Seventh Circuit Rejects Gartenberg Analysis In Affirming District Court's Dismissal Of Excessive Fee Suit Against Mutual Fund Adviser

Developments Of Note

Seventh Circuit Rejects Gartenberg Analysis in

Affirming District Court's Dismissal of Excessive Fee

Suit Against Mutual Fund Adviser

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Fannie Mae and Freddie Mac

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Banking and Insurance Sectors

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Material Supervisory Determinations

Developments Of Note

Seventh Circuit Rejects Gartenberg Analysis In

Affirming District Court's Dismissal Of Excessive Fee Suit

Against Mutual Fund Adviser

The US Court of Appeals for the Seventh Circuit (the

"Seventh Circuit") affirmed the dismissal by the US

District Court for the Northern District of Illinois (Eastern

Division) (the "District Court") of an excessive fee

suit brought under Section 36(b) of the Investment Company Act

of 1940, as amended (the "1940 Act"), against an

adviser (the "Adviser") of registered open-end funds

(the "Funds") by Fund shareholders. On appeal, the

plaintiffs argued that the Adviser had breached the fiduciary

duty with respect to compensation that it owed the Funds under

Section 36(b) because the fees it charged the Funds for its

advisory services were disproportionate to the value of those

services, as evidenced by the fact that the Funds' fees

exceeded those charged the Adviser's institutional clients

whose accounts were being managed using similar investment

strategies. The plaintiffs also argued that the District Court

erred in using the multi-factor analysis for suits under

Section 36(b) of the 1940 Act established by the US Court of

Appeals for the Second Circuit in Gartenberg v. Merrill

Lynch Asset Management, Inc ., 694 F2d 923 (2d Cir. 1982)

("Gartenberg").

The District Court Decision. In granting the

Adviser's motion for summary judgment, the District Court

analyzed the allegations in the complaint and the evidence

adduced in their support using the Gartenberg factors,

e.g., the comparability of a fund's fees to other

similar funds; the cost to the adviser to provide services to

the fund; the nature and quality of the services provided,

including the fund's performance history; whether and to

what extent the fund's adviser realizes economies of scale

as the fund's assets increase; and the conduct of,

expertise, and level of information possessed by the fund

directors charged with approving the fee. Based on its

Gartenberg analysis, the District Court determined

that the evidence proffered by the plaintiffs established that

others paid different amounts for similar services, but did not

support a reasonable inference that the difference was enough

to put the amounts charged outside of the range that could be

expected to result from arms'-length bargaining.

The Seventh Circuit's Decision. The Seventh

Circuit's opinion was written by Chief Judge Easterbrook,

who, along with his Seventh Circuit colleague Judge Posner, is

noted for his economics-based approach to legal analysis. The

opinion places heavy emphasis on the role of market forces in

controlling mutual fund advisory fees. Although it affirmed the

District Court's decision, the Seventh Circuit explicitly

rejected the Gartenberg approach. The Seventh Circuit

held that Section 36(b) does not establish a reasonable fee

standard to be set by the judiciary, rather it imposes a

fiduciary duty grounded in the law of trusts. The Seventh

Circuit explained: "[a] fiduciary duty differs from rate

regulation. A fiduciary must make full disclosure and play no

tricks but it is not subject to a cap on compensation. The

trustees (and in the end investors, who vote with their feet

and dollars), rather than a judge or jury, determine how much

advisory services are worth." Citing examples of

situations in which fiduciary duty applies to the determination

of compensation, the Seventh Circuit explained that "&

the rule in trust law is straightforward: [a] trustee owes an

obligation of candor in negotiation, and honesty in

performance, but may negotiate in his own interest and accept

what the settlor or governance institution agrees to pay."

The Seventh Circuit observed that it could imagine

circumstances where a fiduciary's compensation could be so

outside established norms that a court could "infer that

deceit must have occurred, or that the persons responsible for

decision [sic] have abdicated&." However, in this

instance, the Seventh Circuit found that the plaintiffs

"do not contend that [the Adviser] pulled the wool over

the eyes of the disinterested trustees or otherwise hindered

their ability to negotiate a...