Will the Court Reject a Market-Based Approach for Advisory Fees?
Below, Howe & Russell’s Kevin Russell recaps today’s argument in Jones v. Harris Associates (08-586). Check the case page at SCOTUSwiki for additional updates.
When the Court granted certiorari in Jones v. Harris Associates, No. 08-586, it likely thought that it was taking the case to decide whether the size of the fees charged by investment advisors to their mutual fund clients, standing alone, could render the fee unlawful under the Investment Company Act, or whether a violation could be shown only in cases in which the mutual fund's board was misled into approving an unusually large fee (as the Seventh Circuit had held). But by the time the case was argued this morning, it was difficult to tell whether there was any real dispute about the legal standard at all, much less how the Court is likely to resolve the case.
Section 36 of the Act imposes on fund advisors a "fiduciary duty with respect to the receipt of compensation for service." In this case, the defendant charged a mutual fund a fee that was comparable to the industry average for mutual funds, but around double what it charged its non-mutual fund clients for what the plaintiffs alleged were similar services. The Seventh Circuit said that in the absence of any evidence that the advisor had mislead the mutual fund's board about the facts material to its decision, the board's approval of the fee precluded any claim that the advisor had breached its fiduciary duty. Given full disclosure, the court of appeals concluded, the market could be counted on to keep the amount of the fees reasonable.
In his opening statement to the Court this morning, plaintiffs' counsel David Frederick asked the Court to adopt instead a two-pronged inquiry: (1) did the advisor mislead the board; and (2) in any event, was the fee "fair," defined as comparable to the fee that would have been reached in an arms-length negotiation? (Congress enacted the Investment Company Act because investment advisors have a close relationship to their clients "“ ordinarily the advisor creates the fund and appoints the fund's board of directors, which in turn, approves the fees the advisor charges the fund).
When it came time for the Solicitor General to argue, Assistant Curtis Gannon embraced essentially the same basic test, as articulated by the Second Circuit in a case called Gartenberg. As did John Donovan, counsel for Defendants, who also embraced the Gartenberg test and expressly declined to defend that test adopted by the Seventh Circuit.
Instead of arguing over the basic test, the parties argued instead over fine gradations in the articulation of the test that, in the end, appeared to come down to how extraordinary the rate must be in order to show that it is not the kind of fee an arms-length negotiation would produce. Defendants' counsel argued for a high threshold given that the rate must be approved by disinterested members of the fund's board. He pointed out that the statute directs courts to give "such consideration at the court considers due under the circumstances" to the fact that the mutual fund's board approved the fee. That, he argued, indicated that Congress did not intend courts to give the equivalent of de novo review to fee agreements. Justice Scalia scoffed, finding the statutory language was "utterly meaningless." "It tells the court," he said, "to make its own judgment." Nonetheless, overall, Justice Scalia seemed to have no appetite for a test that put courts in the position of setting advisor fees.
In addition to arguing about what Justice Breyer called the "tone of voice" of the Gartenberg standard, the parties disagreed about the evidentiary means for establishing that a fee is greater than would be produced in arms-length negotiations. Frederick argued that courts should compare what the advisor charges its non-mutual-fund clients, rather than looking to average fees within the mutual fund industry. He asserted that because boards of directors are selected by advisors, and boards have essentially no way to fire an advisor who asks for too much money, comparisons with the fees charged other mutual funds do not provide an appropriate benchmark. Several Justices were skeptical, seemingly having greater confidence in the ability of boards to reach disinterested decisions about fees. Justice Scalia, for example, speculated that even if a board could not directly fire an advisor, it could set the advisor's fee so low that the advisor would quit.
Donovan, on the other hand, insisted that the comparison with non-mutual fund fees amounted to comparing apples and oranges. He argued that the district court had already applied the Gartenberg standard and found that the comparison between the defendants' fees for the mutual fund and other clients was inapt because the defendants provide different and greater services to the mutual fund. As a result, he argued, even if the Seventh Circuit applied the wrong test, the Court should affirm the district court's judgment in the defendants’ favor based on the record. Several Justices, including Justice Ginsburg, questioned whether that view of the record was correct, which eventually led to digging through the particulars of the petition and joint appendices.
Based on the argument, it is difficult to speculate how the case will be decided, or even what the Court will decide. There did not seem to be five votes for adopting the Seventh Circuit's market-based approach. The Court may reject that standard and decide little else, perhaps adopting the basic Gartenberg test with some degree of explication, and sending the case back to the court of appeals for application of the test. On the other hand, the Court may decide that as the argument in this case demonstrates, the terms of Gartenberg test do not provide significant guidance on how to identify an unfairly large fee, and use the facts of this case to provide an object lesson to lower courts. If the Court goes that route, it would not be surprising to see a decision holding that a comparison with non-mutual fund rates can be appropriate when the advisor is providing comparable services to its institutional clients with a remand to have the lower courts sort out whether that is what happened in this case.