Securities Law - Investment Company Act - Supreme Court Reverses Seventh Circuit And Follows Judge Posner's Dissent

SUPREME COURT UPHOLDS POSNER DISSENT

On March 30, 2010 The United States Supreme Court unanimously reversed the Seventh Circuit Court Of Appeals in the case of Jones et al. v. Harris Associates, L.P. Harris Associates, No. 08-586. Harris Associates is a mutual fund case involving investment advisory fees that can be charged by an advisor to Oakmark, a captive mutual fund which Harris Associates organized. For about 30 years the principle set forth in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F. 2d 923, a Second Circuit case was considered the settled law. Gartenberg set forth two versions of a test to determine whether fees charged a mutual fund violates § 36(b) of the Investment Company Act of 1940: (1) whether the fee schedule represents a charge that was within the range of what would have been negotiated at arm’s-length in the light of all of the surrounding circumstances, and (2) to be guilty of a violation of § 36(b), the advisor must charge a fee that is so disproportionately large that it bears no reasonable relation to the services rendered and could not have been the product of arm’s-length bargaining.

In the United States District Court Judge Kocoras held that the fees charged were proper under the Gartenberg test and granted summary judgment in favor of Harris Associates. Plaintiffs’ mutual fund investors appealed to the Seventh Circuit, 527 F.3d 629 (May 2008). The Seventh Circuit in an opinion by Judge Easterbrook held that the Seventh Circuit disapproves the Gartenberg approach and stated that “a fiduciary must make full disclosure and play no tricks but it is not subject to a cap on compensation.” “The Trustees of a mutual fund, rather than a judge or jury, determine how much an advisory service is worth.” The judgment of the District Court granting summary judgment in favor of Harris Associates was affirmed.

The case then becomes even more interesting. There was a petition for rehearing. The panel voted unanimously to deny the petition. A Judge called for a vote on the suggestion for rehearing en banc but the majority did not favor such rehearing and it was denied. Judge Posner with Judges Rovner, Wood, Williams and Tinder dissented. Judge Posner wrote a dissent to the denial. The dissent quotes the Oakmark Prospectus and states “Subject to the overall authority of the board of trustees, [Harris Associates] furnished continuous investment supervision and management to the Funds and also furnishes office space, equipment and management personnel.” The Oakmark Fund, “Prospectus,” Jan. 28, 2008, p. 36. Recall Professor Kuhnen’s observation that “when directors and the management are more connected, advisers capture more rents and are monitored by the board less intensely.”

There now being a split in the Circuits, the Supreme Court granted certiorari. 559 U.S. ____ (2010). On March 30, 2010 Judge Alito wrote for the unanimous court and reversed the judgment of the Seventh Circuit. The Supreme Court concluded that Gartenberg was correct in its formulation of what § 36(b) requires: to face liability under § 36(b) an investment advisor must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and it could not have been the product of arm’s-length bargaining. The Supreme Court stated that the Investment Company Act modifies fiduciary duty in a significant way: it shifts the burden of proof from the fiduciary to the party claiming breach, 15 USC, § 88-35(b)(1) to show that the fee is outside the range that arm’s length bargaining would produce.

Judge Alito went on to state that by focusing almost entirely on the element of disclosure the Seventh Circuit Panel erred. See, 527 F.32 at 632 (An investment provider “must make full disclosure and play no tricks but is not subject to a cap on compensation”). Judge Alito stated that although the Gartenberg standard may lack sharp and analytical clarity, it had provided a workable standard for nearly three decades. The judgment of the Seventh Circuit was vacated and the case remanded.
In the writer’s opinion, the reversal of the Seventh Circuit was important for another reason.

Had the ruling of the Seventh Circuit not been overturned businesses would argue in unrelated matters that accurate disclosure would justify other actions without further examination.

Edward X. Clinton, Sr.