On April 8, 2009, the U.S. Court of Appeals for the Eighth Circuit decided Gallus v. Ameriprise Financial, Inc. ,1the latest significant case involving Section 36(b) of the Investment Company Act of 1940 (the "1940 Act"). In Gallus , the Eighth Circuit reversed the District Court's grant of summary judgment for the investment adviser and remanded the case, which concerns potentially excessive advisory fees for further consideration. This opinion was the first appellate opinion to address Section 36(b) since the Seventh Circuit, in Jones v. Harris Associates ,2rejected the standard articulated by the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc. 3over 25 years ago. Gallus articulated a different standard from the standards provided by either Gartenberg or Jones for judicial review of fee cases under the fiduciary duty standards of Section 36(b).
While Gallus reaffirmed the Gartenberg standard (described below) for evaluating whether an advisory fee violates the duties imposed by Section 36(b), Gallus expanded on this standard in two significant ways. First, the court in Gallus emphasized that a violation of Section 36(b) could arise from either (i) an excessive fee (as noted in Gartenberg), or (ii) improprieties by the adviser during the fee negotiation process. Thus, the court in Gallus concluded that the appropriate standard of review by the court under Section 36(b) includes an evaluation of an adviser's conduct throughout a negotiation for advisory fees, in addition to a review of the final result of the negotiation. Second, the Gallus court concluded that a Section 36(b) review should consider the fees charged by the adviser to institutional clients with similar investment programs to the mutual fund. Applying that standard, the Eighth Circuit held that the District Court erred in failing to take into account the fees charged by the adviser to institutional clients.
Background Of Section 36(b)
A. Investment Company Amendments Act of 1970
Section 36(b) of the 1940 Act imposes a "fiduciary duty" upon an investment company adviser with respect to its compensation and authorizes derivative actions by a fund's shareholders against an adviser for breach of this duty. Since its enactment under the Investment Company Amendments Act of 1970, there has been significant litigation under Section 36(b) concerning advisers' fiduciary duties and the appropriate process for board review of registered investment company fees.
In the widely followed Gartenberg decision, the Second Circuit concluded that to violate Section 36(b) "the [investment 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."4The Gartenberg standard of review has been applied in the Second Circuit5and has been adopted by both district and appellate courts in other circuits as well.6
Gartenberg and its progeny provide factors that courts should consider in determining whether a fund's board of directors and its investment adviser have breached their fiduciary duty under Section 36(b). These factors include: (1) the nature and quality of the advisory services; (2) the profitability of a fund to the adviser; (3) the payments received by the adviser and its affiliates from all sources involving the fund, including any "fall-out" benefits received; (4) the sharing of economies of scale as the fund increases in size; and (5) the relationship that the amount of the advisory fee bears to the fees paid by other funds of similar size and objective.7The Securities and Exchange Commission implicitly endorsed the Gartenberg approach in its 2004 amendments to the forms governing registered fund shareholder reports.8
Recently, however, the Seventh Circuit rejected the Gartenberg standard. In Jones , the court held that the fiduciary duty imposed by Section 36(b) does not permit judicial review for reasonableness or make the federal judiciary a "rate regulator." Rather, the court opined that the fiduciary standards of trust law apply and that the appropriate test is whether the adviser's client made a voluntary choice with the benefit of adequate information. Notably, in analogizing to other exercises of fiduciary duty, the court said that when "the persons charged with the trust's administration make a decision [regarding compensation], it is conclusive."9Emphasizing its position that judges should not regulate advisory fees, the court concluded that so long as an investment adviser "make[s] full disclosure and play[s] no tricks," judges will not be in the business of "determin[ing] how much advisory services are worth."
The Eighth Circuit's Decision In Gallus
The Eighth Circuit noted that the District Court had properly utilized the Gartenberg factors in its determination that the fee charged did not constitute a breach of Section 36(b). Although the court approved of the approach taken in Gartenberg , stating that "the Gartenberg factors provide a useful framework for resolving claims of excessive fees . . . ,"10the court warned that the standard created by the Gartenberg test does not create a blanket "safe harbor" for advisory fees that are consistent with industry norms but may be exorbitant in the context of the particular fund.
Nevertheless, the Gallus court expanded upon the Gartenberg standards, stating, "We believe that the proper approach to Section 36(b) is one that looks to both the adviser's conduct during negotiation and the end result."11For the end result (the amount of the advisory fees), the Gallus court generally was satisfied with the Gartenberg standard. However, the court provided an additional standard for review, stating that the adviser has a duty to be honest and transparent during the negotiation process and that "unscrupulous behavior with respect to either [the negotiation or the end result] can constitute a breach of fiduciary duty." The Eighth Circuit noted that plaintiffs accused the adviser of, among other things, misleading the fund's board about certain fee arrangements with non-fiduciary clients and creating a report for the board that may have "purposefully omitted, disguised or obfuscated" information that, if accurately presented to the board, might have impacted the board's decision as to whether to approve the advisory fee. The Gallus court remanded the case to the District Court to determine whether the adviser's behavior during the negotiation was a breach of its fiduciary duty under Section 36(b).
