Chapter 7. Shareholder Expenses and
A. Investment Adviser Fees
Disclosure Regarding Approval of
Investment Advisory Contracts
by Directors of Investment Companies
Investment Company Act Release No. 26350
Securities and Exchange Commission
February 19, 2004
69 Fed. Reg. 7852
Unlike most business organizations, registered management investment
companies (Afunds@ ) are typically organized by an investment adviser that is
responsible for the day-to-day operations of the fund. In most cases, the investment
adviser is organized as a corporation, whose shareholders may have an interest in the
fund that is quite different from the interests of the fund=s shareholders. One of the
key areas where the interests of fund shareholders and shareholders of the investment
adviser diverge is fees. While fund shareholders ordinarily prefer lower fees to
achieve greater returns, shareholders of the fund=s investment adviser often want to
maximize profits through higher fees.
The Investment Company Act relies on fund boards of directors to police
conflicts of interest, including conflicts with respect to fees to be received by
investment advisers. Section 15(a) makes it unlawful for any person to serve as an
investment adviser to a fund, except pursuant to a written contract that has been
approved by a majority vote of the fund=s shareholders and that continues in effect
for not more than two years, unless its continuance is approved at least annually by
the board of directors or a majority vote of the shareholders. In addition, Section
15(c) requires that the terms of any advisory contract, and any renewal thereof, be
approved by a vote of the majority of the disinterested directors. Section 15(c) also
requires a fund=s directors to request and evaluate, and an investment adviser to a
fund to furnish, such information as may reasonably be necessary to evaluate the
terms of any advisory contract. As part of their fiduciary duties with respect to fund
fees, boards of directors are required to evaluate the material factors applicable to a
decision to approve an investment advisory contract.
Gartenberg v. Merrill Lynch Asset Management, Inc.
694 F.2d 923 (2d Cir. 1982),
cert. denied, 461 U.S. 906 (1983)
OPINION OF THE COURT
Irving L. Gartenberg and Simone C. Andre, two shareholders of the Merrill
Lynch Ready Assets Trust, a money market fund (the "Fund"), appeal from a
judgment of the Southern District of New York, Milton Pollack, Judge, entered after
a non-jury trial, dismissing their consolidated derivative actions against the Fund and
its affiliates, Merrill Lynch Asset Management, Inc., the adviser and manager of the
Fund (the "Manager") and Merrill Lynch, Pierce, Fenner & Smith, Inc. (the
"Broker"). The plaintiffs claimed violations of ' 36(b) of the Investment Company
Act of 1940 (the "Act"). The principal claim is that the fees paid by the Fund to the
Manager for various services, including investment advice and processing of daily
orders of the Fund's shareholders, were so disproportionately large as to constitute a
breach of fiduciary duty in violation of ' 36(b). We affirm the judgment dismissing
. . . The Fund, organized in 1975 as a no-load, diversified, open-end
investment company, invests in short-term money market securities expected to pay
the highest current income consistent with preservation of capital and maintenance of
liquidity, such as short-term securities of the U.S. Government or its agencies, bank
certificates of deposit, and commercial paper. An investor may purchase and redeem
shares of the Fund without any charges or penalties. There is a daily declaration of
dividends, reflecting the net income of the Fund's portfolio. As the district court
noted, the purchaser's investment in the Fund is more like a bank account than the
traditional investment in securities. Idle money can be invested in the Fund for as
little as a day and put to work earning interest. The ease of entrance and egress for
the investor, coupled with the ability to share in high yields which the modest
investor could not obtain through a bank deposit and might not be able to realize
alone, has with the rise (until recently) of interest rates attracted an increasing
number of investors. As a result the size of the Fund increased enormously over a
few years, from $288 million in April 1977 to over $19 billion as of September 1981.
