Financial Services Alert - April 6, 2010 April 06, 2010
In This Issue

U.S. Supreme Court Issues Decision in Harris Associates Mutual Fund Excessive Fee Case

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.

Adviser Conduct

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.” 


Harris 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.

U.S. Supreme Court Vacates Decision in Ameriprise Financial v. Gallus Mutual Fund Excessive Fee Case and Remands to Eighth Circuit for Consideration in Light of Harris Associates

Subsequent to its decision in Jones v. Harris Associates (“Harris Associates”) discussed above, the U.S. Supreme Court (the “Supreme Court” or the “Court”) addressed the Eighth Circuit decision in Ameriprise Financial v. Gallus (“Gallus”), a case also involving an excessive advisory fee claim under Section 36(b) of the Investment Company Act of 1940, as amended.  In Gallus, which was decided after the Seventh Circuit decision reviewed in Harris Associates, the Eighth Circuit applied yet another Section 36(b) standard that encompassed both the multi‑factor Gartenberg approach and the Seventh Circuit’s approach focused on adviser conduct in the contract approval process (see the April 14, 2009 Alert for a more detailed discussion of Gallus).  The Supreme Court accepted Gallus for review after agreeing to review Harris Associates.  In a summary disposition order, the Court vacated Gallus and remanded the case to the Eighth Circuit for further proceedings in accordance with Harris Associates.

Department of Labor Concludes that “Typical” Office-Based Mortgage Loan Officers are Eligible for Overtime Pay

The U.S. Department of Labor’s Wage and Hour Division recently issued an “Administrator’s Interpretation” in which it concluded that employees who perform the “typical duties of a mortgage loan officer” do not qualify as exempt from overtime eligibility under the commonly used exemption for “administrative employees.”  In reaching this conclusion, the Wage and Hour Division specifically withdrew two earlier Wage and Hour Division opinion letters in which it had concluded that mortgage loan officers could qualify as exempt from overtime eligibility as administrative employees.

The Fair Labor Standards Act (the “FLSA”) provides that employees are entitled to overtime pay at the rate of time and one-half for hours worked over 40 in a workweek unless an FLSA exemption applies.  The time and one-half calculation is applied to most forms of pay, including wages, salaries, commissions and many forms of bonuses. 

In recent years, there has been considerable litigation on a class action or “collective action” basis seeking overtime pay, including some claims by groups of mortgage loan officers.  Employers typically defend such claims by mortgage loan officers based on one or both of two FLSA exemptions – the outside sales exemption and the administrative exemption.  For the outside sales exemption to apply, a mortgage loan officer must, among other requirements, “customarily and regularly” work away from the employer’s offices and even any home office.  This requirement makes that exemption inapplicable to mortgage loan officers who do not spend a substantial portion of their work time away from both an employer office and a home office.  Employers that classify office-based mortgage loan officers as exempt from overtime pay eligibility have therefore relied on the administrative exemption.

The basic standard for application of the administrative exemption is that an employee must (1) have a base salary of at least $455 per week; and (2) have a “primary duty” of performing “office or non-manual work directly related to the management or general business operations of the employer or the employer’s customers.”  That primary duty must include “the exercise of discretion and independent judgment with respect to matters of significance.”  29 C.F.R. §541.200. 

The application of the administrative exemption to employees who sell mortgages and financial products has been hotly debated and increasingly litigated.  Until the issuance of the Administrator’s Interpretation, the Wage and Hour Division had provided considerable support for the application of the administrative exemption to such positions through opinion letters issued during the most recent Bush administration. 

