Jones v. Harris Associates: Let the First Lawsuit Bloom

We are pleasantly surprised by the 9-0 Supreme Court decision today in Jones v. Harris Associates, 559 U.S. ___ (2010).  By vacating the 7^th Circuit opinion and remanding the case, the Court ruled in favor of mutual fund shareholders who simply wanted their day in court to argue that when a money manager (Adviser) charges double the management fees to captive mutual funds that it charges large, independent institutional investors, there might be a breach of fiduciary duty.  

Long  Journey
The plaintiffs sued Harris Associates L.P. (“Harris Associates”) back in August of  2004, claiming that Harris Associates breached its fiduciary duty under the Investment Company Act,  to fund shareholders by charging excessive fees. The district court prevented a trial from occurring when, in 2007, it granted Harris Associate’s motion for summary judgment.

In May of 2008, the 7^th Circuit affirmed this decision, but introduced a new legal standard, rejecting the long-followed approach articulated by the 2^nd Circuit in Gartenberg v. Merrill Lynch Asset Mgmt. Opting for a market-based, disclosure-oriented test, Judge Easterbrook determined that “[a] fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.” Short of “pulling the wool over the eyes” of the fund board members, the board’s approval of the fee “is conclusive.” In other words, evidence of lower fees paid to institutional clients was not considered.

In a memorable dissent to a denial of en banc rehearing, Judge Posner along with four others on the 7^th Circuit questioned Easterbrook’s departure from the Gartenberg standard and  insisted that “there is no doubt that the captive funds are indeed captive . . . [and noted that Harris had a practice of ] “charging its captive funds . . . more than twice what it charges independent” clients. For additional background, see Jones v. Harris Associates: Let 8,000 Lawsuits Bloom, Part 1 and Part 2.

Today’s Decision: “Gartenberg-Plus Ruling”

Professor William Birdthistle has deemed the unanimous decision, a  “Gartenberg-Plus Ruling.” This is an apt description. In the majority opinion, Alito first affirms the basic principles in Gartenberg. 

“[W]e conclude that Gartenberg was correct in its basic formulation of what §36(b) requires: to face liability under §36(b), an investment adviser must charge a fee that 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.” (Page 9)

 Next, however, unlike the 2^nd Circuit in Gartenberg, the Supreme Court asserted that “comparisons between the fees that an adviser charges a captive mutual fund and the fees that it charges its independent clients” are relevant.

 “Petitioners contend that such a comparison is appropriate. . .  but respondent disagrees. . . . Since the Act requires consideration of all relevant factors . . . we do not think that there can be any categorical rule regarding the comparisons of the fees charged different types of clients. . . . . Instead, 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  reiterated that reviewing courts need to give deference to the conclusions made by a mutual fund board of trustees during its annual review of management fees. However, the Court noted that a reviewing court should weigh that deference in relationship to the actual circumstance, including whether the trustees were “fully informed” and their “care and consciousness” in performing the review. A “court’s evaluation of an investment adviser’s fiduciary duty must take into account both procedure and substance.” 

 The Court explicitly rejected Easterbrook’s new test, writing, “By focusing almost entirely on the element of disclosure, the Seventh Circuit panel erred.” It also rejected his market-based approach in an industry where arm’s length bargaining is absent. 

 “By the same token, courts should not rely too heavily on comparisons with fees charged to mutual funds by other advisers. These comparisons are problematic because these fees, like those challenged, may not be the product of negotiations conducted at arm’s length. See 537 F. 3d, at 731–732 (opinion dissenting from denial of rehearing enbanc); Gartenberg, supra, at 929 (“Competition between money market funds for shareholder business does not support an inference that competition must therefore also exist between [investment advisers] for fund business. The former may be vigorous even though the latter is virtually non-existent”).” (Pages 14-15)