Jones v. Harris Associates

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Argued November 2, 2009.

Authorship: Connor Williams of Stanford Law School (with SCOTUSblog's Lyle Denniston covering the cert.-stage proceedings, and Howe & Russell's Kevin Russell contributing to the argument recap)

Docket: 08-586

Issue: Whether the Seventh Circuit contravened the Investment Company Act in holding that a shareholder’s claim that the fund’s investment adviser charged an excessive fee is not cognizable under Section 36(b), unless the shareholder can show that the adviser misled the fund’s directors who approved the fee.

Contents

Briefs and Documents

Oral Argument

Transcript (November 2, 2009)

Merits Briefs

Amicus Briefs

Certiorari-Stage Documents=

Oral Argument Recap

Kevin Russell of Howe & Russell wrote the following for SCOTUSblog:

When the Court granted certiorari in Jones v. Harris Associates, No. 08-586, it likely thought that it was taking the case to decide whether the size of the fees charged by investment advisors to their mutual fund clients, standing alone, could render the fee unlawful under the Investment Company Act, or whether a violation could be shown only in cases in which the mutual fund’s board was misled into approving an unusually large fee (as the Seventh Circuit had held). But by the time the case was argued this morning, it was difficult to tell whether there was any real dispute about the legal standard at all, much less how the Court is likely to resolve the case.

Section 36 of the Act imposes on fund advisors a “fiduciary duty with respect to the receipt of compensation for service.” In this case, the defendant charged a mutual fund a fee that was comparable to the industry average for mutual funds, but around double what it charged its non-mutual fund clients for what the plaintiffs alleged were similar services. The Seventh Circuit said that in the absence of any evidence that the advisor had mislead the mutual fund’s board about the facts material to its decision, the board’s approval of the fee precluded any claim that the advisor had breached its fiduciary duty. Given full disclosure, the court of appeals concluded, the market could be counted on to keep the amount of the fees reasonable.

In his opening statement to the Court this morning, plaintiffs’ counsel David Frederick asked the Court to adopt instead a two-pronged inquiry: (1) did the advisor mislead the board; and (2) in any event, was the fee “fair,” defined as comparable to the fee that would have been reached in an arms-length negotiation? (Congress enacted the Investment Company Act because investment advisors have a close relationship to their clients – ordinarily the advisor creates the fund and appoints the fund’s board of directors, which in turn, approves the fees the advisor charges the fund).

When it came time for the Solicitor General to argue, Assistant Curtis Gannon embraced essentially the same basic test, as articulated by the Second Circuit in a case called Gartenberg. As did John Donovan, counsel for Defendants, who also embraced the Gartenberg test and expressly declined to defend that test adopted by the Seventh Circuit.

Instead of arguing over the basic test, the parties argued instead over fine gradations in the articulation of the test that, in the end, appeared to come down to how extraordinary the rate must be in order to show that it is not the kind of fee an arms-length negotiation would produce. Defendants’ counsel argued for a high threshold given that the rate must be approved by disinterested members of the fund’s board. He pointed out that the statute directs courts to give “such consideration at the court considers due under the circumstances” to the fact that the mutual fund’s board approved the fee. That, he argued, indicated that Congress did not intend courts to give the equivalent of de novo review to fee agreements. Justice Scalia scoffed, finding the statutory language was “utterly meaningless.” “It tells the court,” he said, “to make its own judgment.” Nonetheless, overall, Justice Scalia seemed to have no appetite for a test that put courts in the position of setting advisor fees.

In addition to arguing about what Justice Breyer called the “tone of voice” of the Gartenberg standard, the parties disagreed about the evidentiary means for establishing that a fee is greater than would be produced in arms-length negotiations. Frederick argued that courts should compare what the advisor charges its non-mutual-fund clients, rather than looking to average fees within the mutual fund industry. He asserted that because boards of directors are selected by advisors, and boards have essentially no way to fire an advisor who asks for too much money, comparisons with the fees charged other mutual funds do not provide an appropriate benchmark. Several Justices were skeptical, seemingly having greater confidence in the ability of boards to reach disinterested decisions about fees. Justice Scalia, for example, speculated that even if a board could not directly fire an advisor, it could set the advisor’s fee so low that the advisor would quit.

