Supreme Court Sets Standard to Review Investment Adviser Compensation
April 9, 2010
The Supreme Court set the standard for courts to evaluate whether investment adviser compensation is excessive in its recently announced decision in Jones, et al. v. Harris Associates, LP, No. 08-586 (Mar. 30, 2010). The Court’s decision concerns mutual funds governed by the Investment Company Act of 1940, a securities law, but it is widely thought that the decision will also apply to claims regarding investment adviser fees for work on 401(k) ERISA plans. 401(k) plans invest heavily in mutual funds and thus allow for a natural extension of this decision.
In Harris Associates, mutual funds shareholders alleged that the company managing the funds at issue, which also acted as the funds’ investment adviser, had breached its fiduciary duty by receiving excessive compensation. The Court ultimately sent the case back to a federal court of appeals for additional review, but in doing so it adopted the standard of review by which all courts will now evaluate investment adviser compensation. The standard provides: “to face liability…, an investment 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.”
The Court recognized that the primary control for investment adviser compensation is review by an independent board of directors acting in a fiduciary capacity. Significantly, the Court explained that a sliding scale of scrutiny applies to compensation decisions depending upon the fiduciaries’ process of review. If fiduciaries have in place a “robust” process for negotiating and reviewing compensation, the scrutiny will be low and the fiduciaries’ decision subject to a high level of deference. Conversely, if the procedures employed are deficient, or if relevant information was not considered prior to setting the compensation, a court will review the outcome more closely.
To comply with Harris Associates, and obtain a beneficial level of court review, fiduciaries of 401(k) plans are advised to have in place a thorough fee review process that takes into account all information relevant to investment adviser services, including:
- The nature and quality of the services provided;
- The costs to the adviser in providing the service and the profitability of the fund to the adviser, including any collateral benefits that accrue to the adviser because of its relationship with the fund;
- The volume of orders processed by the adviser;
- The extent to which the adviser realizes economies of scale as the fund grows larger; and
- The fees charged by the adviser for similar services performed for other funds.
Further, the process ought to be designed to take into account the independence, expertise, care, and conscientiousness with which the fiduciaries perform their fee review duties.