Jones,Harris,Associates,The,ma law Jones v. Harris Associates: The market (not the courts) shou

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BackgroundDefendant Harris Associates, L.P. serves as manager of the Oakmark Funds, open-end funds (typically mutual funds) without restrictions as to the amount of shares issued; the fund will buy back shares at current asset value whenever investors wish to sell. Open-end funds have grown in popularity because net returns have exceeded market average, and fund managers' compensation has grown commensurately.Plaintiffs Jerry N. Jones, Mary P. Jones, and Arline Winderman - all individual investors in several of the Oakmark funds - argued that Harris Associates breached its fiduciary duty by charging excessive management/ advisory fees in violation of section 36(b) of the Investment Company Act of 1940. That provision states that fund advisors owe a fiduciary duty to the fund with respect to the compensation they receive related to their advisory role, and that an investor in that fund can bring an action for breach of this duty.The district court granted summary judgment in favor of Harris Associates and the Plaintiff appealed. The Seventh Circuit's decision on appeal is found at Jerry N. Jones et al v. Harris Associates, L.P., 527 F.3d 627 (7th Cir. 2008).Section 36(b) and the Gartenberg precedentThe district court ruled in favor of Harris Associates by following the precedent of Gartenberg v. Merrill Lynch Asset Management Inc., 694 F.2d 923 (2nd Cir. 1982) and concluding that Harris Associates' fees were "ordinary." Gartenberg articulated two similar versions of a test to determine a violation of section 36(b): 1) "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;" and/or 2) whether the advisor-manager charges "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." 694 F.2d at 928The court noted that Oakmark Funds charge fees similar to those charged by similar funds, and that those fee structures are legal. 527 F.3d at 631. The court also noted that Oakmark funds have grown "more than the norm for comparable pools," suggesting that Oakmark funds are worth the fee expense. Id.The Plaintiffs argued that the court should not follow Gartenberg for two reasons.             1) Gartenberg relies too heavily on market prices as the measure of reasonableness. The plaintiffs contended that this was inappropriate because fund fees are set incestuously (meaning that advisors dominate the market of mutual funds, which rarely change advisors) rather than by competition.       2) If any market is used as a benchmark, it should be the market for advisory services rendered to institutional clients, which pay lower fees. The Plaintiff claimed that the advisors should charge individual clients the same fees as those charged to institutional clients.The court rejects Gartenberg while affirming the district court opinionAfter reviewing support and criticism for the Gartenberg approach, the Seventh Circuit expressed its disapproval for Gartenberg. The court rejected the notion that the judiciary should play a role in regulating the rates charges by advisors except in the most extraordinary circumstances. Rather, the court firmly held that the market (fund trustees and investors, in the case of mutual funds) will dictate the appropriateness of a rate. If fund charges excessive rates, investors will move their money to another fund.The court stated: "Section 36(d) does not say that fees must be 'reasonable' in relation to a judicially created standard. It says instead that the advisor has a fiduciary duty." 527 F.3d at 632. The court noted that the term "fiduciary duty" is familiar from the law of trusts, indicating a duty of "candor in negotiation, and honesty in performance" but leaving open the ability of the fiduciary to negotiate fairly for his own compensation. Id. When the settlor or persons charged with a trust's administration decide on a particular compensation for the fiduciary, that decision is final, not subject to judicial review except perhaps in instances of fraud. Id. The court wrote: "Judicial price-setting does not accompany fiduciary duties. Section 36(b) does not call for a departure from this norm." Id. at 633.This same concept applies outside of the traditional trust realm - the court applied the concept to business corporations, lawyers, and more. In each such instance, the fiduciaries may bargain hard to demand substantial compensation, but the investors or clients - not the judiciary - make the ultimate decision regarding the fees paid.  The same theory applies in mutual funds, where a committee of independent directors sets the top managers' compensation without any judicial review for "reasonableness." Id. Market competition will ultimately weed out the businesses and funds that set compensation too high, because those funds will charge more, with fewer profits to distribute to investors, who may therefore go elsewhere with their investment dollars. Id.The court rejected plaintiffs' arguments on appeal, finding that the competitiveness among funds for investors prevents funds from charging excessive fees. "Mutual funds rarely fire their investment advisors, but investors can and do "fire" advisers cheaply and easily by moving their money elsewhere." Id.. at 634. The court also rejected the plaintiffs' argument that institutional funds should provide the benchmark for fees, since institutional funds require a lower time commitment. Id.Result: Courts will question fees only in exceptional circumstancesCourts that follow the Seventh Circuit's lead in the future will take a laissez-faire approach to fund manager/advisor fees. In order to successfully challenge fees as excessive under section 36(b) of the Investment Company Act of 1940, investors may have to demonstrate extraordinary facts like fraud and deception resulted in the fees charged.