What Constitutes a Breach of “Fiduciary Duty”? (Jones v. Harris Associates Argument Preview)
Below, Connor Williams, a 3L at Stanford Law School, previews Jones v. Harris Associates, one of three cases to be heard by the Supreme Court on Monday, November 2. Check the Jones v. Harris Associates (08-586) SCOTUSwiki page for additional updates.
On November 2, in Jones v. Harris Associates (No. 08-586), the Court will consider the standard that should be used to determine whether fees charged by investment advisers breach the "fiduciary duty" that the advisers owe to the shareholders.
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.
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.