The fiduciary duty in mutual fund excessive fee cases: Ripe for reexamination

Duke Law Journal

Volumn 59, Issue 1, 2009, Pages 145-181

  Johnson, Emily D ^a  

^a DUKE UNIVERSITY   (United States)

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EID: 77951709239     PISSN: 00127086     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (210)

1. Oversight Hearing on Mutual Funds: Hidden Fees, Misgovernance and Other Practices that Harm Investors Before the Subcomm. on Financial Management, the Budget, and International Security of the S. Comm. on Governmental Affairs, 108th Cong. 3 (2004) (opening statement of Sen. Fitzgerald), available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi? dbname=108_senate_hearings&docid=f:92686.pdf.
2. Almost 90 million American households have assets in mutual funds. INV. CO. INST., 2008 INVESTMENT COMPANY FACT BOOK 8 (48th ed.).
3. In November 2008, the United States' mutual fund industry managed nearly $9.35 trillion. Inv. Co. Inst., Trends in Mutual Fund Investing: November 2008 (2008), http://www.ici.org/stats/mf/arctrends/trends_11_08.html. At the end of 2007, the mutual fund industry had over $12 trillion under management according to the industry trade group. INV. CO. INST., supra note 2, at 20. The value of mutual fund holdings, however, declined sharply, along with the rest of the market, due to the 2008 credit crisis.
4. See generally The Joint Economic Committee Majority Staff, From Wall Street to Main Street: Understanding How the Credit Crisis Affects You (2008), available at http://jec.senate.gov/index.cfm?FuseAction=Files.View&File Store_id=b2087603-5883-4777-b13e-6b30845d4265 (describing the causes and effects of the credit crisis).
5. Mutual funds are a type of investment company. Investment companies include mutual funds, closed-end funds, and unit investment trusts (UITs).
6. See INV. CO. INST., supra note 2, at 9 fig.1.1 (aggregating the assets of mutual funds, closed-end funds, exchange-traded funds, and UITs as investment company assets).
7. Burton G. Malkiel, Are Markets Efficient?-Yes, Even if They Make Errors, WALL ST. J., Dec. 28, 2000 ("Over the past three-year, five-year and 10-year periods, more than 75% of active [mutual fund] managers underperformed index funds when both are measured after expenses. Those that do outperform in one period are not typically the ones who outperform in the next.")
8. Susan Woodward, Make Mutual Funds Bare All!, WALL ST. J., Jan. 16, 2004, at A10.
9. In 2007, investors paid more than $100 billion in mutual fund costs. JOHN C. BOGLE, ENOUGH 44 (2009).
10. See PETER J. WALLISON & ROBERT E. LITAN, Competitive Equity: A Better Way to Organize Mutual Funds 9 (2007) ("[T]he expense ratios of the 811 [actively managed U.S. equity] funds range[d] from approximately 60 basis points to 170 basis points, or a difference in cost of almost 300 percent.").
11. Fees are based on the amount of assets under management. Donald C. Langevoort, Private Litigation to Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty, 83 WASH. U. L. Q. 1017, 1020 (2005).
12. JOHN C. BOGLE, The Little Book of Common Sense Investing: The Only Way To Guarantee Your Fair Share of Stock Market Returns 155 (2007) ("Most comparisons of fund costs rely solely on reported expense Ratios, and uniformly find that higher costs are associated with lower returns.").
13. Neil Weinberg, Fund Manager Knows Best, FORBES, Oct. 14, 2002, at 208.
14. JOHN C. BOGLE, The Battle for the soul of Capitalism 162 tbl.7.1 (2005).
15. See, e.g., John C. Coates IV & R. Glenn Hubbard, Competition in the Mutual Fund Industry: Evidence and Implications for Policy, 33 J. CORP. L. 151, 163 (2007) ("[T]he mutual fund industry's market structure is consistent with competition providing strong constraints on advisory fees.")
16. Inv. Co. Inst., Key Issues: Fees and Expenses, http://www.ici.org/issues/fee/index.html (last visited Apr. 14, 2009) ("Investors continue to benefit from intense competition in the financial services industry. In the investment company industry, this vibrant competition has produced substantially lower costs along with an array of innovative investment products and services that make saving and investing simpler, more accessible, and more affordable.").
17. See, e.g., WALLISON & LITAN, supra note 7, at 8-13 ("[T]here is strong evidence that the mutual fund industry is not as price competitive as its structure would suggest.... [T]he prices... are not converging toward a common level, although convergence would be expected in a competitive market.")
