Capital Markets

Supreme Court Rules on Investment Adviser Fees

The high court reaches back 70 years to reject two lower court rulings on investment adviser compensation.
Robert WillensApril 19, 2010

The Investment Company Act of 1940 (ICA) regulates investment companies, including mutual funds. In that context, an “investment adviser,” in most cases, will create a mutual fund, select the fund’s directors, manage the fund’s investments, and perform other services for the fund.

The ICA created an array of protections for mutual-fund shareholders, two being that no more than 60% of a fund’s directors may be “interested persons,” and that as per Section 36b, a fiduciary duty is imposed upon investment advisers with respect to compensation received from a mutual fund.

The issue of investment adviser fees came to a head in March, when the Supreme Court handed down an opinion in Jones v. Harris Associates, L.P., _US_ (2010). In the case, the petitioners were shareholders in mutual funds managed by Harris Associates LP, an investment adviser. The petitioners filed the action pursuant to Section 36b of the ICA, and their complaint alleged that Harris had violated that section by charging fees “that were disproportionate to the services rendered and not within the range of what would have been negotiated at arms-length in light of all the surrounding circumstances.”

The United District Court for the Northern District of Illinois granted summary judgment for Harris, and the Seventh Circuit Court of Appeals affirmed the lower court’s decision. The Seventh Circuit reasoned that “a fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.” In the Seventh Circuit’s view, the amount of compensation would be relevant only if the compensation were so unusual as to give rise to an inference that deceit must have occurred or that the persons responsible for the decision had abdicated. However, the Supreme Court rejected the standard adopted by the Seventh Circuit, vacated its decision, and remanded the case for further proceedings consistent with the Supreme Court’s approach to the issue.

WillensFinal“[The Second Circuit Court of Appeals pointed out that] to be guilty of a violation…the adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered….” — Robert Willens

Arm’s-Length Standard Affirmed
In Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F. 2d 923 (2nd Cir. 1982), the Second Circuit Court of Appeals noted that Congress had not explicitly defined what is meant by a “fiduciary duty” with respect to compensation, but concluded that the test is whether the fee structure represents a charge within the range of what would have been negotiated at arm’s length in the light of all of the surrounding circumstances. Thus, in the Second Circuit’s view, “to be guilty of a violation of Section 36b…the 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 arms-length bargaining.

The Supreme Court concluded that Gartenberg was correct in its basic formulation of what Section 36 requires. Indeed, more than 70 years ago, the Supreme Court discussed the meaning of the concept of fiduciary duty in Pepper v. Litton, 308 US 295 (1939). In that case, it noted “…the essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arms-length bargain….” The Court believed that this formulation best expresses the meaning of “fiduciary duty” in Section 36b.

By focusing almost entirely on the element of disclosure, the Seventh Circuit erred. The Gartenberg standard, which the Seventh Circuit rejected, may lack “sharp analytical clarity,” but, nonetheless, the Supreme Court believed it accurately reflects the compromise that is embodied in Section 36b, and it has provided a workable standard for nearly three decades.

Accordingly, the Gartenberg conception of fiduciary duty, as that term is used in Section 36b, was upheld, and the Seventh Circuit, on remand, will be constrained to apply the principles of Gartenberg in reaching its decision.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for