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CCH® PENSION — 04/26/10

Supreme Court allows for limited court review of investment adviser fees

The United States Supreme Court in Jones v. Harris Associates has affirmed a long-standing standard, pursuant to which investment adviser fees will not constitute a breach of fiduciary duty under the Investment Company Act of 1940, if they are not so disproportionately large as not to have been the result of arm's length bargaining. The decision does not invite courts to engage in a free-ranging fairness review, but does modify the applicable standard by allowing reviewing courts to engage a comparative analysis of the varying fees that may be charged by investment advisers to captive mutual funds and independent, institutional clients.

Captive mutual fund charged higher fees

Participants in three separate mutual funds managed by an investment adviser filed suit, under Sec. 36(b) of the Investment Company Act of 1940, alleging that the investment adviser had charged fees that were disproportionate to the services rendered and not within the range of what would have been negotiated at arm's length in light of all surrounding circumstances. The investment adviser had established the mutual funds and selected the board of directors which negotiated its fees. The participants in these "captive" mutual funds established by the investment adviser specifically alleged that they were subject to fees that were double the fees the investment adviser assessed other institutional clients, such as pension funds, that were not related to the adviser.

Arm's-length standard of review

The trial court applied the standard adopted in 1982 by the Second Circuit Court of Appeals in Gartenberg v. Merrill Lynch Asset Management and issued summary judgment to the investment adviser, concluding that the participant had failed to raise a triable issue of fact as to whether the fee charges were so disproportionately large as to not have been the result of arm's length bargaining.

Seventh Circuit focus on disclosure and not fee comparison

The Seventh Circuit affirmed the trial court's ruling, but rejected the Gartenberg test, dismissing the need for a comparative fee analysis or any cap on compensation. Noting that a fiduciary must fully disclose fees, the Seventh Circuit explained that the fiduciary requirements under the Investment Company Act do not invite rate regulation, other than to ensure compensation is not "so unusual" as to give rise to an inference that "deceit must have occurred, or that the persons responsible for the decision have abdicated their duty."

Supreme Court affirms and modifies Gartenberg test

The Supreme Court affirmed the validity of the Gartenberg standard, holding that an investment adviser would be liable under Sec. 36(b) of the Investment Company Act for breach of fiduciary duty if it charged a fee that is "so disproportionately large that it has no reasonable relationship to the services rendered and could not have been the product of arm's length bargaining." Thus, mere disclosure of fees is not sufficient to satisfy Investment Company Act Sec. 36(b), and the fee assessment may be subject to review if the party alleging the breach can prove that the fee is outside the acceptable range.

The centerpiece of the mutual fund investors' complaint was on the disproportionately higher fees assessed by the investment adviser to the captive mutual funds than to its independent, institutional clients. The Second Circuit, in Gartenberg, rejected the necessity of a comparison between the fees charged by the adviser to a money market fund and a pension fund. The Supreme Court articulated a middle approach, stating that in reviewing fees, courts may give fee comparisons the "weight they merit in light of the similarities and differences between the services that the clients in question require." However, reviewing courts are cautioned to be "wary of inapt comparisons." Thus, if the services rendered by the investment adviser to different clients vary to the degree the comparison is not probative, the comparison must be rejected by the court in applying Sec. 36(b). Moreover, the Court cautioned that even if a comparison of fees was relevant, the Investment Company Act does not proscribe fee disparities and does not require fee parity between mutual funds and institutional clients.

In reviewing a fee assessment that has been negotiated and approved by a mutual fund board, the Court indicated that the deference due the decision should be commensurate to the robustness of the board's negotiation and review processes. Circumstances that would warrant closer review (and less deference) would involve conflicts of interest between the directors and the investment adviser and the failure of the investment adviser to disclose material information to the board that would hamper the board's ability to act as an independent check on management.

Thus, under the standard expressed by the Court, a fee may be determined to be excessive, even if negotiated and approved by the board, but only if evidence establishes that the fee is so disproportionately large that it bears no relationship to the services rendered and could not have been the product of arm's length bargaining. In remanding the case back to the Seventh Circuit, the Supreme Court stressed that the reviewing court is not empowered to "second guess" informed decisions by a disinterested board of directors or required to engage in a precise calculation of fees representative of the arm's length bargaining.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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