The Fund has an 8-person Board of Trustees, of whom 2 are interested and 6
are independent and unaffiliated. The operations of the Fund are conducted by the
Manager, which provides the Fund with office space and facilities, administrative
staff, equipment, portfolio management, compliance with SEC and state
recordkeeping and reporting requirements, and services to Fund shareholders. For
the processing of approximately 80% of the purchases and redemptions of shares of
the Fund the Manager uses the Broker, another Merrill Lynch affiliate, which is the
largest registered broker-dealer in the United States, with 408 domestic offices
located in numerous cities and towns, in which more than 7,000 account executives
are located. In addition, the Manager uses the vast facilities of the Merrill Lynch
organization and its affiliates to render special services to the Fund. For example,
Merrill Lynch Economics, Inc. provides economic research and forecasting services
while Merrill Lynch Government Securities, Inc. provides expertise with respect to
U.S. government and agency securities. A customer located anywhere in the United
States can call the nearest office of the Broker or the Bank of New York, the Fund's
custodian and transfer agent, order the purchase or redemption without charge of
shares of the Fund, and through use of wires and computers the transaction will be
carried out immediately. An average of 30,000 such orders are processed daily by
the Broker's large organization.
Under the foregoing management the Fund has performed reasonably well in
terms of average percentage yields for its shareholders. Its average percentage yields
from 1978 through 1980 were slightly above the average for all similar funds. In
1980 it ranked 37th out of 76 money funds in terms of yield.
For all of these services the Manager charges the Fund an advisory fee based
on a percentage of the average daily value of the Fund's net assets. The fee rate is
graduated downward as the Fund's total assets increase in value. Since 1979 the
schedule called for payment of 0.50% (1/2 of 1%) of the Fund's average daily value
of net assets under $500 million and for various intermediate percentages as the value
of the net assets increases down to 0.275% for assets in excess of $25 billion,
resulting in an effective rate of 0.288%. This schedule is the product of a series of
negotiations by the 6 independent Fund Trustees with the Manager over the period
from 1977 to 1979, which resulted in reductions in the effective rate as the Fund
grew in size.
Three studies were made at the Fund's instance to determine the estimated
cost of the processing services provided by the Broker through the Manager to the
Fund, two by the Merrill Lynch organization's internal accounting staff [the "Diemer
estimate" and the "Fitz-Gerald estimate"] and one by the independent accounting firm
of Peat, Marwick, Mitchell & Co. ("PMM"). The estimates ranged from $2.02 to
$7.50 per Fund order. The earlier internal study which produced the lowest figure
did so mainly because it used a modified "incremental" cost method of accounting,
based on the assumption that most costs would have been incurred by the Broker
even if it had processed no Fund orders. By the time the PMM study was conducted
in late 1979, however, modified full cost accounting methods were used for the
reason that Fund orders represented a sizeable proportion of all business processed by
the Broker; indeed, by April 1981 Fund orders accounted for 37% of all Broker
business, necessitating the hiring by the Broker of close to 3,000 non-sales personnel.
Had the Manager been required to reimburse the Broker for these costs instead of
their being absorbed by the Broker as another Merrill Lynch affiliate, the Broker'sI
net profit after taxes would have been greatly reduced, resulting in a figure ranging
from a 38.4% profit to a substantial loss depending on which cost accounting study
I Editor's note: The court evidently intended to refer to the Manager, not the
was used. In 1980, for instance, the last calendar year for which full figures are
available, the Manager's fee was slightly over $33 million on the Fund's average net
assets of $11.16 billion. Based on the volume of orders generated by 675,324
purchasers, the Broker's processing costs, estimated according to the PMM study,
were so large that the Manager suffered a loss during 1980.
Judge Pollack, construing the legislative history of the Act, decided that the
standard for determining whether the Manager had been guilty of a breach of
fiduciary duty in violation of ' 36(b) was not whether its fees were "reasonable" as
urged by plaintiffs but whether they were unfair to the Fund and shareholders, which
was to be determined by reference to the nature, quality and extent of the [M]anager's
services to the Fund, the money market fund industry practice and level of
management fees, and to a lesser extent the Manager's net earnings as a result of
providing the services. After reviewing the evidence and appraising the live witness-
es who testified, he concluded that the compensation paid to the Manager was fair.
