The US Court of Appeals for the Seventh Circuit (the “Seventh Circuit”) affirmed the dismissal by the US District Court for the Northern District of Illinois (Eastern Division) (the “District Court”) of an excessive fee suit brought under Section 36(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), against an adviser (the “Adviser”) of registered open-end funds (the “Funds”) by Fund shareholders. On appeal, the plaintiffs argued that the Adviser had breached the fiduciary duty with respect to compensation that it owed the Funds under Section 36(b) because the fees it charged the Funds for its advisory services were disproportionate to the value of those services, as evidenced by the fact that the Funds’ fees exceeded those charged the Adviser’s institutional clients whose accounts were being managed using similar investment strategies. The plaintiffs also argued that the District Court erred in using the multi-factor analysis for suits under Section 36(b) of the 1940 Act established by the US Court of Appeals for the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc ., 694 F2d 923 (2d Cir. 1982) (“Gartenberg”).
The District Court Decision. In granting the Adviser’s motion for summary judgment, the District Court analyzed the allegations in the complaint and the evidence adduced in their support using the Gartenberg factors, e.g., the comparability of a fund’s fees to other similar funds; the cost to the adviser to provide services to the fund; the nature and quality of the services provided, including the fund’s performance history; whether and to what extent the fund’s adviser realizes economies of scale as the fund’s assets increase; and the conduct of, expertise, and level of information possessed by the fund directors charged with approving the fee. Based on its Gartenberg analysis, the District Court determined that the evidence proffered by the plaintiffs established that others paid different amounts for similar services, but did not support a reasonable inference that the difference was enough to put the amounts charged outside of the range that could be expected to result from arms’-length bargaining.
The Seventh Circuit’s Decision. The Seventh Circuit’s opinion was written by Chief Judge Easterbrook, who, along with his Seventh Circuit colleague Judge Posner, is noted for his economics-based approach to legal analysis. The opinion places heavy emphasis on the role of market forces in controlling mutual fund advisory fees. Although it affirmed the District Court’s decision, the Seventh Circuit explicitly rejected the Gartenberg approach. The Seventh Circuit held that Section 36(b) does not establish a reasonable fee standard to be set by the judiciary, rather it imposes a fiduciary duty grounded in the law of trusts. The Seventh Circuit explained: “[a] fiduciary duty differs from rate regulation. A fiduciary must make full disclosure and play no tricks but it is not subject to a cap on compensation. The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth.” Citing examples of situations in which fiduciary duty applies to the determination of compensation, the Seventh Circuit explained that “… the rule in trust law is straightforward: [a] trustee owes an obligation of candor in negotiation, and honesty in performance, but may negotiate in his own interest and accept what the settlor or governance institution agrees to pay.” The Seventh Circuit observed that it could imagine circumstances where a fiduciary’s compensation could be so outside established norms that a court could “infer that deceit must have occurred, or that the persons responsible for decision [sic] have abdicated….” However, in this instance, the Seventh Circuit found that the plaintiffs “do not contend that [the Adviser] pulled the wool over the eyes of the disinterested trustees or otherwise hindered their ability to negotiate a favorable price for advisory services. The fees are not hidden from investors – and [the Funds’] net return has attracted new investment rather than driving investors away.”
The Seventh Circuit expressly rejected the plaintiffs’ claim that mutual fund fees must be judged against the fees charged to an adviser’s institutional clients, stating that, “[d]ifferent clients call for different commitments of time,” and describing specific differences between managing mutual funds and managing institutional accounts. In addition, in rejecting Gartenberg, the Seventh Circuit rejected the plaintiffs’ request that the court be guided in interpreting Section 36(b) by the statutory provision’s legislative history, as the Gartenberg court had been.Potential Impact of the Seventh Circuit’s Decision. The long-term implications of the Seventh Circuit’s decision are not clear. The standard set forth in Gartenberg remains the law in the Second Circuit, and has been followed by district courts in other circuits; furthermore, the Securities and Exchange Commission relied on certain factors discussed by the Gartenberg court in establishing disclosure requirements for board approval of advisory contracts. The Seventh Circuit decision does, however, establish a split in the circuit courts, thereby creating the possibility that the current plaintiffs, or future litigants in a Section 36(b) suit, may petition the U.S. Supreme Court to decide what standard properly applies under Section 36(b). (Jones v. Harris Associates, No. 07-1624 (7th Cir. 2008).)