18. John P. Freeman, The Mutual Fund Distribution Expense Mess, 32 Iowa J. Corp. L. 739, 741 n.8 (2007) ("Through its practice of taking funding directly from fund shareholders, while advocating the interests of shareholders' adversaries when it comes to controversies over fund fees and expenses, the ICI epitomizes the conflicted, self-serving structure of the money management industry it purports to represent.").
19. Investment Company Act § 36(b), 15 U.S.C. § 80a-35(b) (2006) ("For the purposes of this subsection, the investment advisor of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment advisor or any affiliated person of such investment advisor.").
20. See infra note 230. Institutional clients are also referred to as separately managed accounts.
21. See Richard M. Phillips, Jeffrey B. Maletta & Mark D. Perlow, Seventh Circuit Rejects Gartenberg but Not Business Judgment, K&L Gates, June 12, 2008, http://www.klgates.com/newsstand/Detail.aspx?publication=4613 ("The SEC has express statutory authority to bring Section 36(b) cases, although it has not done so.").
22. See James D. Cox & John W. Payne, Mutual Fund Expense Disclosures: A Behavioral Perspective, 83 WASH. U. L. Q. 907, 914, 923 (2005) ("Plaintiffs are still seeking to achieve their first victory under section 36(b).")
23. John P. Freeman, Stewart L. Brown & Steve Pomerantz, Mutual Fund Advisory Fees: New Evidence and a Fair Fiduciary Duty Test, 61 Okla. L. REV. 83, 126 (2008) ("[N]o plaintiff has ever won a fee case brought under section 36(b).")
24. Lyman Johnson, A Fresh Look at Director "Independence": Mutual Fund Fee Litigation and Gartenberg at Twenty-Five, 61 Vand. L. Rev. 497, 519 (2008) ("The most remarkable statistic under section 36(b) is that, thirty-seven years after its enactment and twenty-five years after Gartenberg, no investor has obtained a verdict against an investment advisor.").
25. Investment Company Act § 36(b)(1), 15 U.S.C. § 80a-35(b)(1).
26. Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923 (2d Cir. 1982).
27. Jones v. Harris Assocs., 527 F.3d 627 (7th Cir. 2008).
28. Id. at 632 (noting the Fourth Circuit followed Gartenberg).
29. Judge Posner dissented from the denial of en banc review. Jones v. Harris Assocs., 537 F.3d 728, 729 (7th Cir. 2008) (Posner, J., dissenting from denial of rehearing en banc). He did not sit on the panel that heard Harris Associates. In addition to the Chief Judge, the panel was composed of Judges Kanne and Evans. Harris Assocs., 527 F.3d at 627. In his dissent, Judge Posner criticized the panel for its failure to "circulate its opinion to the full court in advance of publication, as is required when a panel creates a circuit split." Harris Assocs., 537 F.3d at 732 (Posner, J., dissenting from denial of rehearing en banc). This is not the first time Judges Easterbrook and Posner have been on opposite sides of a case exploring the bounds of a fiduciary duty. Judge Easterbrook wrote the majority opinion in Jordan v. Duff & Phelps, Inc., 815 F.2d 429 (7th Cir. 1987), with Judge Posner dissenting.
30. Harris Assocs., 537 F.3d at 729 (Posner, J., dissenting from denial of rehearing en banc).
31. Jones v. Harris Assocs., 129 S. Ct. 1579 (2009).
32. See infra note 184 and accompanying text
33. Captive investors do not negotiate with the investment advisor at arm's length. See infra note 229 and accompanying text. This Note also calls captive mutual fund investors "retail" investors.
34. A pension fund is an institutional investor. See Coates & Hubbard, supra note 12, at 184 n.131 ("Institutional accounts vary widely, including trusts, foundations, life insurance companies, pension plans, and various levels of high-net-worth individuals.").
35. See, e.g., William A. Birdthistle, Compensating Power: An Analysis of Rents and Rewards in the Mutual Fund Industry, 80 TUL. L. REV. 1401, 1409 (2006) ("[T]he industry's faults can be found in the idiosyncratic structure of mutual funds, a structure that exacerbates the ability of managers to wield substantial power and to use that power to extract rents both overtly and surreptitiously from shareholders.")
36. Paul F. Roye, Director, Div. of Inv. Mgmt., SEC, Remarks before the Fund Governance Program Presented by the Mutual Fund Directors Forum and Fund Directions (Dec. 9, 2004) ("I fully understand that conflict oversight and management is not always easy-but it is a core part of your responsibilities as independent fund directors, particularly because of the conflicts inherent in the external management structure of mutual funds."). Contra WALLISON & LITAN, supra note 7, at 29-31 ("The 'inherent conflict' cited by the SEC and critics of the mutual fund industry, at least as far as fee-setting is concerned, is nothing more than the usual divergence of interests between a buyer and a seller....").