Donovan, on the other hand, insisted that the comparison with non-mutual fund fees amounted to comparing apples and oranges. He argued that the district court had already applied the Gartenberg standard and found that the comparison between the defendants’ fees for the mutual fund and other clients was inapt because the defendants provide different and greater services to the mutual fund. As a result, he argued, even if the Seventh Circuit applied the wrong test, the Court should affirm the district court’s judgment in the defendants’ favor based on the record. Several Justices, including Justice Ginsburg, questioned whether that view of the record was correct, which eventually led to digging through the particulars of the petition and joint appendices.

Based on the argument, it is difficult to speculate how the case will be decided, or even what the Court will decide. There did not seem to be five votes for adopting the Seventh Circuit’s market-based approach. The Court may reject that standard and decide little else, perhaps adopting the basic Gartenberg test with some degree of explication, and sending the case back to the court of appeals for application of the test. On the other hand, the Court may decide that as the argument in this case demonstrates, the terms of Gartenberg test do not provide significant guidance on how to identify an unfairly large fee, and use the facts of this case to provide an object lesson to lower courts. If the Court goes that route, it would not be surprising to see a decision holding that a comparison with non-mutual fund rates can be appropriate when the advisor is providing comparable services to its institutional clients with a remand to have the lower courts sort out whether that is what happened in this case.

Connor Williams of Stanford Law School wrote the following for SCOTUSblog:

All three of the attorneys (representing the petitioner, the federal government, and the respondent) who took to the podium during the oral argument in Jones v. Harris Associates urged the Court to adopt the Gartenberg standard for determining whether an investment advisor had breached the fiduciary duty established by Section 36 of the Investment Company Act. They disagreed, however, on the narrower issue of how exactly the standard should be articulated to determine when fees charged to mutual fund shareholders by their advisers violate the law. Although the three advocates shared the load of hauling Gartenberg toward the finish line, members of the Court appeared to struggle to find a workable rule that would not anoint the judicial branch as the designated fee regulator.

One exchange during the argument could signal that at least two Justices were willing to look beyond the standards proposed by the parties and the United States. First, Chief Justice Roberts raised questions the proper role of the Securities and Exchange Commission (SEC) in regulating the investment fees issue. He asked Assistant to the Solicitor General Curtis Gannon whether “[i]t makes a lot more sense to have the SEC regulate rates than to have the courts do it, doesn’t it?” However, the idea of the SEC as the chief defender of mutual fund shareholders was not fully developed in the respondent’s brief, but appeared instead in an amicus brief filed by the Mutual Fund Directors Forum on behalf of the respondent. The brief (which also embraces Gartenberg) highlights guidelines that the SEC has issued within the last decade with the intent to promote the independence of board members and protect shareholders.

Gannon declined to fully concede the Chief Justice’s point. Instead, he responded that such a regime might make sense in the abstract, and he noted that the SEC does have the authority to file suit under Section 36. When asked by Justice Ginsburg whether the SEC had in fact filed any such suits, Gannon answered that none have been filed since 1980. Justice Ginsburg’s question perhaps suggests skepticism of the SEC’s interest in robustly regulating this area (and, in so doing, highlights the potential free-for-all that could ensue if the Court leaves the question of the appropriate standard for the SEC to resolve).

Justice Scalia concluded the exchange by advancing another argument found principally in the Forum’s amicus brief. After asking whether the SEC was aware of the divergence in fees that investment advisers charge to their “captive” clients versus other clients, Justice Scalia noted that the SEC has not embraced Jones’s suggestion that the fees charged to “captive” investors should be compared with those charged to independent investors. That lack of support, Justice Scalia posited, “suggests . . . that the SEC may think that this is indeed a self-contained industry and that the comparison with investment advice given to other entities is – is not a fair one.” The Forum’s brief quotes a 2004 SEC guideline that requires disclosure when a board relies on a comparison to fees paid under other investment advisory contracts, but it then notes: “[T]he amended disclosure requirements implemented by the release do not require this kind of comparison. Rather, they merely provide that, if the board in its discretion conducts the comparison, that fact must be disclosed.”

