When the U.S. Supreme Court issued its Jones v. Harris Associates L.P. decision in March 2010, the justices articulated what a mutual fund shareholder must prove in order to demonstrate that the fund's investment adviser breached the "fiduciary duty with respect to the receipt of compensation for services" as imposed by section 36(b) of the Investment Company Act of 1940. Jones found that liability under section 36(b) will not attach unless an investment adviser 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."

One issue the Supreme Court was asked to address was the relevance of comparisons of advisory fees that an adviser charges to a fund for which it serves as primary investment adviser to advisory fees that the adviser charges to institutional clients. Jones rejected any assertion that "there can be any categorical rule regarding the comparisons of the fees charged different types of clients." However, the opinion went on to express skepticism regarding the probative value of any such comparison: 

[T]here may be significant differences between the services provided by an investment adviser to a mutual fund and those it provides to a pension fund which are attributable to the greater frequency of shareholder redemptions in a mutual fund, the higher turnover of mutual fund assets, the more burdensome regulatory and legal obligations, and higher marketing costs. …If the services rendered are sufficiently different that a comparison is not probative, then courts must reject such a comparison. Even if the services provided and fees charged to an independent fund are relevant, courts should be mindful that the [1940] Act does not necessarily ensure fee parity between mutual funds and institutional clients.

And in a reminder to always read the footnotes, Jones stated that "[o]nly where plaintiffs have shown a large disparity in fees that cannot be explained by the different services in addition to other evidence that the fee is outside the arm's-length range will trial be appropriate."

Beginning in 2003 and continuing through the Jones decision, the plaintiffs' bar brought several substantially similar section 36(b) lawsuits, each of which—including Jones—alleged that fund advisory fees were excessive when viewed against advisory fees charged by the same advisers to non-fund clients, including institutions.[1] After the Supreme Court issued the Jones decision, plaintiffs largely abandoned section 36(b) litigation comparing fund advisory fees to institutional advisory fees.

Changes in Institutional Marketplace

At the same time, since Jones was decided, the institutional asset management marketplace has changed considerably. The Investment Company Institute's amicus brief filed in the Jones case stated that:

Advisers often provide mutual fund investors with around-the-clock customer support, extensive websites, check-writing privileges, automatic investment programs, and tax reporting services, in addition to professional portfolio management. Services for non-mutual fund institutional clients are tailored to their more limited needs, and usually focus principally on portfolio management.[2] 

Indeed, in 2010 institutional asset management services reflected portfolio management and little else. However, just as iPhones and Androids have displaced BlackBerrys, an array of advice- and technology-oriented services is increasingly displacing simple portfolio management[3]—one asset manager provides clients with a platform that enables them to assess risk;[4] institutional clients are seeking assistance with portfolio construction and whole portfolio technology solutions;[5] and asset managers are being asked to provide services such as model building, thought leadership, and content.[6]

What does asset management evolution have to do with section 36(b) litigation?

Maybe quite a bit. A fund board member can no longer take for granted that institutional asset management services are simply portfolio management services. Some services provided by an asset manager to an institutional client—for example, portfolio construction or outsourced chief investment officers—come with significant costs of their own. Increasingly, it is no longer accurate to say that institutional asset management services are simply a subset of the services provided to retail mutual fund investors. Instead, in many instances, portfolio management may be the sole common service, while mutual fund investors and institutional investors are provided with different types of services tailored to meet their individual needs.

Questions for the Adviser

In this environment, a fund board member may be well served to request that the primary adviser supply the board not only with comparative fee information, but with information about the services provided to institutional clients, how these clients are charged for these services, and the cost of providing them with these services. In particular, board members should be asking questions such as:

• What other types of clients do you have in strategies that mirror our funds?
• What do their fees look like?
• Do you have clients that have remained in strategies that mirror our funds for several years? If yes, what types of services do you offer them now as compared to when they were first onboarded? What do their fees look like now?
• What types of services other than investment management services are you now providing to institutional clients? How are you charging for these services—is the fee wrapped into the investment management fee, or are separate fees charged for each service? 
• How much does it cost you to provide each of these ancillary services?

In instances in which asset managers have expanded the types of services they offer to institutional clients beyond portfolio management, board members should seek to establish that fund management fees are not being used inappropriately to subsidize the cost of the new services provided to institutional clients.

Clearly, much has changed in the asset management industry since Jones was decided in 2010. However, one constant has been: "Where a board’s process for negotiating and reviewing investment adviser compensation is robust, a reviewing court should afford commensurate deference to the outcome of the bargaining process … if the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight."[7] Another constant is that "where the board's process was deficient or the adviser withheld important information, the court must take a more rigorous look at the outcome."[8]

As the nature of the institutional asset management industry changes, directors must continue to request all relevant information and assess fund investment management fees against not only the level of institutional investment management fees, but the menu of services made available to institutions in exchange for those fees.

Ethan Corey has spent 22 years as an investment management lawyer and has deep knowledge and expertise in distribution issues (including FINRA rules) as well as 1940 Act and Advisers Act issues. Before joining Practus, he was a senior vice president and associate general counsel at MFS Investment Management in Boston, where he oversaw global regulatory initiatives and supervised the MFS Legal Department's Distribution, Regulatory and Corporate Group. Corey also served as counsel at Dechert LLP and senior counsel at the Division of Investment Management at the SEC.