37. See 15 U.S.C. § 80a-5(1) (2006) (defining an open-end company as "a management company which is offering for sale or has outstanding any redeemable security of which it is the issuer").
38. SEC, Mutual Funds, http://www.sec.gov/answers/mutfund.htm (last visited Apr. 14, 2009).
39. WALLISON & LITAN, supra note 7, at 2 ("One of the most basic rules of personal finance is never to put all of one's financial eggs in one basket.... This advice follows from the efficient market hypothesis, which holds that no single investor can have more information at any given moment than is in the market as a whole, and therefore no investor, no matter how skilled, can consistently 'beat the market' in picking individual securities.").
40. Redeemable shares are a hallmark of mutual funds. Redeemable shares entitle investors to sell their shares back to the fund at the current net asset value minus any redemption or deferred sales load fees.
41. See SEC, supra note 31 (describing traditional and distinguishing characteristics of mutual funds, including redeemable shares). Because shares are redeemable, new sales are crucial to the fund's existence. Without new sales, a fund could be redeemed out of existence. John P. Freeman & Stewart L. Brown, Mutual Fund Advisory Fees: The Cost of Conflicts of Interest, 26 J. CORP. L. 609, 614 (2001).
42. In 2007, there were 8,752 mutual funds (including funds of funds). INV. CO. INST., supra note 2, at 15 fig.1.8.
43. See INV. CO. INST., A GUIDE TO UNDERSTANDING MUTUAL FUNDS 10 (2008), available at http://www.ici.org/pdf/bro_understanding_mfs_p.pdf ("Virtually all mutual funds are externally managed; they do not have employees of their own. Instead, their operations are conducted by affiliated organizations and independent contractors.").
44. A. Joseph Warburton, Should Mutual Funds Be Corporations? A Legal & Econometric Analysis, 33 J. CORP. L. 745, 748 (2008).
45. John A. Otoshi, Note, Class Action Treatment of Shareholders' Suits Under Section 36(b) of the Investment Company Act, 83 COLUM. L. REV. 2039, 2039 (1983).
46. Birdthistle, supra note 29, at 1418
47. For more information on the role of the underwriter and transfer agent, see William P. Rogers & James N. Benedict, Money Market Fund Management Fees: How Much Is Too Much?, 57 N.Y.U. L. REV. 1059, 1063 nn.10-11 (1982). For a brief overview of the types of service providers a fund typically relies on, see INV. CO. INST., supra note 2, at 164-68.
48. The investment advisor is a legal entity that has its own employees. INV. CO. INST., supra note 2, at 166. Merrill Lynch, Harris Associates, and Fidelity are examples of investment advisors.
49. Rogers & Benedict, supra note 41, at 1063
50. INV. CO. INST., supra note 2, at 166.
51. See Edward Wyatt, Empty Suits in the Board Room
52. Under Fire, Mutual Fund Directors Seem Increasingly Hamstrung, N.Y. TIMES, June 7, 1998, at C1 ("In practice, of course, the entire operation is run by one fund company-Fidelity or Merrill Lynch, Navellier or Fundamental-which not only provides... services, but is the brand name that brings shareholders to the fund.").
53. Conference on Mutual Funds, 115 U. PA. L. REV. 726, 739 (1967) (remarks of Abraham L. Pomerantz).
54. Rogers & Benedict, supra note 41, at 1064
55. 15 U.S.C. § 80a-15(c) (2006).
56. Warburton, supra note 36, at 750
57. INV. CO. INST., supra note 2, at 165 (emphasis added).
58. Rogers & Benedict, supra note 41, at 1072
59. Krantz v. Fidelity Mgmt. & Research Co., 98 F. Supp. 2d 150, 151 (D. Mass. 2000).
60. Id. at 151-52; see also Migdal v. Rowe Price-Fleming Int'l, Inc., 248 F.3d 321, 330-31 (4th Cir. 2001) (dismissing a claim that overlapping service between twenty-two and thirty-eight boards with an aggregate compensation of either $65,000 or $81,000 rendered directors "interested").
61. Conference on Mutual Funds, supra note 47, at 739 (remarks of Abraham L. Pomerantz).
62. Id. Pomerantz called for more SEC regulation. Id. at 740.
63. Johnson, supra note 17, at 505
64. Founder and former CEO of The Vanguard Group
65. BOGLE, supra note 6, at 145-46
66. 'If Only I Had Bought...', USA TODAY, Apr. 16, 2007, at 8B, available at http://www.usatoday.com/money/top25-stocks.htm.
67. See, e.g., Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923, 929-30 (2d Cir. 1982) ("Congress... recognized... the potentially incestuous relationships between many advisers and their funds....")
