The U.S. Court of Appeals for the Eighth Circuit (the “Appeals Court”) reversed a decision by the District Court for the District of Minnesota (the “District Court”) in which the District Court dismissed plaintiffs’ claims in a shareholder suit brought against an investment adviser (the “Adviser”) alleging that the fees the Adviser charged 11 mutual funds (the “Funds”) violated Section 36(b) of the Investment Company Act of 1940, as amended (the “1940 Act”). The plaintiffs claimed that the Adviser violated its statutory fiduciary duty under Section 36(b) by misleading the Funds’ board (the “Board”) during the annual approval of the Funds’ advisory fees and by demanding excessive fees. Following limited discovery, the District Court granted the Adviser’s motion for summary judgment based on an analysis of the factors cited in the Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923 (2d Cir. 1982) (“Gartenberg”). Earlier in the proceedings, the District Court determined that the period for which damages in the suit would be calculated was restricted to the year preceding the date the suit was filed.
Harris Associates. As the Appeals Court noted in its opinion, the U.S. Supreme Court will review the decision in Jones v. Harris Associates, 537 F.3d 728 (7th Cir. 2008) (“Harris Associates”) (see the March 10, 2009 Alert), a Section 36(b) case that expressly rejected the Gartenberg standard. Oral argument in Harris Associates is scheduled for the October 2009 term. The Appeals Court noted that the some observers have suggested that the Supreme Court may establish a new standard of review for Section 36(b) cases.
Board Approval of the Advisory Fees. The Appeals Court noted that the Board had access to a wide variety of information during its review of the Adviser’s fees, including reports on the services provided to the Funds, the personnel providing those services, the Funds’ investment performance, comparative data from Lipper, Inc. on advisory fees charged the Funds and other funds in the industry, and the Adviser’s profits from its relationship with the Funds. The Appeals Court concluded that the Adviser and the Board focused primarily on the issue of how the Funds’ fees compared to those of their mutual fund peer group. During the approval process, the Board became aware that the fees charged the Adviser’s mutual fund clients and those charged its institutional clients differed, with the institutional clients being charged lower fees, in some cases half the fee charged Funds with similar mandates. The Board requested a report from the Adviser explaining the similarities and differences between the two types of accounts (the “Report”), which the Adviser subsequently produced.
Plaintiffs’ Arguments. The plaintiffs argued that (1) the advisory contract review was inherently flawed because it was based not on the Adviser’s costs and profits but on external factors, in particular, fee arrangements for similar mutual funds, (2) the Adviser provided comparable advisory services to its institutional clients at a substantially lower fee than it charged the Funds, and (3) the Adviser misled the Board about arrangements with institutional clients to prevent the Board from questioning the higher fees charged the Funds. The plaintiffs’ expert testified that the Report was improperly designed to make the fee discrepancy between the Funds and institutional accounts seem smaller and more justifiable than it actually was. Expert testimony for the plaintiffs also indicated that the Adviser’s services provided to the Funds were similar, if not identical, to the services provided to the Adviser’s institutional clients. Expert testimony for the Adviser, on the other hand, contended that the difference in fees was warranted by additional services provided to the Funds, such as compliance with legal and regulatory requirements, shareholder communication and more frequent Board support. The Adviser also pointed out that fee discrepancies between mutual funds and institutional accounts managed by the same investment adviser were common throughout the industry. Although the Adviser objected to the plaintiffs’ characterization of the Report as inaccurate and misleading, the Adviser’s primary argument was that the contents of the Report were irrelevant because an adviser cannot be liable for a breach of fiduciary duty under Section 36(b) as long as its fees are roughly in line with industry norms.
The Appeals Court’s Analysis. The Appeals Court indicated that the appropriate standard for decisions in Section 36(b) cases encompassed both the multi-factor Gartenberg test and the fiduciary conduct standard articulated by the Seventh Circuit in Harris Associates. The Appeals Court characterized the latter as deriving from the plain language of Section 36(b) and imposing on advisers a duty to be honest and transparent throughout the fee approval process. The Appeals Court indicated that its conclusion was consistent with Gartenberg, which it viewed as addressing only the question of whether the advisory fee itself was so high that it violated Section 36(b). The Appeals Court also noted that Gartenberg did not address, much less overrule, an earlier Section 36(b) case in the Second Circuit, Galfand v. Chestnutt, 545 F.2d 807 (2d Cir. 1976), which found a Section 36(b) violation when an adviser obtained a favorable change in a fund’s advisory fee schedule without making full disclosure to the fund’s board.
Applying these standards, the Appeals Court found that the District Court erred in holding that no Section 36(b) violation occurred simply because the fees charged the Funds satisfied the Gartenberg multi-factor test. Although the Appeals Court viewed the District Court as properly applying the Gartenberg factors to determine whether the fee itself constituted a breach of fiduciary duty, the District Court should not have rejected a comparison between the fees charged the Funds and the fees charged the Adviser’s institutional clients. The Appeals Court noted that the District Court had based its decision to reject the fee comparison on dicta in Gartenberg where the court had deemed inappropriate a comparison of the advisory fees for fundamentally different investment vehicles, in that case, money market funds and equity pension funds. The Appeals Court found that in this case, however, a comparison was not necessarily irrelevant given the greater similarity between the funds and accounts being compared, and in fact, the argument for comparing mutual fund advisory fees with fees charged to two institutional accounts was particularly strong because the investment advice may have been essentially the same for both accounts. Given the conflicting expert testimony on the accuracy and veracity of the Report and the Report’s relevance, the Appeals Court held that the District Court should have explored the disputed issues of material fact concerning the similarities and differences between the fees charged the Funds and the Adviser’s institutional accounts. Similarly, the Appeals Court found that the District Court should have determined whether the Adviser purposely “omitted, disguised, or obfuscated” information that it presented to the Board about the fee discrepancy between the Funds and the Adviser’s institutional accounts, noting that there were material questions of fact on this issue as well.
The Appeals Court cautioned that the “candid, transparent negotiation” of mutual fund fees does not require discussion of every issue that plaintiffs might find relevant and does not require that a fund adviser adopt a particular negotiation strategy with fund boards. The Appeals Court went on to say that while basing mutual fund fees on an industry median will not provide safe harbor protection from Section 36(b) liability, a negotiation strategy similar to that employed by the Adviser was not necessarily suspect, and that “an effort to meet or surpass the value offered by one’s primary competitors is a common business strategy, and there is no reason to assume it indicates bad faith.”
Statutory Damages. Relying on the plain language of Section 36(b), which provides that “[n]o award of damages shall be recoverable for any period prior to one year before the action was instituted,” the Appeals Court held that if the plaintiffs have continued to suffer damage during the litigation, both the language of the statute and the interest of judicial economy suggest that damages suffered after a plaintiff filed suit should be available in that action (and not be excluded for periods subsequent to the filing of the suit as contended by the Adviser and ruled by the District Court).
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The Appeals Court remanded the case to the District Court for further proceedings not inconsistent with the Appeals Court’s views.