The U.S. Supreme Court is looking at whether an investment advisor breaches its fiduciary duty when it sets different fees for captive mutual fund investors and independent fund investors.
If the fund shareholders who brought the suit, Jones vs. Harris Associates, win, any holding that changes the current interpretation of the breach-of-fiduciary standard could affect executives’ pay packages.
The plaintiffs are suing based on Section 36(b) of the Investment Company Act of 1940.
The ICA creates a “fiduciary duty with respect to the receipt of compensation for services” for investment advisors, and it gives shareholders the right to sue in connection with allegations of violations of that duty.
A 1970 amendment limits the fees that an advisor can charge for advising mutual funds.
The Harris Associates shareholders say the fund company set fees that are too high.
The 7th U.S. Circuit Court of Appeals rejected that argument, holding that the limit on fees applies only if an advisor misled fund directors in securing approval for the fees.
The 7th Circuit ruled that mutual fund fees are a product of market forces and that courts should not be engaged in “[j]udicial price-setting.”
The shareholders appealed to the Supreme Court. The Obama administration has filed a “friend of the court” brief that urges the Supreme Court to put limits on investment advisor fees.
“If the court creates a higher fiduciary standard, that’s going to have a significant impact on investment advisors,” says Jim Gregory, a partner in the employee benefits and executive compensation group at Proskauer Rose L.L.P., New York. “And if the court were to take a broader view of the fiduciary duty, then it might take it upon itself to say what is or isn’t an appropriate level of executive compensation.”
In its ruling, the 7th Circuit relied on the 2nd Circuit Court of Appeal’s 1982 decision in Gartner vs. Merrill Lynch Asset Management. Known as the “Gartner standard,” the decision held that a breach of fiduciary duty occurs only when the advisor “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.”
The plaintiffs in Jones vs. Harris Associates argue, however, that the 1970 fiduciary standard requires a higher standard, and that the advisor must fully disclose material facts relating to the transaction and ensure that the transaction is fair to shareholders.
By charging unaffiliated institutional investors a fee less than that imposed on the shareholders, and by failing to disclose compensation to the mutual funds’ board members, Harris Associates failed to fulfill its fiduciary duty, the plaintiffs argue.
If the Supreme Court were to decide that the fiduciary standard required a higher obligation of investment advisors–one that would be satisfied only if the fee charged were deemed “fair” or “reasonable”–then shareholders of publicly held companies might similarly question whether the firms’ compensation committees or boards of directors had failed in their fiduciary duty to shareholders by negotiating an excessively high pay package for the chief executive officer and other company executives, Gregory says.
And if this were to happen, then a range of life insurance-funded executive compensation arrangements–non-qualified deferred compensation plans, executive bonuses, supplement executive retirement plans and the like–could be at risk.
But Gregory says nothing in the transcript for the U.S. Supreme Court oral arguments in the Jones case suggests that the court is open to interpreting the fiduciary requirement so liberally.
“In reviewing the transcript, my sense is that the justices’ questions were narrowly focused on how to deal with the [fiduciary issue] in the mutual fund world,” Gregory says. “I don’t see anything to suggest the U.S. Supreme Court will try to use this case as an opportunity to say something more broadly about executive compensation.”
Gregory warns, however, of severe consequences if the court determines that investment advisors, as fiduciaries, could not set much higher fees for their “captive” clients, such as the Jones plaintiffs, than they set for independent or institutional investors.
“If the Supreme Court decides the fiduciary duty was not met, there could be two significant results,” Gregory says. “First, fees might come down for mutual fund investors. Secondly, there could be a flood of litigation because plaintiffs would have a lower hurdle to surmount in alleging a breach of fiduciary duty. This is what’s at stake in this case.”