68. U.S. Gen. Accounting Office, Mutual Fund Fees: Additional Disclosure Could Encourage Price Competition 82 (2000) ("Although most mutual funds are organized as corporations, their structure and operation differ from a typical corporation because of the relationship between the fund and its adviser. Typically, the adviser, who is a legal entity separate from the fund, conducts the fund's operations, and the advisory fees it charges to the fund represent revenue to the adviser, creating a possible conflict of interest.").
69. Even industry supporters acknowledge that boards "rarely fire" investment advisors. Coates & Hubbard, supra note 12, at 153. The authors, however, do not reach the conclusion that the structure of mutual funds prevents competition. Id. at 153-54.
70. Birdthistle, supra note 29, at 1410. Chief Judge Easterbrook recognized this reality in Harris Associates. Jones v. Harris Assocs., 527 F.3d 627, 634 (7th Cir. 2008) ("Mutual funds rarely fire their investment advisers....").
71. For example, thousands of investors flocked to the Magellan Fund to have Peter Lynch manage their money. See PETER S. LYNCH & JOHN ROTHCHILD, Beating The Street 82-139 (1993) (describing the Magellan Fund).
72. Freeman & Brown, supra note 33, at 617
73. See 15 U.S.C. § 80(a)-15(c) (2006) (mandating board control over advisory contracts).
74. Money for Old Hope, ECONOMIST, Mar. 1, 2008, at 3 (discussing the asset management business as a whole, which includes but is not limited to mutual funds, and noting that "fees in the industry tend to grow at around 15% a year because markets rise by an average of 8% and savings grow by 5-6%.").
75. Langevoort, supra note 8, at 1021
76. See infra notes 74-77
77. Inv. Co. Inst., Frequently Asked Questions About Mutual Fund Fees 2-5 (2004), available at http://www.ici.org/pdf/bro_mf_fees_faq_p.pdf.
78. Cox & Payne, supra note 17, at 925
79. Inv. Co. Inst., supra note 71, at 6.
80. The authority for the distribution fee comes from the ICA Rule 12b-1, 17 C.F.R. § 270.12b-1 (2009). For a criticism of 12b-1 fees, see generally Freeman, supra note 13.
81. INV. CO. INST., supra note 71, at 4-5.
82. Id. at 4-5. For other readings regarding 12b-1 fees
83. see Cox & Payne, supra note 17, at 925 n.87.
84. INV. CO. INST., supra note 71, at 9.
85. See Freeman & Brown, supra note 33, at 616 ("To protect fund shareholders from self-dealing, Congress imposed a requirement that at least forty percent of a fund board needs to be composed of directors ostensibly independent of the investment advisor.").
86. Rogers & Benedict, supra note 41, at 1070
87. Wharton School of Finance and Commerce, A Study of Mutual Funds, H.R. Rep. No. 87-2274, at 28 (1966).
88. See id. at 30 ("[T]he special structural characteristics of this industry, with an external adviser closely affiliated with the management of the mutual fund, tend to weaken the bargaining position of the fund in the establishment of advisory fee rates.").
89. See Report of the SEC on the Public Policy Implications of Investment Company Growth, H.R. Rep. No. 89-2337, at 12-13 (1966) (discussing the various ways in which the existing restraints on management compensation are inadequate, and providing recommendations to rectify the problem of unreasonable compensation).
90. Id. at 13; Rogers & Benedict, supra note 41, at 1081 (discussing the modifications the SEC recommended).
91. WALLISON & LITAN, supra note 7, at 32
92. In pertinent part Section 36(b) provides: For the purposes of this subsection, the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser. 15 U.S.C. § 80a-35(b) (2006).
93. See Rogers & Benedict, supra note 41, at 1088 ("Prior to enactment of the section, courts had held that once a defendant demonstrated that a management fee was approved by the board and the shareholders of the fund, the plaintiff was required to establish that the fee was so high as to constitute a waste of corporate assets. This corporate waste standard had proved virtually impossible for plaintiffs to meet, and, in effect, precluded legal challenges to management fees." (footnotes omitted)).
94. 15 U.S.C. § 80a-35(b)(2).
95. Johnson, supra note 17, at 528
96. See Langevoort, supra note 8, at 1037 ("Once the mutual fund is viewed as a product to be marketed within liberal societal expectations as to fair advertising like any other, then any notion that the producer is a 'fiduciary' is awkward and disorienting. The transaction is instead simply embedded in the morals of the marketplace. To be sure, the law disagrees-the adviser is deemed a fiduciary to the fund and its investors." (footnotes omitted)).