The Administrator’s Interpretation expressly changes the Wage and Hour Division’s position concerning mortgage loan officers, including by specifically withdrawing two opinion letters that had found the administrative exemption applicable to certain mortgage loan officers.  In the Interpretation, the Wage and Hour Division rejected most of the arguments that employers have frequently raised to support the position that mortgage loan officers are engaged in work that is directly related to management or general business operations.  Courts are not bound by the Administrator’s Interpretation, but it is entitled to some deference by courts and may well be relied upon by courts to support the conclusion that mortgage loan officers may qualify for overtime pay.  Potential liability could be substantial.  Among other considerations, awards of overtime pay are subject to possible doubling under the FLSA’s liquidated damages provision.  The statute of limitations is at least two years and can be three years in some circumstances.  Successful plaintiffs’ lawyers can obtain awards of their attorney’s fees from the employers that they sue.  

Employers of mortgage loan officers should review their compensation practices in light of the Administrator’s Interpretation and consider modifications if they have treated office‑based mortgage loan officers as ineligible for overtime pay.

Federal District Court Dismisses ERISA Claims Relating to Securities Lending Practices

In Fishman Haygood Phelps Walmsley Willis & Swanson, LLP, et al. v. State Street Corp., et al., Case No. 09-10533 (D. Mass. Mar. 25, 2010), the U.S. District Court for the District of Massachusetts granted a motion to dismiss ERISA breach of fiduciary duty and prohibited transaction claims involving a bank’s securities lending program. 

The case involved the plaintiff law firm’s defined contribution plan (the “Plan”), which invested in collective trusts managed by the defendants.  Certain of the collective trusts participated in defendants’ securities lending program, under which the collective trust would lend securities to brokers and other borrowers.  Cash collateral provided by borrowers to secure the loans was invested through commingled cash collateral pools.  A portion of the income generated by the investments was retained by the collective trusts as compensation for lending their securities.

Certain collective trusts in which the Plan was invested participated in the securities lending program pursuant to a lending agreement that provided that the cash collateral would be invested in short-term instruments.  In a complaint filed in 2009, the plaintiff alleged that the defendants in fact invested the collateral in instruments with unusually high risk and unusually long duration, including mortgage-backed securities.  While none of the securities in the collateral pools was in default or considered impaired prior to the filing of the complaint, and the pools had adequate sources of liquidity to meet the obligations of lenders under the securities lending program, the plaintiff nonetheless alleged that the investments were imprudent and caused injury to the Plan as a result of decreases in the net asset value of the collateral pools.  The alleged negative impact on the net asset value of the collateral pools was based on mark-to-market valuation – valuing units of the pools based on current market prices of the underlying financial instruments.  However, the collateral pools at issue did not price on a mark-to-market basis, but rather used amortized cost pricing, under which the pools maintained a constant $1.00 unit price even when the net asset value of the underlying securities fell below a dollar.  As a result, investors who redeemed units of a collective trust participating in the securities lending program incurred no losses on account of the collective trust’s investment in the collateral pools, and in particular, the Plan’s transactions in the collective trusts were transacted at values per unit that reflected a constant $1.00 unit price of the collateral pools.

Defendants moved to dismiss the complaint on the ground that the claimed losses were speculative, and that without an actual injury, the plaintiff lacked standing to assert claims.  Because of the complexity of the facts, the court permitted the parties to conduct limited discovery and to submit expert reports and take expert depositions addressed to the threshold jurisdictional question – whether the Plan had incurred an injury.  Plaintiff’s expert calculated realized and unrealized losses based on collateral pool investments using mark-to market valuation.  Injury attributed by plaintiff to unrealized losses was based largely on defendants’ public filings, which reflected that the collective trusts had incurred “unrealized losses” due to “losses on longer duration instruments [in the collateral pools] stemming from a lack of liquidity in the secondary market.”  

Defendants and their expert argued, among other things, that the collateral pools’ respective net asset values had substantially recovered, that income received by the plaintiff from the securities lending program exceeded any unrealized loss, and that the hypothetical prudent alternative investment proffered by the plaintiff (a money market fund) earned lower returns than the those actually earned under the securities lending program. 

