Originally published May 22, 2008
Keywords: Mutual Funds, mutual fund fees, income interest, Oakmark, Harris Associates, Investment Company Act of 1940, section 36(b), investment adviser, Gartenberg, fee schedule
The US Court of Appeals for the Seventh Circuit and the US Supreme Court issued decisions in two important cases impacting mutual funds. In the Seventh Circuit, the court rejected the Gartenberg analysis, holding that Section 36(b) of the Investment Company Act of 1940 does not imply judicial review for reasonableness of fees charged by a fund's investment adviser. On the same day, the Supreme Court upheld a statute that allows applicable state residents to exclude from their state taxable income interest received from state-issued municipal bonds, thus preserving single state municipal bond funds.
Jones v. Harris Associates, L.P — Seventh Circuit rejects Gartenberg analysis
In Jones v. Harris Associates, L.P.,1 the Seventh Circuit affirmed the district court's decision to reject shareholders' claims that Harris Associates, the adviser to the Oakmark complex of mutual funds, charged excessive management fees under Section 36(b) of the Investment Company Act of 1940.
Section 36(b) states, in relevant part, that "the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser."2 This section grants the Securities and Exchange Commission, or the security holder, a right to bring an action against an investment adviser for excessive compensation. Section 36(b) further notes that "approval by the board of directors of such investment company of such compensation or payments . . . shall be given such consideration by the court as is deemed appropriate under all the circumstances . . . ."3
The current leading case under Section 36(b) is Gartenberg v. Merrill Lynch Asset Management, Inc.,4 in which the Second Circuit stated that the critical test under Section 36(b) is "whether the fee schedule 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."5 Further, the Gartenberg court stated that in order to violate Section 36(b), 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 arm's-length bargaining."6
The district court in Jones, following Gartenberg, concluded that Harris Associates did not violate Section 36(b) because its management fees were ordinary in comparison to the management fees charged by other advisers to funds of similar size and investment goals. In reviewing the district court's decision, the Seventh Circuit rejected the district court's concurrence with the Gartenberg analysis, but affirmed its decision on different grounds. The Seventh Circuit declined to follow Gartenberg because it believed that "[t]he existence of the fiduciary duty does not imply judicial review for reasonableness." 7 The court noted that, contrary to Gartenberg, Section 36(b) does not require that fees be reasonable under a judicially created standard; rather, the section provides that the adviser has a fiduciary duty with respect to fees it receives from investment companies or security holders. The Seventh Circuit reasoned:
|
A fiduciary duty differs from rate regulation. A
fiduciary must make full disclosure and play no tricks
but is not subject to a cap on compensation. The
trustees (and in the end investors, who vote with their
feet and dollars), rather than a judge or jury,
determine how much advisory services are
worth.8
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The existence of a fiduciary duty requires the court to be concerned with "whether the [fund board] made a voluntary choice . . . with the benefit of adequate information."9 Under Section 36(b), the adviser is compelled by its fiduciary duty to disclose all information that would be material to the trustees or the investors when considering or negotiating the fees charged. Because the management fees charged by Harris Associates were fully disclosed to the trustees and the investors, the Seventh Circuit found no violation of Section 36(b) and ruled in favor of the adviser.
Jones v. Harris Associates, L.P. further demonstrates a split among the circuit courts that have considered actions against advisers of mutual funds under Section 36(b). The Second Circuit's Gartenberg analysis, also followed by the Fourth Circuit,10 advocates a judicially-determined reasonable standard for fees charged, while the Third Circuit11 and the Seventh Circuit have concluded that the question of whether an adviser has met its fiduciary obligation under Section 36(b) is determined by whether the adviser has made full and candid disclosure regarding fees to fund boards and investors. The impact of the Seventh Circuit's approach and its rejection of the Gartenberg standard is unclear at this time.
Kentucky v. Davis — Supreme Court preserves single state municipal bond funds
On May 19, 2008, the Supreme Court issued its much anticipated decision in Kentucky v. Davis, a case reviewing the constitutionality of a Kentucky statute that exempts from state income taxes interest on bonds issued by Kentucky or its political subdivisions but not on bonds issued by other states or their subdivisions.12 The Supreme Court's decision to uphold the statute preserves a widely used state income tax exemption currently available in 41 states that allows applicable state residents to exclude from their state taxable income the interest that they receive from state-issued municipal bonds. A contrary opinion would have significantly affected the $2.6 trillion municipal bond industry, which includes a number of single state municipal bond mutual funds specifically tailored to this tax exemption.
The respondents in this case, George and Catherine Davis, originally sued the Commonwealth of Kentucky for a state income tax refund on interest they paid on out-of-state municipal bonds, arguing that the Kentucky statute violated the US Constitution's commerce clause through its differential tax treatment of municipal bond income.13 The respondents claimed that the statute violated the so-called "dormant commerce clause," which is meant to prohibit "economic protectionism" — where a state's "regulatory measures are designed to benefit in-state economic interests by burdening out-of-state competitors." 14 The Kentucky Court of Appeals agreed with the respondents' reasoning and, in 2006, reversed a lower court decision upholding the Kentucky statute.
The Supreme Court reversed, finding that the Kentucky statute's favoring of in-state municipal bonds serves a traditional government function based on legitimate objectives distinct from economic protectionism, namely the issuance of debt securities that fund public projects whose aim is to protect its citizens' health, safety and welfare.15 Under this reasoning, the Supreme Court concluded that there was no violation of the dormant commerce clause and also noted that the differential tax scheme, which is supported by all 50 states, is necessary for the continued viability of single state funds that serve smaller municipal borrowers, an important segment within the municipal bond market that serves a key operational function in "absorb[ing] [debt] securities issued by smaller or lesser known municipalities that interstate markets tend to ignore." 16
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Footnotes
1. http://www.ca7.uscourts.gov/fdocs/docs.fwx?submit=showbr&shofile=07-1624_014.pdf
2. Section 36(b) under the Investment Company Act of
1940.
3. Id.
4. Gartenberg v. Merrill Lynch Asset Management,
Inc., 694 F.2d 923 (2d Cir. 1982).
5. Jones v. Harris Associates L.P. at 5 (quoting
Gartenberg v. Merrill Lynch Asset Management, Inc. at
928).
6. Id.
7. Id. at 10.
8. Id. at 8.
9. Id.
10. See Midgal v. Rowe Price-Fleming International,
Inc., 248 F.3d 321 (4th Cir. 2001).
11. See Green v. Fund Asset Management, L.P.,
286 F.3d 682 (3d Cir. 2002).
12. http://www.law.cornell.edu/supct/html/06-666.ZS.html
Kentucky v. Davis, 553 US __ (2008).
13. Id. at 6.
14. Id. at 7 (quoting New Energy Co. of Ind.
v. Limbach, 486 U.S. 269, 273-274 (1998)). Under the
"dormant commerce clause" concept, a state's
statute may not impermissibly discriminate against interstate
commerce.
15. Id. at 11-13 (citing its earlier finding
under United Haulers Assn., Inc. v. Oneida-Herkimer Solid
Waste Management Authority, 550 U.S. __ , 7-10
(2007)).
16. Id. at 20-23.
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