97. See Green v. Nuveen Advisory Corp., 295 F.3d 738, 742 (7th Cir. 2002) ("[Section] 36(b) does not explain the term 'fiduciary duty'....").
98. Rogers & Benedict, supra note 41, at 1082-89 ("[T]he Commission and the industry never did concur on what the term 'fiduciary duty' meant in this context.").
99. Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923, 925, 928 (2d Cir. 1982).
100. Economies of scale are the cost advantages a firm realizes as it grows
101. See CAMPBELL R. MCCONNELL & STANLEY L. BRUE, Microeconomics 160-62 (16th ed. 2004) (discussing economies of scale).
102. Gartenberg, 694 F.2d at 928.
103. Freeman & Brown, supra note 33, at 645
104. Gartenberg, 694 F.2d at 928.
105. Krinsk v. Fund Asset Mgmt., 875 F.2d 404, 409 (2d Cir. 1989) (citing Gartenberg, 694 F.2d at 929-30).
106. Krantz v. Prudential Invs. Fund Mgmt. LLC, 305 F.3d 140, 143 (3d Cir. 2002) (per curiam).
107. Migdal v. Rowe Price-Fleming Int'l, Inc., 248 F.3d 321, 326-27 (4th Cir. 2001).
108. See, e.g., Lori A. Martin & Martin Lybecker, It's Too Early to Disregard the Gartenberg Factors During Advisory Fee Renewals, WILMERHALE, May 27, 2008, http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8329 (noting that Gartenberg "has been applied by district courts in the First, Second, Third, Fourth, Fifth, Eighth, Ninth and Tenth Circuits").
109. See Phillips et al., supra note 16 ("[D]irectors should continue to engage in a thoroughgoing Section 15(c) process that considers the Gartenberg factors, along with other information the directors deem important, in determining the reasonableness of management fees.").
110. Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, 69 Fed. Reg. 39,797, 39,801 (June 30, 2004) (codified at 17 C.F.R. pts. 239, 240, and 274).
111. JAMES D. COX, ROBERT W. HILLMAN & DONALD C. LANGEVOORT, SECURITIES REGULATION, CASES AND MATERIALS 1116-17 (5th ed. 2006).
112. Jones v. Harris Assocs., 527 F.3d 627, 632 (7th Cir. 2008) ("Having had another chance to study this question, we now disapprove the Gartenberg approach.").
113. Brief and Required Short Appendix of Plaintiffs-Appellants at 33, Jones v. Harris Assocs., No. 07-1624 (7th Cir. 2008), 2007 WL 1582568 [hereinafter Brief of Plaintiffs].
114. See supra note 101 and accompanying text
115. Brief of Plaintiffs, supra note 115, at 37
116. Id.; Jones v. Harris Assocs., 527 F.3d 627, 631 (7th Cir. 2008).
117. Brief of Plaintiffs, supra note 115, at 27. Chief Judge Easterbrook conflated the plaintiffs' arguments regarding the district court's comparative fee analysis with the plaintiffs' description of Gartenberg's flaws. Compare Harris Assocs., 527 F.3d at 631 (stating that the plaintiffs contended that the court should not follow Gartenberg because it relies too much on the market and disregards the fees charged to institutional clients), with Brief of Plaintiffs, supra note 115, at 33-37 (noting that the comparative fee structure analysis of the district court was inappropriate because it assumed market competition set mutual fund fee rates and ignored a comparison to institutional clients' fees, but urging the court to consider whether Gartenberg should be uncritically accepted because it fails to appreciate the immateriality of recent fund performance and understates the fiduciary duty standard).
118. Harris Assocs., 527 F.3d at 632.
119. Id. ("Section 36(b) does not say that fees must be 'reasonable' in relation to a judicially created standard. It says instead that the adviser has a fiduciary duty.").
120. See supra note 112 and accompanying text
121. Harris Assocs., 527 F.3d at 632.
122. Id. At first blush this standard seems similar to Gartenberg's "disproportionately large" standard, but, as Judge Posner's dissent points out, the panel's standard can only be compared to other mutual fund fees, whereas the Gartenberg standard is "not so limited." Jones v. Harris Assocs., 537 F.3d 728, 732 (7th Cir. 2008) (Posner, J., dissenting from denial of rehearing en banc).
123. Harris Assocs., 527 F.3d at 634 ("Mutual funds come much closer to the model of atomistic competition than do most other markets.").
124. See supra notes 81-85 and accompanying text (describing the mutual fund studies of the 1960s)
125. Harris Assocs., 527 F.3d at 633.
126. Id. at 634 (citing Coates & Hubbard, supra note 12).
127. Id. at 635 ("As § 36(b) does not make the federal judiciary a rate regulator, after the fashion of the Federal Energy Regulatory Commission, the judgment of the district court is affirmed."); id. at 633 ("Section 36(b) does not create a rate-regulation mechanism, and plaintiffs' proposal to create such a mechanism in 2008 cannot be justified by suppositions about the market conditions of 1970."); id. ("Judicial price-setting does not accompany fiduciary duties. Section 36(b) does not call for a departure from this norm.").
