The U.S. Supreme Court (the “Supreme Court” or the “Court”) issued its much awaited decision in Jones v. Harris Associates (“Harris Associates”), a decision that vacates and remands a Seventh Circuit decision in an excessive fee suit under Section 36(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), 527 F.3d 627 (7th Cir. 2008). (For background on this case in the lower courts, see the March 10, 2009 and June 3, 2008 Alerts.) In broad terms, Harris Associates unanimously endorses the multi‑factor approach to Section 36(b) established by the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982)(“Gartenberg”) and rejects the Seventh Circuit’s approach to Section 36(b), which focused almost exclusively on an adviser’s disclosures to the directors of a registered investment company (a “fund”) in connection with the directors’ approval of the fund’s advisory contract. (Under Section 36(b), an investment adviser to a fund is deemed to have a fiduciary duty with respect to its receipt of compensation for services from the fund. Section 36(b) gives fund shareholders a private right of action against the investment adviser for any breach of that fiduciary duty.)
Section 36(b) Standard for Adviser Compensation
In Harris Associates, the Supreme Court concluded, consistent with the approach articulated in Gartenberg, that plaintiffs making a Section 36(b) claim must demonstrate that the fee charged by the investment adviser is so disproportionately large that it bears no reasonable relationship to the services rendered by the investment adviser and could not have been a product of arm’s length bargaining, taking into account all relevant factors and circumstances. The Court further stated that Section 36(b) does not permit a court to review a fund’s advisory fee for reasonableness.
Role of Independent Directors
The Court’s opinion emphasizes the significant role played by a fund’s independent directors (those who are not “interested persons” of the fund under the 1940 Act) in approving a fund’s advisory fee and the deference that courts should give a fund board’s decision in conducting a Section 36(b) analysis:
Where a board’s process for negotiating and reviewing investment-adviser compensation is robust, a reviewing court should afford commensurate deference to the outcome of the bargaining process. Thus, if the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently. This is not to deny that a fee may be excessive even if it was negotiated by a board in possession of all relevant information, but such a determination must be based on evidence that the fee “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.” [citations omitted]
The Court further observed that the standard for fiduciary breach under Section 36(b) does not call for “judicial second-guessing of informed board decisions” or suggest that a court may “supplant the judgment of [independent] directors apprised of all relevant information, without additional evidence that the fee exceeds the arm’s-length range.”
Fee Comparisons with an Adviser’s Non-Fund Clients and with Comparable Unaffiliated Funds
In Harris Associates, the Supreme Court maintained that Section 36(b) requires an analysis of all relevant factors (as provided in Gartenberg). The Court nevertheless singled out two factors that were in particular controversy in the lower court decisions in this case -- comparisons between (a) the fee charged the fund in question and (b)(i) the advisory fees charged by the fund’s adviser to its other clients receiving similar investment advice and (ii) the advisory fees charged by other advisers to comparable funds.
As to fee comparisons with an adviser’s other clients, the Court expressly refused to state a categorical rule but allowed that courts may “give such comparisons the weight that they merit in light of the similarities and differences between the services that the clients in question require.” The Court cautioned that courts should be wary of “inapt comparisons” because of the possibility of significant differences between the services provided to different types of clients, and observed that even where comparisons with an adviser’s other clients were relevant, the 1940 Act does not guarantee fee parity for funds. Harris Associates also cautions against (but does not dismiss) reliance on fee comparisons with similar funds sponsored by other advisers, citing the concern first expressed in Gartenberg that the fees charged similar funds may not be the product of arm’s length bargaining.
In the decision reviewed by the Court, the Seventh Circuit expressly rejected the Gartenberg approach and limited a court’s analysis under Section 36(b) almost entirely to the question of whether an adviser had met the disclosure obligations under the fiduciary principles applicable to a trustee negotiating its compensation. In contrast, the Supreme Court held that an adviser’s compliance with its disclosure obligations in connection with the advisory fee approval process is only a factor that must be considered “in calibrating the degree of deference that is due a board’s decision to approve an adviser’s fees.”
ConclusionsHarris Associates does not materially alter the process for advisory contract approval followed by fund boards and advisers that have been sensitive to and, as applicable, complied with (a) the requirements of Section 15(c) of the 1940 Act under which a fund board must request, and a fund’s adviser, must provide information reasonably necessary to evaluate a fund’s advisory contract, (b) the multi-factor approach to advisory contract consideration and approval set forth in Gartenberg and the many cases that have followed it and (c) the registration statement disclosure requirements regarding advisory contract approval disclosure adopted by the SEC. The Court’s decision nevertheless highlights the importance of ensuring not only the quality of a board’s deliberations (including the information provided to the board to support those deliberations), but also the creation of an appropriate record of the approval that will enable a court applying Harris Associates to accord the board’s decision substantial deference.