The court rejected the plaintiff’s claim that unrealized losses could form the basis for Article III standing.  The court held that, because the defendants did not value the collateral pools’ assets on a mark-to-market basis, but rather used the amortized cost method, which essentially guaranteed the withdrawal of invested funds with no loss, the plaintiff had not established any injury.  The court also credited defendants’ expert analysis that showed that the hypothetical prudent investments advanced by plaintiff would have obtained lower returns than those earned under the securities lending program.  Citing First Circuit authority defining the appropriate measure of damages in an ERISA case alleging imprudence as a comparison between investments made by a defendant and a hypothetical, prudent investor, the court agreed that the defense expert’s findings that defendants’ investment outperformed hypothetical investments in money market funds undermined any allegation of injury-in-fact.  On these grounds, the case was dismissed based on plaintiff’s lack of standing to assert claims.

Pamrapo Savings Bank Assessed $5 Million Fine for Bank Secrecy Act Violations

Pamrapo Savings Bank, SLA (the “Bank”) of Bayonne, New Jersey, consented to the assessment of a $5 million civil money penalty by the OTS for violations of the Bank Secrecy Act (the “BSA”).  The Bank also pleaded guilty in the U.S. District Court for the District of New Jersey to conspiracy to violate the BSA. 

As explained in a press release issued by the U.S. Department of Justice, the Bank, which had previously consented to a cease and desist order with the OTS in September 2008 based on anti-money laundering deficiencies, admitted that it willfully violated the BSA to avoid the costs of compliance with the law.  As a result of its ineffective compliance program, the Bank failed to file currency transaction reports (“CTRs”) and suspicious activity reports (“SARs”) related to approximately $35 million in illegal and suspicious financial transactions, including more than $5 million in structured currency transactions.  In discussing this new enforcement action, OTS Acting Director John E. Bowman cautioned that “[e]ven during an economic downturn, institutions must remain focused on complying with important laws and regulations to ensure that criminals do not use our nation’s financial system for their illicit enterprises.”

The $5 million civil money penalty assessed by the OTS will be satisfied through an asset forfeiture payment to the U.S. Justice Department.  FinCEN is also investigating the Bank’s BSA failures and may impose additional civil money penalties.

NCUA Proposes New Regulation that Would Provide FCU Directors with Clear Guidance Regarding Their Fiduciary Duties to FCU They Serve

The National Credit Union Administration (“NCUA”) issued a notice of proposed rulemaking (the “NPR”) in which the NCUA, among other things, proposed the adoption of a new NCUA regulation at 12 C.F.R. §701.4 (“§701.4”) that would set forth the duties of a federal credit union (“FCU”) director in managing the affairs of the FCU he or she serves.  As proposed, §701.4 provides that a Board of Directors of an FCU may delegate authority to carry out functions, but may not delegate the Board’s responsibility to carry out such functions.  The proposed §701.4 specifies the duties of care and loyalty of an FCU director, states that a director of an FCU must understand how to evaluate the FCU’s financials and provides guidance on when a director of an FCU may properly rely on management and other third parties.  The NCUA said that the proposed §701.4 “responds to the need to provide [FCU] directors with uniform standards.”

Proposed §701.4 states that an FCU director, among other things:

Must act in the best interests of FCU members;

  • Must carry out his or her duties in good faith, in a manner reasonably believed to be in the best interests of the membership of the FCU, and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances;
  • Must administer the affairs of the FCU fairly and impartially and without discrimination in favor of or against any particular member;
  • Is generally entitled to rely on information prepared or presented by FCU employees or consultants whom the director reasonably believes to be reliable and competent in the functions performed;
  • May not indemnify an official or employee for liability for misconduct that is grossly negligent, reckless or willful in connection with a decision that affects the fundamental rights of members;
  • Must understand the FCU’s balance sheet and income statement and ask, as appropriate, substantive questions of management and the internal and external auditors; and
  • Must direct the operations of the FCU in conformity with the requirements set forth in the Federal Credit Union Act, the NCUA’s regulations, other applicable law and sound business practices.
Comments on the NPR are due to the NCUA by May 28, 2010.