128. Jones v. Harris Assocs., 537 F.3d 728, 729 (7th Cir. 2008) (per curiam).
129. The panel voted unanimously to deny the plaintiffs' petition for a rehearing. But the rules of the Seventh Circuit permit a judge to request that any motion be considered by the court en banc. 7th Cir. R. 1(a)(2). A judge, likely Judge Posner, requested a vote on the request for an en banc hearing. Since a majority of the circuit did not favor a rehearing, the petition was denied. Judge Posner dissented from that denial. Jones v. Harris Assocs., 537 F.3d 728, 729 (7th Cir. 2008) (Posner, J., dissenting from denial of rehearing en banc).
130. J. Mark Ramseyer, Commentary, Not-So-Ordinary Judges in Ordinary Courts: Teaching Jordan v. Duff & Phelps, Inc., 120 HARV. L. REV. 1199, 1199 (2007) (detailing another case in which Judges Easterbrook and Posner disagreed on a fiduciary duty standard).
131. Floyd Norris, The Supremes Will Decide Which Economics Makes Legal Sense, N.Y. TIMES, Mar. 9, 2009, http://norris.blogs.nytimes.com/2009/03/09/the-supremes-will-decide-which-economics-makes-legal-sense/.
132. For a critical commentary on executive compensation by Judge Posner, see generally Richard A. Posner, Are American CEOs Overpaid, and, if So, What if Anything Should Be Done About It?, 58 DUKE L.J. 1013 (2009).
133. Harris Assocs., 527 F.3d at 632. Chief Judge Easterbrook cited Green v. Nuveen Advisory Corp., 295 F.3d 738 (7th Cir. 2002), and Green v. Fund Asset Management, 286 F.3d 682 (3d Cir. 2002).
134. Harris Assocs., 537 F.3d at 729 (Posner, J., dissenting from denial of rehearing en banc).
135. Id. at 730-31 (quoting Camelia M. Kuhnen, Social Networks, Corporate Governance and Contracting in the Mutual Fund Industry (Mar. 1, 2007), http://ssrn.com/abstract=849705).
136. Jones v. Harris Assocs., 527 F.3d 627, 634 (7th Cir. 2008).
137. Harris Assocs., 537 F.3d at 731 (Posner, J., dissenting from denial of rehearing en banc).
138. Id. A price floor is the value below which a price will not, or will not be allowed to, fall.
139. Norris, supra note 141
140. E.g., Floyd Norris, Judges in Dispute over Mutual Funds, N.Y. TIMES, Aug. 15, 2008, at C3, available at http://www.nytimes.com/2008/08/16/business/16place.html.
141. See, e.g., Ropes & Gray, Appeals Court Rejects Mutual Fund Excessive Fee Claims, Adopting New Standard for Evaluation of Fees, ROPES & GRAY, May 20, 2008, http://www.ropesgray.com/litigationalert/("The immediate consequences of the Harris opinion are difficult to predict.").
142. Norris, supra note 163
143. Jones v. Harris Assocs., 129 S. Ct. 1579 (2009).
144. Supreme Court, November 2, 2009 Session, http://www.supremecourtus.gov/oral_arguments/argument_calendars/MonthlyArgumentCalNovember2009.html (last visited Aug. 27, 2009).
145. Freeman et al., supra note 17, at 126.
146. Freeman & Brown, supra note 33, at 614
147. Freeman et al., supra note 17, at 144-45 ("Under the McDonnell Douglas framework, once a prima facie case of disparate treatment is made, the defendant must produce evidence to rebut the presumption of discrimination. At this point it becomes incumbent on the defendant to articulate a legitimate non-discriminatory reason explaining why the disparity exists. In the fund fee context, the advisor would need to produce evidence showing that the captive fund was fairly treated-a task it could accomplish by identifying and quantifying the service differences between picking portfolio securities for third-party institutional clients versus the captive mutual fund. Once the defendant has presented evidence to explain the fee disparity, it remains for the plaintiff to show the pricing disparity evidences a breach of fiduciary duty. The plaintiff would do this by proving, by a preponderance of the evidence, that the differences in services the defendant identified do not adequately explain or justify the fee disparity. Here, the plaintiff's ultimate burden will be to show that the captive fund was charged substantially more than free market clients for like work." (footnote omitted)).
