Supreme Court Oral Argument in Fund Fee Case Raises Questions of Judicial Involvement in Determining Fees and Fiduciary Duty of Advisers
Supreme Court Justices questioned the efficacy of having judicial involvement in determining the fairness of the fees investment advisers charge the mutual funds they advise in oral argument in a case questioning the viability the 1982 Gartenberg ruling. Some justices also wanted to know if the fiduciary duty imposed on advisers by Section 36(b) of the Investment Company Act is the same as the fiduciary duty imposed on corporate directors and officers.
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 Second Circuit 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.
The case is on appeal from a Seventh Circuit panel ruling that expressly disapproved the Second Circuit’s Gartenberg approach based on the panel’s view that a fiduciary duty differs from rate regulation. The 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. The court of appeals denied rehearing en banc, with five judges dissenting. The Supreme Court granted certiorari. Oral argument was held November 2, 2009. (Jones v. Harris Associates L.P., Dkt. No. 08-586).
Justice Kennedy began by asking the investors’ counsel if investment advises are fiduciaries in the same sense as a corporate officers and directors are fiduciaries or do their fiduciary duties differ. The justice is essentially asking if there are different standards, depending on what kind of fiduciary you are. Counsel replied that, while the basic concept is the same, the statutory references to fiduciary duty in the 1940 Act with respect to compensation force one to focus on the fairness of the fee charged. The concept of fiduciary duty in this context goes to the fairness of the fee.
In response to Justice Kennedy’s question on whether the test for an adviser’s compensation would be the same that of a company director or any officer, counsel said that the difference is that in an advisory circumstance the indicia of an arm's-length transaction may be achieved. The directors can fire the head of a company, said counsel, but the investment adviser has appointed the members of the board. Counsel noted the earlier Daily Income Fund case, in which the Court said that the earmarks of an arm's-length transaction are absent.
Justice Stevens asked the Solicitor General why the fiduciary status of an investment adviser is different from the fiduciary status of a president of a corporation. The Government replied that it is different because "fiduciary" in the 1940 Act can mean different things in different circumstances. The chief difference here, and what Congress was intending to counteract, was the inherent structural impediment to arm's-length bargaining between the investment adviser and the board of directors.
Justice Kennedy asked the Solicitor General why Congress used the term "fiduciary" in a very special sense in the 1940 Act because, while the Justice thought a fiduciary has the highest possible duty, apparently the submission is that the investment adviser fiduciary has a lower duty, a lesser duty than to charge a reasonable fee. The Government believes that Congress used the term "fiduciary duty" in 36(b) to counterbalance the lack of arm's-length bargaining that exists between the board of directors and the investment adviser.
The Solicitor General noted that as Section 36(b) was being drafted in 1969 the SEC submitted a memo to Congress explaining that the shift from reasonableness to fiduciary duty largely achieved some procedural objectives of shifting the focus from the board of directors to the investment adviser, and the text of the statute specifically makes it a fiduciary duty with respect to receipt of compensation. The government thinks that one salutary affect of that was to clarify that the Court's burden here, the court's duty here, wasn't just to establish what the single most reasonable fee would be, but whether the bargain fell within the range of what arm's length bargaining otherwise would have achieved. To this argument, Chief Justice Roberts said that, if we are going to have regulation of what fees can be charged, it makes a lot more sense to have the SEC regulate rates than to have courts do it.
Chief Justice Roberts queried counsel for the investors whether technological changes make a difference in terms of disclosures required, noting that all you have to do is push a button and you find out exactly what the management fees are. You look it up on Morningstar and it is right there and you can make whatever determination you'd like, including to take your money out. Counsel said that an investor may know going in what the fee is, but that does not address the problem Congress was intending to address, which is that as larger and larger sums of assets were accreted to the mutual fund, the investor was not obtaining the benefits of economies of scale. The chief justice replied that, investors not getting such benefits could quickly go to another fund. It was then that counsel posited that Congress was trying to protect the company, not the individual investor. The individual investor might lessen the damages that that investor suffers, but the fund, the people remaining, continue to pay excessive fees.
Justice Sotomayor said that using the word "fair fee" is meaningless, because it has to be fair in relationship to something. She understands the Seventh Circuit to be saying that a fair fee is paying market value. Counsel replied that what the court has earlier said is that fair is what is reflective of what an arm's-length agreement would produce
Justice Sotomayor also noted that Congress did not say a reasonable fee. It did say fiduciary duty, and there is a subtle but very important difference between a reasonable fee and a fiduciary duty with respect to fees
Justice Scalia asked investors’ counsel if the fund directors could make the adviser accept a lower fee. Counsel replied that, in practical terms, they could not because the adviser picks the directors. The justice was incredulous that a disinterested board of directors, which is what the statute requires, could not cut the adviser’s fee in half. Counsel said there is no evidence in any record of where that has actually happened. The directors have no leverage.
In a later dialogue with counsel for the adviser, Justice Scalia focused on statutory language that gave courts open-ended discretion. After counsel noted that Section 36(b) instructs courts to give such consideration as they consider due to the deliberations of the board, Justice Scalia called the language "meaningless" and said that it tells courts to make their own judgment. Such consideration as the court deems due, he repeated, give it whatever consideration you feel like. It's utterly meaningless to the justice.
.