Two Recent Decisions Impact Mutual Fund Fees And Income Interest Taxability

Originally published May 22, 2008

Keywords: Mutual Funds, mutual fund fees,

income interest, Oakmark, Harris Associates, Investment Company

Act of 1940, section 36(b), investment adviser, Gartenberg, fee

schedule

The US Court of Appeals for the Seventh Circuit and the US

Supreme Court issued decisions in two important cases impacting

mutual funds. In the Seventh Circuit, the court rejected the

Gartenberg analysis, holding that Section 36(b) of the

Investment Company Act of 1940 does not imply judicial review

for reasonableness of fees charged by a fund's investment

adviser. On the same day, the Supreme Court upheld a statute

that allows applicable state residents to exclude from their

state taxable income interest received from state-issued

municipal bonds, thus preserving single state municipal bond

funds.

Jones v. Harris Associates, L.P

Seventh Circuit rejects Gartenberg

analysis

In Jones v. Harris Associates, L.P.,1

the Seventh Circuit affirmed the district court's decision

to reject shareholders' claims that Harris Associates, the

adviser to the Oakmark complex of mutual funds, charged

excessive management fees under Section 36(b) of the Investment

Company Act of 1940.

Section 36(b) states, in relevant part, that "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."2 This

section grants the Securities and Exchange Commission, or the

security holder, a right to bring an action against an

investment adviser for excessive compensation. Section 36(b)

further notes that "approval by the board of directors of

such investment company of such compensation or payments . . .

shall be given such consideration by the court as is deemed

appropriate under all the circumstances . . .

."3

The current leading case under Section 36(b) is

Gartenberg v. Merrill Lynch Asset Management,

Inc.,4 in which the Second Circuit stated that

the critical test under Section 36(b) is "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."5 Further, the

Gartenberg court stated that in order to violate

Section 36(b), 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."6

The district court in Jones, following

Gartenberg, concluded that Harris Associates did not

violate Section 36(b) because its management fees were ordinary

in comparison to the management fees charged by other advisers

to funds of similar size and investment goals. In...