148. Langevoort, supra note 8, at 1024
149. John M. Greabe et al., Moving Beyond Gartenberg: A Process-Based and Comparative Approach to § 36(b) of the Investment Company Act of 1940, 28 ANN. REV. BANKING & FIN. L. 133, 146 (2009). The authors represent the plaintiffs in Jones v. Harris Associates. Jones v. Harris Assocs., 527 F.3d 627, 629 (7th Cir. 2008).
150. Greabe et al., supra note 178, at 146.
151. Johnson, supra note 17, at 528
152. Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923, 928 (2d Cir. 1982).
153. See supra notes 126-27 and accompanying text
154. BLACK'S LAW DICTIONARY 1478 (8th ed. 2004). Thomas Jefferson was an early proponent of sunset laws, arguing that no legislation or constitution should last for more than nineteen years. In contemporary times, commentators have advocated sunset laws for regulatory statutes and agencies. GUIDO CALABRESI, A COMMON LAW FOR THE AGE OF STATUTES 59-60 (1982).
155. Jones v. Harris Assocs., 527 F.3d 627, 633 (7th Cir. 2008).
156. Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006).
157. Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 VA. L. REV. 669, 669 (1984).
158. 15 U.S.C. § 80a-35(b)(2) (2006).
159. For a discussion of the inefficiency of the mutual fund market, see Part III.B.2.
160. Harris Assocs., 527 F.3d at 635.
161. 15 U.S.C. § 80a-15(c) (2006).
162. Harris Assocs., 527 F.3d at 632.
163. 15 U.S.C. § 80a-35(b)(2).
164. Easterbrook & Fischel, supra note 188, at 670
165. Coates & Hubbard, supra note 12, at 154 ("[W]e find that enough investors are sensitive to advisory pricing that higher fees significantly reduce fund market shares.").
166. Id. at 153 ("The periodic attacks on the mutual fund industry start with a correct premise-that mutual fund boards rarely fire advisers-but reach a faulty conclusion-that the structure of mutual funds prevents competition.").
167. See WALLISON & LITAN, supra note 7, at 8 ("The [mutual fund] industry... does not appear to conform to the 'law of one price'-that is, the prices of the collective investment services that mutual funds provide are not converging toward a common level, although convergence would be expected in a competitive market.").
168. E.g., Cox & Payne, supra note 17, at 911 ("[I]t is not conceivable that meaningful arbitrage can be introduced efficiently in the pricing of mutual fund shares....")
169. Edwin J. Elton, Martin J. Gruber & Jeffrey A. Busse, Are Investors Rational? Choices Among Index Funds, 59 J. FIN. 261, 286 (2004) (observing that arbitrage opportunities do not exist in mutual funds).
170. Langevoort, supra note 8, at 1032
171. John Bogle argues that this is already happening as managers charge excessive fees and focus on salesmanship over stewardship. BOGLE, supra note 11, at 167.
172. Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, 1988 DUKE L.J. 879, 879.
173. Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928).
174. DeMott, supra note 206, at 880
175. See Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985) (discussing the business judgment rule).
176. Edward B. Rock, Saints and Sinners: How Does Delaware Corporate Law Work?, 44 UCLA L. REV. 1009, 1016 (1997).
177. Though over eight thousand mutual funds exist, fewer than seven hundred firms serve as fund sponsors. INV. CO. INST., supra note 2, at 13, 15.
178. Rock, supra note 210, at 1013
179. See e.g., Martin & Lybecker, supra note 108 ("Independent directors should continue to consider the Gartenberg factors.... The Gartenberg approach has shaped how mutual fund boards of directors have conducted so-called 15(c) renewals for almost thirty years.... [B]oards of directors can clearly document that they have served as independent watchdogs on the management of investment companies by continuing to review the nature and quality of the services provided to the investment company and its shareholders.")
180. Krinsk v. Fund Asset Mgmt., 875 F.2d 404, 409-12 (2d Cir. 1989) (discussing each Gartenberg factor).
181. See sources cited supra note 17
182. Freeman et al., supra note 17, at 144-45 (proposing replacing the Gartenberg test with the McDonnell Douglas framework).
183. The Gartenberg factors do not have to end a board's fiduciary duty analysis. Professor Rock suggests that factors and cases can guide critical players like boards but do not create a safe harbor from vigilantly performing their duties. Confusion reigns when "a player interprets the cases as establishing a substantive safe harbor, rather than explicating a conduct norm." Rock, supra note 210, at 1063. Boards should work to protect shareholders even if that work takes them beyond Gartenberg.
