Background on Jones v. Harris Associates L.P.
Oral arguments before the U.S. Supreme Court on November 2
A Case Manufactured by Trial Lawyers
Jones v. Harris Associates L.P. is the latest in a series of cases to come before the Supreme Court that are driven by attempts of the contingency fee plaintiffs’ bar to establish a line of attack on an industry.
The recent cases in this line include:
- Verizon Communications Inc. v. Law Offices of Curtis V. Trinko LLP (target, telecommunications industry; decision, 2004);
- Bell Atlantic v. Twombly (target, the telecommunications industry; decision, 2007); and
- Stoneridge v. Scientific Atlanta (target: investment banking, corporate law firms, accounting firms; decision, 2008).
In each of these cases, the Court turned back an attempt to create new lines of attack for mass litigation against the industry in question.
Similarly, the petitioners in Jones v. Harris are asking the Supreme Court to create a new legal basis for liability, as well as to expand existing liability, so they can to unleash aggressive litigation against fund advisers.
Jones v. Harris is a creation of the trial bar. According to the GoingLegal.com blog, Jones “was one of about a dozen cases brought in 2003 and early 2004 based on the excessive fee provisions of the Investment Company Act of 1940.” The suits were almost identical, with complaints that were virtual carbon copies of one another. Such swarming—bringing similar cases in numerous jurisdictions in a brief period—is typical of the early “test” stages of a trial bar assault on an industry.
The trial bar’s swarming strategy has targeted funds regardless of their fee level or their performance. The Oakmark funds advised by Harris offer prime examples: According to evidence introduced in the district court, all three of the funds cited in this litigation significantly outperformed their peers, and the district court found that the fees charged by Harris were “in line” with those charged by similar funds in other families. For example, the Oakmark Global Fund was ranked No. 1 in net return among 254 comparable funds, as defined by Lipper, for the three-year period ended March 31, 2004, and charged fees that were below the median for its peer group.
In the past several years, according to Securities Litigation Report, more than 500 private class actions and derivative suits have been filed against mutual fund advisers. Many of these cases include claims that advisers violated their fiduciary duty by receiving excessive fees.
Jones v. Harris Introduces a Split Among Federal Circuits
In Jones v. Harris, the petitioners—Jerry Jones, Mary Jones, and Arline Winerman—are shareholders in the Oakmark family of funds. Respondent Harris Associates L.P. is a money management firm that acts as investment adviser to the Oakmark funds.
Jones v. Harris was filed in U.S. District Court in Chicago. The district court granted summary judgment to Harris, applying the widely accepted framework for review of mutual fund advisory fees laid down by the 1982 Gartenberg decision in the U.S. Second Circuit Court of Appeals.
The plaintiffs appealed to the Seventh Circuit Court of Appeals, arguing that the Seventh Circuit should not follow Gartenberg because it relies too heavily on market prices as a benchmark for fees. They instead asked the court to use Harris’s fees for institutional accounts as a benchmark to assess the fees it charged Oakmark, rather than fees charged by other advisers to comparable mutual funds. Evidence introduced in the district court indicated that Harris’s fees for institutional accounts were about half the fees it charged the mutual funds, reflecting the vast differences in services, risks, and capital requirements needed to serve these very distinct clients.
In May 2008, a three-judge Seventh Circuit panel headed by Chief Judge Frank Easterbrook upheld the district court’s dismissal of the case. However, Judge Easterbrook said the court “disapprove(s) the Gartenberg approach.” In his opinion, Easterbrook said that “we are skeptical about Gartenberg because it relies too little on markets,” and noted that there is robust competition in the mutual fund industry that provides funds with “a powerful reason to keep [costs] low.” He added: “Mutual funds come much closer to the model of atomistic competition than do most other markets.” Easterbrook’s opinion specifically rejected the plaintiffs’ call for courts to compare the fees that Harris charged the Oakmark funds with the lower fees that Harris charged its institutional clients.
The Seventh Circuit panel decision created a split between the circuits after almost 30 years during which courts consistently relied on Gartenberg. In April 2009, after the Supreme Court had agreed to hear Jones, a decision by the U.S. Eighth Circuit Court of Appeals in another fee case, Gallus v. Ameriprise Financial Inc., introduced took yet another approach. In Gallus, a three-judge panel reversed a district court’s dismissal of the suit and remanded the case for further consideration by the district court. The Eighth Circuit panel said that while Gartenberg provides a useful framework for resolving claims of excessive fees, “the proper approach to [excessive fee claims] is one that looks to both the adviser’s conduct during negotiation [of the advisory fee] and the end result.” The panel also said that the district court “erred in rejecting a comparison between the fees charged to Ameriprise’s institutional clients and its mutual fund clients.” Ameriprise has petitioned the Supreme Court to review this decision after it decides Jones v. Harris.
