Last week, in Jones v. Harris Associates, No. 08-586 (U.S. Mar. 30, 2010), the U.S. Supreme Court held that fees which investment advisers charge mutual funds may not be so high that they must have resulted from undue influence. More specifically, the Jones Court held that a mutual fund shareholder, in order to show that a mutual fund investment adviser breached the “fiduciary duty with respect to the receipt of compensation for services” that is imposed by section 36(b) of the Investment Company Act of 1940, 15 U.S.C. § 80a-35(b), must prove that the fee which the investment adviser received from the mutual fund “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.”
The U.S. Supreme Court’s Jones decision is linked here.
In so holding, the Jones Court essentially adopted the standard set forth 28 years ago by the U.S. Court of Appeals for the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982). Most federal courts of appeals, as well as the Securities and Exchange Commission, had already adopted the Gartenberg standard of what fees charged by investment advisers to mutual funds are excessive.
In Jones, the U.S. Supreme Court rejected the even more stringent standard for liability set forth by the intermediate federal appellate court (the U.S. Court of Appeals for the Seventh Circuit). Under the Seventh Circuit’s mistaken standard, a mutual fund investment adviser “must make full disclosure [to the board of directors of the mutual fund] and play no tricks but is not subject to a cap on compensation.”
As the Securities Law Prof Blog observes, mutual fund shareholders may have won the battle but lost the war. According to that blog, “at least as of a few years ago, no shareholder has ever persuaded a court that mutual fund fees were excessive under the Gartenberg standard.” In other words, notes the Associated Press, in the more than quarter-century since the Second Circuit decided Gartenberg, “no fee challenge [brought by mutual fund investors against the mutual fund’s investment adviser] has prevailed at trial.” The AP does note, however, that some lawsuits by mutual fund investors alleging the funds’ investment advisers’ fees have been settled, resulting in refunds to the investors.
In sum, the U.S. Supreme Court’s Jones decision does not, as a practical matter, preclude all lawsuits by mutual funds’ shareholders alleging that the funds’ investment advisers’ compensation was excessive. However, the Jones decision confirms that mutual funds’ shareholders’ burden of proof in such lawsuits is high.
The issue of what fees charged by investment advisers to mutual funds are excessive arises frequently, because, in the Jones Court’s words, “the forces of arm’s-length bargaining do not work in the mutual fund industry in the same manner as they do in ther sectors of the American economy.” Because of the relationship between a mutual fund and its adviser, the fund often cannot, in practice, terminate its relationship with the adviser.
Typically, a separate entity called the investment adviser forms the mutual fund, which may have no workers of its own. The adviser appoints the fund’s directors, manages the fund’s investments, and provides other services.
If you or your company may wish to bring a lawsuit for violations of securities laws or if you are your company are being sued for alleged violations of securities laws, and you reside in the New York City area, call the Law Offices of David S. Rich, LLC at (212) 209-3972.