The package of services described above was found to be extensive and valuable,
providing Fund customers with the vast facilities of the Merrill Lynch organization,
which were not available to non-Merrill Lynch funds.
The Manager's fee schedule was found by Judge Pollack to "bear a fair
relation to the subject matter from which they are derived". He further found that
"the total fee was fair to the Fund" after taking into consideration the nature and
extent of the services, the fees charged by other advisers to other money market
funds, the overall cost to the Merrill Lynch organization of providing the services,
and the fee schedule's allowance for economies of scale by reducing the rate as the
Fund's net assets increased. Judge Pollack also gave weight to the process by which
the 6 noninterested trustees of the Fund approved of its management agreement with
the Manager. The trustees, who were represented by capable independent counsel,
were found to be competent, independent and conscientious in the performance of
their duties. They were furnished with sufficient information to evaluate the contract.
They thoroughly reviewed and weighed all facts pertinent to the fee, many of which
are now part of the record, before approving the Manager's fee after negotiations.
The district court rejected plaintiffs' argument that in determining the fairness
of the Manager's compensation the court must take into account as an offset to the
Manager's fee the value to the Merrill Lynch organization of "fall-out" business
generated by Fund customers who, after opening up a no-charge Fund account,
transact other financial business with the Merrill Lynch Broker, such as purchases of
stocks and bonds, for which the customer is charged a fee or commission. Thirty-
eight percent of new Fund customers for the third quarter of 1979 transacted some
non-Fund business through the Broker by January 1980. The fall-out benefit
argument was rejected on the ground that any such offset could not be measured
since it could not be established with certainty and without heavy expense what
portion of the increase in brokerage business would have gone to the Broker without
regard to the Fund. Judge Pollack further reasoned that the idea of an offset lacked
logic since the customer would in any event have to pay a brokerage fee on non-Fund
business. The possible benefit to the Merrill Lynch organization from a "float"
resulting from its having the use of redemption funds before paying them to the
redeeming Fund customer was found unpersuasive since it was obvious to all
concerned. Plaintiffs' claim that there was unnecessary duplication in the Manager's
services based on the Bank of New York's obligation to perform them was rejected
for lack of proof.
The district court further found that an adequate disclosure of the pertinent
facts needed to determine the fairness of the Manager's fee had been made to the
Fund's trustees and shareholders.
Section 36(b) of the Investment Act of 1940, which governs this case,
provides 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" paid by the investment company or its security holders and that in an action
by a security holder on behalf of the investment company against the adviser or
affiliate "[i]t shall not be necessary to allege or prove that any defendant engaged in
personal misconduct" but "the plaintiff shall have the burden of proving a breach of
Appellants contend that the district court erred in rejecting a "reasonableness"
standard for determining whether the Manager performed its "fiduciary duty" in
compliance with ' 36(b). They further urge that the district court erred in relying
primarily, in determining whether there was a breach of fiduciary duty, on other
money market funds' level of management fees and on the Broker's costs. They
argue that since each investment company fund is a captive of its manager, from
which it cannot as a practical matter divorce itself, and since there is no possibility
that a competitor will take the fund's business from its manager by offering a lower
rate, the manager sets its own fee and the fund has no practical alternative but to pay
it. It is contended that the test should therefore be what rate would have resulted
from arm's-length negotiations in light of the services to be rendered. Appellants
further contend that under this standard the fee in this case would have been
substantially lower because of economies of scale, the Fund's massive bargaining
power as the largest fund in history, and the Broker's duplication of services which
the Bank of New York was already required to render. In short it is argued that a fee
percentage which may have been reasonable when the Fund was freshly-launched
became unreasonable when the Fund grew to its present huge size.