The Gallus court also stated that the application of the Gartenberg factors by the District Court was too limited because the lower court failed to consider evidence that the adviser offered comparable advisory services to institutional clients at a substantially lower fee than the one it charged to its mutual fund clients. The District Court's rejection of the comparison data was grounded in dicta of Gartenberg , in which the court refused to compare the adviser's fees for "fundamentally different investment vehicles - money market funds and equity pension funds."12The Eighth Circuit, however, distinguished Gartenberg , concluding that when there is a great similarity between the institutional funds and the mutual funds, a court should consider the comparison between fees. Comparing fees of institutional and mutual fund clients was particularly relevant in this case, the court noted, "because the investment advice may have been essentially the same for both accounts." This approach of comparing fees paid by institutional clients and mutual fund clients deviates from numerous district court holdings and Jones .13
Impact Of Gallus Decision
The Gallus opinion's emphasis on the fee setting process could lead to increased litigation under Section 36(b) and may make it more difficult for defendants in such cases to secure dismissal on the pleadings.14Under the Gallus standard, plaintiffs will claim to be entitled to discovery of all materials concerning the fee review process and may, for example, attempt to exploit any variations between draft materials and final materials to bolster their claims and avoid dismissal before trial. Further, Gallus gives new life to plaintiffs' arguments that differences between institutional fund fees and mutual fund fees are central to a board's consideration of advisory contracts under Section 15(c). The Gallus court, however, reemphasized that the burden of proof belongs to the plaintiffs in both the existence of a breach of fiduciary duty and in showing financial harm resulting from the breach.
1 No. 07-2945 (8th Cir. Apr. 8, 2009).
2 527 F.3d 627 (7th Cir. 2008), cert. granted, (U.S. Mar. 9, 2009) (No. 08-586).
3 694 F.2d 923 (2d Cir. 1982), cert. denied, 461 U.S. 906 (1983).
4 Gartenberg , 694 F.2d at 928.
5 See, e.g. , Wexler v. Equitable Capital Management Corp. , No. 93 CIV 3834, 1994 WL 48807 (S.D.N.Y. Feb. 17, 1994) (not reported in F. Supp.); Olesh v. Dreyfus Corp. , No. 94 CIV 1664, 1995 WL 500491 (E.D.N.Y. Aug. 8, 1995) (not reported in F. Supp.); In re TCW/DW North American Government Income Trust Securities Litigation , 941 F. Supp. 326 (S.D.N.Y. 1996); Strougo v. Scudder, Stevens & Clark, Inc. , 964 F. Supp. 783 (S.D.N.Y. 1997); and In re Salomon Smith Barney Mutual Fund Fees Litigation , 528 F. Supp. 2d 332 (S.D.N.Y. 2007).
6 See, e.g. , Migdal v. Rowe Price-Fleming Int'l, Inc. , 248 F.3d 321 (4th Cir. 2001); Batra v. Investors Research Corp., et al. , 1991 U.S. Dist. LEXIS 14773 (W.D. Mo. Oct. 4, 1991); Barrett v. Van Kampen Merritt Inc., et al. , 1993 U.S. Dist. LEXIS 3936 (N.D. Ill. Mar. 26, 1993); and Krantz v. Fidelity Mgmt. & Research Co. , 98 F. Supp. 2d 150 (D. Mass. 2000) ( Krantz was settled before it could be decided on the merits.)
7 See generally Gartenberg , 694 F.2d at 929-930.
8 Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, Securities Act No. 33-8433 (June 23, 2004).
9 Jones at 10-11.
10 Gallus at 11.
12 Id. at 11-13.
13 Schuyt v. Rowe Price Prime Reserve Fund, Inc. , 663 F. Supp. 962 (S.D.N.Y. 1987); Miller v. Mitchell Hutchins Asset Mgmt. , 2002 U.S. Dist. LEXIS 27675 (S.D. Ill. Mar. 12, 2002); Strougo v. Bea Assocs. , 188 F. Supp. 2d 373, 384 (S.D.N.Y. 2002); In re AllianceBernstein Mut. Fund Excessive Fee Litig. , 2005 U.S. Dist. LEXIS 24263 (S.D.N.Y. Oct. 19, 2005); and In re Evergreen Mut. Funds Fee Litig. , 240 F.R.D.115 (S.D.N.Y. 2007).
14 The Supreme Court will hear Jones during its next term, which begins on October 5, 2009.
Benjamin J. Haskin is Partner in the Asset Management Group in the Firm's Washington, DC office. Rose DeMartino is Partner in the Asset Management Group in the New York office. Mary Eaton is Partner in the Litigation Department in Willkie's New York office. Ryan Leshaw is an Associate in the Asset Management Group in the Washington, DC office.