It is, of course, impossible to draw firm conclusions from this colloquy. At most, it signals the impact made by a particular amicus brief, and a reluctance by the Chief Justice and Justice Scalia to insert courts into fee determinations. At the very least, it further highlights the fact that even when both parties and the federal government outwardly agreed on the Gartenberg standard, the Court is nevertheless tasked with a difficult line-drawing exercise.

Pre-Argument Articles

Argument Preview

Background

Open-end investment companies – more commonly known as mutual funds – are often created and managed by investment advisers. Although the funds and advisers are separate entities, the overlapping nature of their relationship can create conflicts of interest. In an attempt to shield mutual fund shareholders from the dangers that can arise from these conflicts, Congress enacted the Investment Company Act of 1940 (ICA), which imposed structural safeguards on the industry. Congress amended the ICA in 1970 to provide shareholders with additional protection – including a provision, codified as 15 U.S.C. § 80a-36(b), that created a “fiduciary duty with respect to the receipt of compensation for services” for investment advisers and provided shareholders with a private right of action for a violation of that duty.

The petitioners in this case are shareholders in several mutual funds formed and advised by the respondent Harris Associates. In 2004, they filed a lawsuit against Harris Associates alleging that the company had breached its fiduciary duty to the shareholders under Section 36(b) by charging them “excessive” fees and failing to provide full and accurate disclosure to the funds’ board members and shareholders of material facts relating to compensation. Additionally, petitioners alleged violations of other structural provisions of the ICA relating to public disclosure and board independence.

Harris filed a motion for summary judgment, which the district court granted. The court relied on the Second Circuit’s 1982 decision in Gartenberg v. Merrill Lynch Asset Management, Inc., holding that a breach of fiduciary duty occurs only when an adviser “charge[s] 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.” Reasoning that the fees paid by petitioners were comparable to those paid by other mutual funds, the district court concluded that no breach of fiduciary duty for purposes of Section 36(b) had occurred.

On appeal, the Seventh Circuit – in an opinion by Chief Judge Frank Easterbrook – affirmed the district court’s decision granting summary judgment but specifically “disapprove[d] the Gartenberg approach,” which it characterized as relying “ too little on markets.” Because there was no evidence that Harris “pull[ed] the wool over the eyes” of its shareholders, the court concluded, the fees were a product of market forces, and there was no reason to engage in “[j]udicial price-setting.” By a vote of a five to five, the Seventh Circuit denied rehearing en banc. Judge Richard Posner dissented. In his view, the rejection of Gartenberg was based on “an economic analysis that is ripe for reexamination.”

Petition for Certiorari

The shareholders filed a petition for certiorari in which they made three main arguments: (1) the Seventh Circuit’s opinion conflicted with the decisions of three other circuits; (2) the decision was wrong on the merits; and (3) the proliferation and popularity of mutual funds make this an important issue for consideration. In its brief in opposition, Harris Associates countered that even if the Seventh Circuit disapproved of Gartenberg, it adopted a substantially identical standard that will lead to identical results. Further, the issue is largely academic and has been infrequently litigated, with uniform results. The Court granted certiorari on March 9, 2009.

Merits Arguments

Both petitioners and respondent grasp for the Gartenberg mantle, with each side emphasizing different phrases from the holding. Petitioners focus on the Second Circuit’s use of “arm’s-length bargaining,” while respondent argues that the court’s use of “so disproportionate” essentially created a threshold for Section 36(b) violations that shareholders here did not meet.