In support of their advocacy of a "reasonableness" standard as the test by
which a fiduciary's conduct under ' 36(b) should be governed, appellants point to
excerpts from the Act's tortuous legislative history, just as the district court relied on
other portions of the same history apparently rejecting that criterion in favor of a
"breach of fiduciary duty" standard. The legislative history contains statements of
legislators and legislative reports pointing in both directions. Bills introduced in
1967 and 1968, which would have imposed a "reasonableness" test, failed of passage.
When the mutual fund industry objected to this standard, a bill was introduced in
1969 containing ' 36(b) in its present form, which was enacted in 1970. The Senate
Report on the bill and the House Committee Report accompanying the companion
bill do not define the term "fiduciary duty" as used in the bill or how it was to be
distinguished from the term "reasonable" that had been used in predecessor bills. See
Investment Company Amendments Act of 1970, S.Rep. No. 91-184, 91st Cong., 2d
Sess. (1970), reprinted in  U.S. Code Cong. & Ad. News 4897 . . . . The
Senate Report does state that an adviser-manager would not be precluded from
earning a profit on services provided by it to a fund, that a "cost-plus" type of
contract is not required, and that the court is not authorized "to substitute its business
judgment for that of a mutual fund's board of directors in the area of management
fees," id. at 4902-03. On the other hand, the same Report states that a "corporate
waste" standard would be "unduly restrictive," [id.] at 4901, and Congressman Moss,
Chairman of the Committee on Interstate and Foreign Commerce, who was one of
the chief sponsors of ' 36(b), explained to the House that "[t]his [bill], by imposition
of the fiduciary duty, would in effect require a standard of reasonableness in the
charges". Thus there was no attempt to set forth a definitive test by which
observance or breach of fiduciary duty was to be determined.
In short, the legislative history of ' 36(b) indicates that the substitution of the
term "fiduciary duty" for "reasonable," while possibly intended to modify the
standard somewhat, was a more semantical than substantive compromise, shifting the
focus slightly from the fund directors to the conduct of the investment adviser-
manager. As the district court and all parties seem to recognize, the test is essentially
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.
The Senate recognized that as a practical matter the usual arm's length bargaining
between strangers does not occur between an adviser and the fund, stating:
"Since a typical fund is organized by its investment adviser which provides it
with almost all management services and because its shares are bought by
investors who rely on that service, a mutual fund cannot, as a practical matter
sever its relationship with the adviser. Therefore, the forces of arm's-length
bargaining do not work in the mutual fund industry in the same manner as
they do in other sectors of the American economy." S.Rep. No. 91-184,
supra,  U.S. Code Cong. & Ad. News at 4901.
To be guilty of a violation of ' 36(b), therefore, the adviser-manager 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.
To make this determination all pertinent facts must be weighed.
We disagree with the district court's suggestions that the principal factor to be
considered in evaluating a fee's fairness is the price charged by other similar advisers
to funds managed by them, that the "price charged by advisers to those funds
establishes the free and open market level for fiduciary compensation," that the
"market price ... serves as a standard to test the fairness of the investment advisory
fee," and that a fee is fair if it "is in harmony with the broad and prevailing market
choice available to the investor". Competition between money market funds for
shareholder business does not support an inference that competition must therefore
also exist between adviser-managers for fund business. The former may be vigorous
even though the latter is virtually non-existent. Each is governed by different forces.
Reliance on prevailing industry advisory fees will not satisfy ' 36(b).