An Added Twist: A Split Within the Seventh Circuit
After the Easterbrook panel issued its opinion in Jones v. Harris, the Seventh Circuit denied the plaintiffs’ request for a rehearing en banc (a hearing by the full court) on a 5-5 vote. Judge Richard Posner issued a dissent, joined by four other judges, arguing that the case “merits the attention of the full court” because the Easterbrook panel’s “economic analysis … is ripe for reexamination.” Posner noted that “The outcome of this case may be correct” (emphasis original), but argued that the full court should hear the case because “of the creation of a circuit split, the importance of the issue to the mutual fund industry, and the one-sided character of the [Easterbrook] panel’s analysis.”
Easterbrook and Posner are acknowledged intellectual giants of the federal bench and are both champions of the “law and economics” school of legal thinking. A dispute between them on a point of interpretation regarding the ability of competition to constrain fees was widely recognized as an important legal event.
In March 2009, the Supreme Court agreed to hear the case.
The Investment Company Act and the Gartenberg Decision
Mutual funds operate under a comprehensive regulatory scheme based in the federal securities laws, particularly the Investment Company Act of 1940. Among other things, that Act requires funds to be overseen by boards of directors (or trustees), including independent directors charged with the primary responsibility for protecting investor interests.
In 1970, Congress amended the Act to provide greater protection for investors against excessive adviser compensation. It strengthened the standards of independence for independent directors. It also greatly expanded the role of fund boards and their independent directors in evaluating and approving advisory fees, including a requirement that those fees be approved by a majority of the fund’s independent directors. Fund boards have risen to that challenge, exercising rigorous oversight over advisers’ compensation.
Under the Act, 40 percent of a board’s directors must be independent. Today’s boards, however, are more independent than the law requires: At least 75 percent of directors are independent on 90 percent of all boards.
The 1970 amendments also added Section 36(b), which imposes a narrowly tailored fiduciary duty on a mutual fund’s investment adviser “with respect to the receipt of compensation for services” from the fund. Section 36(b) grants the Securities and Exchange Commission or fund shareholders the right to bring a suit against the adviser for a breach of that duty. Under Section 36(b)(2), a court reviewing a claim that the adviser breached its duty is required to give the board’s approval of the fee such consideration as the court determines is “appropriate under all the circumstances.”
As the Supreme Court has recognized, Congress intended Section 36(b) to serve as a check on excessive compensation. In its 1982 decision in Gartenberg v. Merrill Lynch Asset Management Inc., the Second Circuit laid down a standard for courts to use in evaluating whether an adviser had violated its fiduciary duty under Section 36(b):
To be guilty of a violation … 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.
This standard, and the analytical framework that the Second Circuit laid out, has been widely adopted by other federal courts and has provided useful guidance for investment advisers and fund directors for almost 30 years, and was incorporated in disclosure rules adopted by the Securities and Exchange Commission.
Potential Consequences: More Litigation and Expense; Less Competition and Choice
The petitioners propose a liability standard that would give the trial bar an annual invitation to sue over virtually every fund’s advisory fee. Their proposal would turn judges into rate-setters—and fund advisers into deep pockets for trial lawyers. Advisers would bear millions of dollars in legal expenses defending every suit. Ultimately, those costs could spill over to fund shareholders, and this new climate of vexatious litigation could cause advisers to demand higher fees in anticipation of skyrocketing legal expenses.
That litigation eventually could drive many investment advisers to stop sponsoring mutual funds—reducing competition and offerings in the most regulated segment of the investment market.
The petitioners also want the courts to focus on a single factor in evaluating mutual fund advisory fees—comparing them to fees that advisers charge institutional separate accounts. That standard ignores the realities of two very separate businesses. Mutual funds and institutional accounts both may receive portfolio management services from the same advisers—but the precise services, capital commitments, risks, and regulations in serving these very different clients are worlds apart. If advisers were forced to charge mutual funds no more than they charge institutional accounts, they could face economic pressure to eliminate or reduce services that investors need, want, and value.
Funds and their investors need clarity under the law—not endless rounds of new and expensive litigation. A plaintiffs’ victory in Jones would mean fund shareholders would ultimately pay increased expenses for reduced services, in a market with fewer choices. That’s not a win for investors.
The Right Outcome: Stick with Gartenberg
The Investment Company Institute, the Independent Directors Council, Fidelity Management & Research Company, the Mutual Fund Directors Forum, and a distinguished group of 25 law and finance professors all urge the Supreme Court to endorse the Gartenberg framework. So, too, does the SEC, through the United States’ amicus brief.
That’s not surprising, because the framework constructed by the Gartenberg decision has served investors, funds, directors, regulators, and courts effectively for almost 30 years. It’s consistent with Congress’s language and intent in adding Section 36(b) to the Investment Company Act in 1970. The Gartenberg framework is flexible: it allows boards and courts to decide which factors are most relevant in each specific case.
Fund boards employ the Gartenberg framework in their review of advisers’ fees. Courts use the Gartenberg standard to evaluate excessive fee claims, allowing those with merit to proceed while weeding out meritless claims before advisers and funds bear the expense of fruitless trials.
Most important, mutual fund investors have benefited from competitive offerings, falling fees, and rising levels of service for almost 30 years, during the period when Gartenberg has set the framework for advisers’ fees.