Voting with their feet and dollars: the role of investors and the influence of the mutual fund market in regulating fees.

AuthorLeist, Anna C.

TABLE OF CONTENTS INTRODUCTION I. BACKGROUND A. Section 36(b) and the Gartenberg Precedent B. The Jones Standard and Creation of a Circuit Split II. POLICY ARGUMENTS AGAINST THE GARTENBERG STANDARD A. Section 36(b) Does Not Provide a Legally Sufficient Basis for a Reasonableness Standard B. Competition in the Mutual Fund Industry C. Fees Are Best Regulated by the Market (Not a Court) III. SUFFICIENCY OF THE FIDUCIARY DUTY A. The Fiduciary Duty Trumps a Reasonableness Standard in Providing Guidance to Advisers in Setting Fees B. The Interplay Between Advisers' Fiduciary Duty and Independent Directors" Role in Approving Fees IV. SUGGESTIONS FOR REFORM RELATED TO MANAGEMENT FEES A. A Review of Reform Proposals B. A Proposal Best Suited to Jones: Disclosure of Dollar Amount Fees Paid by Individual Investors CONCLUSION INTRODUCTION

Investors can and do "vote with their feet and dollars," Chief Judge Easterbrook argued in Jones v. Harris Associates L.P. (1) In the May 19, 2008 decision, the Seventh Circuit rejected the widely used Gartenberg standard, which has stood for over twenty-five years as a tool for courts to assess mutual fund advisory fees under section 36(b) of the Investment Company Act of 1940 (the 1940 Act). (2) The Gartenberg standard, originating from the 1982 Second Circuit case Gartenberg v. Merrill Lynch Asset Management, Inc., (3) promotes judicial intervention in fee setting through essentially establishing the precedent that a "reasonableness" standard be applied to section 36(b) cases. (4) On the contrary, as the Seventh Circuit held in Jones, so long as advisers "make full disclosure and play no tricks" in order to meet their fiduciary duties under section 36(b), investor decisions and market forces are better suited to regulate fees in the mutual fund industry, an arena in which a court is ill-suited to interfere. (5)

This Note urges that the Supreme Court adopt the new standard advanced by the Jones decision. (6) This deferential standard is most reflective of the functioning of the current mutual fund industry, and this Note will demonstrate why that is so. The Jones standard provides a solid framework for courts' interactions with the mutual fund industry in taking on section 36(b) litigation. This Note further argues that the standard created in Jones might be improved upon, and new, inexperienced investors might be better protected through inclusion in investor account statements of enhanced disclosure in the form of dollar-amount fees paid by the individual investors.

Chief Judge Easterbrook's argument in Jones rested on the notion that investors will "vote with their feet," meaning that informed investors will choose advisers based upon fees and return on investment. (7) This voting already occurs through the efforts of experienced investors, who by their decisions create sufficient competition, guiding more inexperienced investors. (8) Additionally, this voting might be encouraged among new and less experienced investors through requiring the additional disclosure mentioned above, which would allow investors to evaluate actual returns against the fees they have paid in a given fund. Thus, investors would be further empowered to "hire" and "fire" advisers. (9) Having access to this information as well as fee information on comparable funds would equip most mutual fund shareholders to make educated decisions on investments and would directly encourage competition in an industry that consists of nearly 9,000 mutual funds to date. (10)

Part I of this Note reviews the judicial and legislative history of section 36(b). It focuses upon the interpretation and reasoning in the Gartenberg and Jones cases and the importance of resolving the circuit split that Jones created. Part II enumerates policy arguments against the Gartenberg standard. It analyzes competition in the mutual fund industry and concludes that enough competition exists to regulate fees through market forces. Part III considers the meaning and sufficiency of the fiduciary duty created under section 36(b) in guiding advisers in the setting of fees and looks at the interplay between this duty and the fiduciary duties of the independent directors on mutual fund boards. Finally, Part IV weighs the various suggestions for reform in the industry as they relate to fees and concludes that, although the Supreme Court should adopt the standard set in Jones, further reform in the way of mandating enhanced disclosure to investors would promote even more competition by educating the average investor.

