the primary role in setting adviser compensation. Second, the SEC has strengthened the ability of fund boards to fulfill their assigned role, Third, courts reviewing section 36(b) claims have properly recognized the importance of responsible decision making. The seminal case in this regard is Gartenberg, which properly views the board’s role as central to the statutory scheme and its purposes.

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