Corporate & Securities Law

By Jim Hamilton

Law and Business Professors, Including former SEC Officials, Urge Supreme Court to Clarify Gartenberg Ruling on Advisory Fees

In a case challenging the 1982 Gartenberg ruling involving the fiduciary duty imposed on mutual fund advisers under Section 36(b) of the Investment Company, law and finance professors have urged the Supreme Court to clarify the Gartenberg factors in recognition of the significant changes that have occurred in the mutual fund industry. In their amicus brief, they ask the Court to allow lower courts to consider the fees charged by advisers of similar funds and whether competition among similarly situated funds affected the advisory fees. Fees charged by competing advisors to similar funds will generally be more probative of advisory fees? fairness than other measures, they aver. The amicus brief was submitted by, among others, former SEC Commissioner Joseph Grundfest and former SEC General Counsel Simon Lorne.

The case is on appeal from a Seventh Circuit panel ruling that expressly disapproved the Gartenberg approach based on the panel?s view that a fidu­ciary duty differs from rate regulation. The panel held that an investment ad­viser?s fiduciary duty to a mutual fund is satisfied when­ever the adviser has made full disclosure and played no tricks on the board. The panel indi­cated that, so long as such disclosure occurs, the board?s approval is conclusive and Section 36(b) imposes no cap on the amount of compensation that the adviser may receive. The court of appeals denied rehearing en banc, with five judges dissenting. The Supreme Court granted certiorari. Oral argument is set for November 2, 2009. (Jones v. Harris Associates L.P., Dkt. No. 08-586).

A core argument of the brief is that competition for mutual fund investors generally constrains advisory fees. The assertion that fund boards rarely dismiss an adviser does not mean that fees are immune from fee competition, argued amici. Rather, the structure of mutual funds allows investors to react easily to fee disparities by investing elsewhere.

Robust fee competition in the fund industry results from a number of factors, said the brief, including investor mobility and choices, low barriers to entry, numerous distribution models, widespread advisory fee reductions, and, most importantly, strong and consistent correlations between lower advisory fees and higher returns.

The brief recognizes that Gartenberg appropriately recognized that courts should consider all pertinent facts when evaluating mutual fund advisory fees under Section 36(b). However, the professor argued that, in dicta the Gartenberg court expressed skepticism regarding the existence of competition among funds and its impact on advisory fees. Gartenberg focused primarily on competition for a fund?s advisory contract and noted that funds rarely fire their advisers. In fact, contended amici, courts should focus at the investor level. Economic evidence demonstrates that investors are fee sensitive, asserted the brief, and advisers are aware of investor preferences and competition for investors constrains fees.

Amici thus urged the Supreme Court to clarify that the dicta in Gartenberg concerning the lack of competitive forces affecting advisory fees in the mutual fund industry are outdated and not binding. In particular, the Court should specify that lower courts should be permitted to consider two sets of facts relating to competition and advisory fees under Section 36(b): (1) evidence of competition for investors by funds similar to the type of fund at issue; and (2) evidence of the extent to which such competition constrains the fees charged by the adviser and approved by the fund?s directors, and whether that competition is likely to produce fees similar to those generated by arm?s-length bargaining.

According to the brief, Gartenberg relies on a 1966 SEC report concluding that cost reductions in the form of lower advisory fees do not figure significantly in the battle for investor favor. Amici argued that the observations in the 1966 report do not accurately characterize today?s fund industry, where competitiveness constrains the amount of advisory fees that a fund adviser can charge. Thus, said amici, the statutory scheme and the evidence about competition in the mutual fund industry demonstrate that consideration of competitive fees is relevant to the evaluation performed by independent directors, in the first instance, and by a court, in the event of a fee challenge.

Full post as published by Jim Hamilton's World of Securities Regulation on September 20, 2009 (boomark / email).