  1. BACKGROUND

    1. Section 36(b) and the Gartenberg Precedent

      Section 36(b), enacted by Congress in 1970, provides that an investment adviser is charged with a fiduciary duty with respect to the receipt of compensation for services provided to a mutual fund, and that a private right of action, or suit by the Securities and Exchange Commission (SEC), will exist for breach of that duty. (11) This section of the 1940 Act, as enacted, was not the first attempt to impose such regulations on advisers. (12) The first Senate bill, rejected by the House of Representatives in 1968, included a statutory requirement of "reasonableness" rather

      than the later adopted fiduciary duty. (13) The Senate report issued with the enacted version of section 36(b) noted an "adequate basis" for this change, finding the fiduciary duty requirement to be more appropriate in regulating advisers. (14)

      At the time, Congress believed that insufficient competition existed in the mutual fund industry. (15) Without competition, it was thought, little incentive existed for mutual fund companies and advisers to negotiate a fair fee; therefore, it would be necessary for courts to closely scrutinize advisers for unfair dealing. (16) The drafters of section 36(b) created adviser responsibility through imposition of a fiduciary duty, which was aimed to encourage bargaining and accountability for the adviser's fee. (17) One commentator noted, "The enactment of section 36(b) reveals a policy decision to transform the very nature of the investment advisory agreement from a mere contractual interaction between the adviser and the fund into a fiduciary relationship." (18)

      Between the time of the enactment of section 36(5) and the issuance of the Jones decision, there were no plaintiff victories in mutual fund fee litigation; however, many eases tested the statutory requirement. (19) Gartenberg was considered the seminal ease and long held sway over most circuit court decisions. (20) In Gartenberg, shareholders of the Merrill Lynch Ready Assets Trust, a large money market fund, (21) claimed that fees "were so disproportionately large as to constitute a breach of fiduciary duty in violation of [section] 36(b)." (22) These shareholders advocated use of a "reasonableness" standard to evaluate advisers' adherence to their fiduciary duty. (23) This argument was supported through reference to the unclear legislative history of section 36(b). (24)

      The court in Gartenberg, although denying a shareholder victory and dismissing the shareholders' argument, adopted a standard that nevertheless appeared to support the shareholders' reasoning. Gartenberg provided that the test for section 36(b) litigation is "essentially 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." (25) The court determined, however, that arm's-length bargaining did not occur in the mutual fund industry. (26) Upon this consideration, the court modified the final test to state that "[t]o be guilty of a violation of [section] 36(b) ... the adviser-manager 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." (27)

      This phrasing would seem to imply: (1) that competition does not exist between advisers so that arm's-length bargaining cannot actually occur; (28) and (2) that a range of reasonableness, between the fee charged and services rendered, must be established by courts so that those fees which are "disproportionately large" (29) may be targeted in section 36(b) litigation. Based on this understanding of the market, the court discouraged reliance upon comparisons to similar funds in assessing the reasonableness of a fee. (30)

      Two theories might explain the lack of plaintiff victories under Gartenberg precedent: (1) courts have been deferential to the independent directors of mutual funds who approve advisory fees; and (2) despite Gartenber's teachings, competition and investor decision making have become sufficient to regulate fees, the result being that there have not been any legitimate excessive fee cases brought to trial. Both inferences are likely correct. In general, courts have deferred to the judgment of mutual fund boards in the absence of deceit by the adviser. (31) Sections 36(b), 15(c), and various other regulations under the 1940 Act were established to ensure that mutual fund boards, namely the independent directors, approve fees according to what the boards deem most appropriate for any given fund. (32) Barring fraud or deceit by the adviser, courts should not interfere with the decisions of mutual fund boards that have undertaken thorough 15(c) processes in setting the exact level of fees. (33) Further, competition and investor decision making are robust processes in today's mutual fund market and tend to pull unjust fees into acceptable ranges. As such, regulation occurs organically, leading courts to conclude their involvement is unwarranted. (34)

      Congress rejected judicial fee setting in the creation of section 36(b). (35) Although the government may enact regulations, and courts may provide guidance, influencing steps of the approval process--for instance, the requirement that independent directors approve fees and stipulations concerning the information...

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