184. The plaintiffs in Harris Associates "maintain[ed] that a fiduciary may charge its controlled clients no more than its independent clients." Jones v. Harris Assocs., 527 F.3d 627, 631 (7th Cir. 2008). This Note disagrees. A fund should be able to charge its controlled clients more than institutional clients if the difference in price arises from actual administrative cost differences. It may be objectionable, however, for a fund to profit from its controlled clients more than from its independent clients when that extra profit results from a lack of arm's-length bargaining.
185. Professor Freeman focuses on courts', not boards', recognition of comparables' power, and maintains that when investment advisors treat a third-party more favorably than their retail clients, that difference should be prima facie evidence of a breach of fiduciary duty. Freeman et al., supra note 17, at 144. This Note's "strongly indicative" standard engages both boards and courts to broaden the narrative development of the fiduciary standard. It also allows for the investment advisor to offer a legitimate basis for a larger profit spread.
186. Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923, 928 (2d Cir. 1982).
187. See Rogers & Benedict, supra note 41, at 1084 ("[T]he Commission and the industry never did concur on what the term 'fiduciary duty' meant in this context.").
188. See id. at 1082-89 (describing Congress's rejection of the reasonableness standard and the legislative compromise that followed).
189. The industry would likely agree with the fairness standard. See Coates & Hubbard, supra note 12, at 204 ("Absent a clear statute, courts fall back on the common law, and absent the presumption of the business judgment rule, that standard would ordinarily be a 'fairness' standard.").
190. S. Rep. No. 91-184, at 5 (1969).
191. H.R. Rep. No. 89-2337, at 131 (1966), available at http://sechistorical.org/collection/papers/1960/1966_InvestCoGrowth/CH3D.PDF.
192. The Eighth Circuit ruled on April 8, 2009, that the district court erred when it rejected a comparison between fees paid by institutional and mutual fund clients. Gallus v. Ameriprise Fin., Inc., 2009 U.S. App. LEXIS 7382 (8th Cir. 2009).
193. Jones v. Harris Assocs., 537 F.3d 728, 731-32 (7th Cir. 2008) (Posner, J., dissenting from denial of rehearing en banc) (quoting Freeman & Brown, supra note 33, at 634).
194. Freeman & Brown, supra note 33, at 631. One would expect the larger funds to pay smaller fees, as a percentage of assets under management, due to economies of scale.
195. Chief Judge Easterbrook suggested reasons why retail investors may be charged more. Jones v. Harris Assocs., 527 F.3d 627, 634-35 (7th Cir. 2008). Judge Posner noted that "[t]he panel opinion throws out some suggestions on why this difference may be justified, but the suggestions are offered purely as speculation, rather than anything having an evidentiary or empirical basis." Harris Assocs., 537 F.3d at 731 (Posner, J., dissenting from denial of rehearing en banc).
196. For example, it may require more skill to manage the liquidity needs of a retail fund, thus warranting higher profit
197. See Freeman & Brown, supra note 33, at 669 (proposing a uniform, clearly delineated system of expense reporting)
198. See Coates & Hubbard, supra note 12, at 187-88 ("Data are not readily available to accurately isolate the pure costs of portfolio management....")
199. Freeman et al., supra note 17, at 109 ("[I]t is undoubtedly correct that a minor amount of commingling of expense items sometimes exists and-quite regrettably-frustrates perfect apples-to-apples comparisons on a universal basis.").
200. This will require that investment advisors disclose these fees to the boards as part of the yearly 15(c) contract approval process
201. Boards do not have a fiduciary duty to shareholders under Section 36(b), but they are accountable to shareholders through state law
202. See Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985) ("Under Delaware law... the business and affairs of a Delaware corporation are managed by or under its board of directors.... [D]irectors are charged with an unyielding fiduciary duty to the corporation and its shareholders.").
203. See supra note 90 and accompanying text
204. 15 U.S.C. § 80a-15(c) (2006).
205. This assumes investment advisors believe that investors will become or are already sensitive to fees when selecting a fund
206. Year-End Review of Markets & Finance 2008 - SOS: 'Save Our Stocks' - A Look Back at a Year of Bailouts, Underwater Investors and Sunken Hopes, WALL ST. J., Jan. 2, 2009, at R9.
207. Timothy R. Homan, IMF Says Losses from Crisis May Hit $4.1 Trillion, BLOOMBERG, Apr. 21, 2009, http://www.bloomberg.com/apps/news?pid=20601087&sid=azkSmZrrIHKQ.
208. See generally Con of the Century, ECONOMIST, Dec. 20, 2008, at 119 (describing the Madoff scandal and estimating a $50 billion cost to investors)
209. Evan Perez and Steve Stecklow, Stanford Is Indicted in Fraud, Surrenders, WALL ST. J., June 19, 2009, at C1 (reporting Allen Stanford's indictment for fraud).
210. Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928).