Guest Columnist: Daniel A. Pollack is a partner at McCarter & English, New York City ; Mr. Pollack argued several of the cases mentioned in this article in the Supreme Court, including Burks v.Lasker and Daily Income Fund v. Fox.
The mutual fund industry can now exhale: it has found a "new best friend" in Justice Samuel Alito and the Supreme Court. After months of uncertainty and anxiety in the industry over the possible outcome of Jones v. Harris Associates, the Supreme Court last week issued a 17-page Opinion, re-affirming 30 years of unbroken precedent on how courts are to judge whether advisory fees are excessive. Gartenberg, long the standard in this area, was solidly endorsed by Justice Alito, writing for a unanimous Court, with Justice Clarence Thomas concurring.
In its Opinion, the Supreme Court implicitly rejects (without naming them) the dueling theorists at the opposite ends of the spectrum: Freeman and Brown on the left; Hubbard and Coates on the right.
Freeman and Brown, in an obscure law review article, provided the "intellectual" underpinnings of the plaintiffs bar's attack on Gartenberg and on the several cases tried to judgment after Gartenberg. These include cases brought against T. Rowe Price, OppenheimerFunds, Franklin Templeton, Merrill Lynch and American Funds. Freeman and Brown argued that mutual funds cannot, without a breach of Section 36 (b) of the Act, be charged more than the fee charged to institutional clients. Hubbard and Coates contended, to the contrary, that in view of the industry's competitive nature, there cannot, as a matter of economic theory, be excessive fees since those charging excessive fees would be driven out of business by those charging fair fees .
Both positions, each rooted in economic theory, were shunted aside by the Supreme Court. The justices stayed solidly within the bounds of Gartenberg and the case law post-Gartenberg.
Jones came to the Supreme Court from the Seventh Circuit in Chicago, where two judges of powerful intellect and views, Judges Frank Easterbrook and Richard Posner, had squared off against each other, both challenging the validity and utility of Gartenberg for different reasons.
But the Supreme Court declined to get involved in the internecine warfare going on in the Seventh Circuit. In the pithy ending to his Opinion, Justice Alito wrote:
"The Gartenberg standard, which the panel [Seventh Circuit] rejected, may lack sharp analytical clarity, but we believe that it accurately reflects the compromise that is embodied in Section 36 (b), and it has provided a workable standard for nearly three decades. The debate between the Seventh Circuit panel [Easterbrook] and the dissent [Posner] ... regarding today's mutual fund market is a matter for Congress, not the courts."
Just how did Justice Alito reach his conclusion upholding Gartenberg? The Opinion relies heavily and repeatedly on two seminal mutual fund cases: Burks v Lasker (1979) and Daily Income Fund v Fox (1984), and on Pepper v Litton (1939),
a bankruptcy case. The latter case defines the nature of the term "fiduciary duty".
Burks was the intellectual underpinning of Gartenberg and is, to this day, along with Gartenberg, the single most cited case in mutual fund law on the structure and governance of mutual funds. In Burks, Justice William J. Brennan, writing for a unanimous Court, held that it is the independent directors of a mutual fund, not the shareholders, who have the power to determine the course of conduct to be followed by the fund. Justice Brennan wrote the now-famous sentence, quoted by Justice Alito in Jones:
"It would have been paradoxical for Congress to have been willing to rely largely upon [boards of directors] as 'watchdogs' to protect shareholder interests and yet, where the 'watchdogs' have done precisely that, require that they be totally muzzled."
In Daily Income Fund, the Supreme Court recognized that lawsuits by mutual fund shareholders were different from all other derivative lawsuits. This is because in such cases shareholders were given a direct right by Congress to sue, on behalf of the Fund, for excessive fees. Thus, in Jones, Justice Alito recognizes that Congress intended these two methodologies -- directorial oversight and shareholder litigation -- to co-exist and re-enforce one another as checks on excessive fees.
There, however, the parallel tracks diverge in Jones. In a series of observations not truly essential to the holding in Jones, Justice Alito goes on to discuss and opine on some of the very nettlesome issues that have arisen in post-2000 mutual fund litigation.
First, Justice Alito takes up the question of "comparisons between the fees that an adviser charges a captive mutual fund and the fees that it charges its independent clients." To some degree, Justice Alito bumps this currently hot topic down to the trial courts and says, "You decide." Thus, he wrote:
"Since the Act requires consideration of all relevant factors, we do not think that there can be a categorical rule regarding the comparisons of the fees charged (to) different types of clients."
Justice Alito goes on to say that such comparisons should be given such weight as "they merit in light of the similarities and differences between the services that the clients in question require, but courts must be wary of inapt comparisons." Score one for the industry on the tag-line qualification! Then, in an exceptionally important and sure-to-be-oft quoted footnote, Justice Alito essentially undermines the plaintiffs bar's counter-argument by writing:
"Only where plaintiffs have shown a large disparity in fees that cannot be explained by the different services, in addition to other evidence that the fee is outside the arm's-length range, will trial be appropriate."
One can hear the cheers rising from law office conference rooms and mutual fund board rooms across the country!
Second, Justice Alito takes up the relationship between procedure and substance in board deliberations. That said, Justice Alito cites with approval Migdal v. Rowe-Price Fleming for the proposition that "Section 36 (b) is sharply focused on the question of whether the fees themselves were excessive." Thus, even with deficient process, if the fees themselves are fair, there will be no breach of Section 36 (b).
In summing up, Justice Alito reminds all concerned that:
"It is important to note that the standard for fiduciary breach under Section 36 (b) does not call for judicial second-guessing of informed board decisions."
Remaining unanswered, perhaps to be decided another day, is the $64 question: How is the trial court to reconcile the matter if some Gartenberg factors are met, but not others? This remains the big future challenge for directors, counsel and judges.
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