In their brief on the merits, petitioners argue that by adopting a “fiduciary duty” standard in 1970, Congress infused the provision with the common law significance of the term “fiduciary duty.” Drawing an analogy to the law of trusts, petitioners argue that this duty requires the investment adviser to: (1) provide full and accurate disclosure of all material facts related to the transaction; and (2) ensure that the transaction is fair to the shareholders. In petitioners’ view, Gartenberg captured this fundamental concern for fairness, but subsequent applications of the decision have improperly untethered the holding from its original meaning. In particular, courts have erroneously discounted evidence that advisers charge much higher fees to their “captive” clients (that is, shareholders – like petitioners – in mutual funds created and managed by the same advisers) than they charge to their independent investors. Moreover, when properly interpreted, the “fiduciary duty” in Section 36(b) should include not only the amount of the fees in question, but also the disclosure requirements. Thus, the Seventh Circuit decision is far afield from the common-law underpinnings of Section 36(b) because it considers the board’s approval of the fees as dispositive and ignores Congressional intent.

Harris Associates argues that under Gartenberg, a breach of “fiduciary duty” can only be triggered by a disproportionately large fee structure; moreover, in enacting Section 36(b)’s “fiduciary duty” standard, Congress in fact rejected precisely the type of “reasonableness” standard now embraced by petitioners. Other features of the ICA – such as its requirement that the plaintiff prove the breach of duty and the important role played by independent boards – reflect this balance. Harris attacks petitioners’ emphasis on the fact that lower fees are often charged to independent clients, explaining that such fee structures reflect disparate services, not market inefficiencies. Further, because the duty in Section 36(b) is explicitly tied to “the receipt of compensation,” it cannot be triggered (as petitioners contend) in cases in which the negotiation process may have been imperfect, but the resulting adviser fees were not disproportionately large. By contrast, petitioners’ interpretation of the text would result in increased litigation.

In essence, this case boils down to a fundamental disagreement over the efficacy of the mutual fund market protecting “captive” investors from exorbitant fees. The conservative members of the Court could graft Chief Judge Easterbrook’s markets-based approach onto Gartenberg, although it is worth noting that the Seventh Circuit decision was argued on September 10, 2007 – before the financial meltdown that left many investors scrambling. Additionally, the United States has filed an amicus brief supporting petitioners that specifically casts doubt on the ability of the market to regulate fees.

Grant Write-up

Joining in a major test case on the fees that investment advisers charge to mutual funds that they control, the Obama Administration on Wednesday urged the Supreme Court to put some clear limits on those fees. Such charges, U.S. Solicitor General Elena Kagan argued, should not be outside the range of what an adviser could charge based on “arm’s-length bargaining.”

The government brief was filed for the U.S. as an amicus in Jones, et al., v. Harris Associates (08-586) — a case the Justices agreed on March 9 to hear. The case will be decided in the new Term started in October.

The approach endorsed by the government for assessing fees is known as the “Gartenberg standard” after the Second Circuit Court’s 1982 ruling in Gartenberg v. Merrill Lynch Assset Management — a ruling that the Supreme Court declined to review in 1983. That standard, the Solicitor General said, “has provided useful guidance for fund boards” and is now reflected in regulations of the Securities and Exchange Commission.

The brief criticized the approach that the Seventh Circuit Court had used in the Harris Associates case. That court said that a 1970 federal law seeming to limit the fees charged for advising mutual funds controlled by the advisers only applies if the adviser misled fund directors in gaining approval for its fees.

It is not enough, Kagan contended, for the adviser to make a full disclosure to a controlled fund, without playing any “tricks.” That approach, Kagan said, is too narrow. A court hearing a challenge to an adviser’s fee must “engage in a more encompassing inquiry,” the brief said, adding that a ”disclosure-only test” would not provide an independent check on compensation that is needed under the Investment Company Act.

The government brief also said that the Circuit Court was wrong in concluding that the fees charged a controlled fund would not run afoul of the law so long as the fees are roughly the same as other funds of similar size are paying their advisers.

A factor that must be considered, according to Kagan’s argument, is whether the fees an adviser charges the funds it controls are “substantially greater than the fees” it charged to institutional clients with which it is not affiliated.

The brief expressed doubt about whether competition among mutual funds for investors was sufficient to keep advisory fees in check. Congress, in fact, has assumed “that disclosure and the presssures of the marketplace were not fully adequate to protect investors from the potential for abuse inherent in the structure of investment companies,” the brief said.

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