We do not suggest that rates charged by other adviser-managers to other
similar funds are not a factor to be taken into account. Indeed, to the extent that other
managers have tended "to reduce their effective charges as the fund grows in size,"
the Senate Committee noted that such a reduction represents "the best industry
practice [which] will provide a guide," S.Rep. No. 91-184, supra,  U.S. Code
Cong. & Ad. News at 4902. However, the existence in most cases of an unseverable
relationship between the adviser-manager and the fund it services tends to weaken the
weight to be given to rates charged by advisers of other similar funds. Report of the
Securities and Exchange Commission on the Public Policy Implications of
Investment Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess. (1966) 131,
148.2 A fund cannot move easily from one adviser-manager to another. Therefore
2 The following statement in the Report of the Securities and Exchange
Commission on The Public Policy Implications of Investment Company Growth,
while directed to mutual funds, is pertinent to money market funds:
"It has been the Commission's experience in the administration
of the Act that in general the unaffiliated directors have not been in a
position to secure changes in the level of advisory fee rates in the
mutual fund industry. In most instances the adviser serves as, or is
closely affiliated with, the fund's principal underwriter which
maintains a distributing organization for the fund's shares. The
organization that has developed over a period of years to manage the
fund's portfolio and to furnish it with some, and in certain cases
virtually all, of the nonadvisory services necessary to its operation
belongs to the adviser and not to the fund. Indeed, in some cases all of
the fund's records are maintained by the fund's adviser. Although the
unaffiliated directors under State law have an unqualified right of
access to these records, the adviser, as a practical matter, is in a
position to seriously hamper any employment of that right which
might interfere with or threaten the adviser's operation of or control
over the fund.
"Thus, negotiations between the unaffiliated directors and fund
advisers over advisory fees would lack an essential element of arm's-
length bargaining -- the freedom to terminate the negotiations and to
bargain with other parties for the same services. In view of the fund's
dependence on its existing adviser and the fact that many shareholders
may have invested in the fund on the strength of the adviser's reputa-
"investment advisers seldom, if ever, compete with each other for advisory contracts
with mutual funds." Id. at 126.
One reason why fund competition for shareholder business does not lead to
competition between adviser-managers for fund business is the relative insignificance
of the adviser's fee to each shareholder. The fund customer's share of the advisory
fee is usually too small a factor to lead him to invest in one fund rather than in
another or to monitor adviser-manager's fees. "Cost reductions in the form of lower
advisory fees ... do not figure significantly in the battle for investor favor." Id.
Hence money market funds do not generally advertise that their advisory fees may be
lower than those charged by advisers to other funds. The disparity is competitively
insignificant. In the present case, for instance, the alleged excessive Manager's fee
amounts to $2.88 a year for each $1,000 invested. If rates charged by the many other
advisers were an affirmative competitive criterion, there would be little purpose in '
36(b). Congress, however, recognized that because of the potentially incestuous rela-
tionships between many advisers and their funds, other factors may be more
important in determining whether a fee is so excessive as to constitute a "breach of
fiduciary duty." These include the adviser-manager's cost in providing the service,
the nature and quality of the service, the extent to which the adviser-manager realizes
economies of scale as the fund grows larger, and the volume of orders which must be
processed by the manager. The legislative history of ' 36(b) makes clear that
"intended that the court look at all the facts in connection with the
determination and receipt of such compensation, including all services
rendered to the fund or its shareholders and all compensation and payments
received, in order to reach a decision as to whether the adviser has properly
acted as a fiduciary in relation to such compensation." S.Rep. No. 91-184,
supra,  U.S. Code Cong. & Ad. News at 4910.
As the district court recognized, the expertise of the independent trustees of a fund,
whether they are fully informed about all facts bearing on the adviser-manager's
service and fee, and the extent of care and conscientiousness with which they perform
their duties are important factors to be considered in deciding whether they and the
adviser-manager are guilty of a breach of fiduciary duty in violation of ' 36(b). But
even if the trustees of a fund endeavored to act in a responsible fashion, an adviser-
manager's fee could be so disproportionately large as to amount to a breach of
fiduciary duty in violation of ' 36(b). Moreover, an intent to defraud need not be
proved to establish a violation. Section 36(b)(1) expressly relieves the plaintiffs of
tion, few unaffiliated directors would feel justified in replacing the
adviser with a new and untested organization simply because of
difficulty in obtaining a reduction in long-established fee rates which
are customary in the industry." H.R. Rep. No. 2337, 89th Cong., 2d
Sess. 131 (1966).
the necessity of alleging or proving that any defendant engaged in personal
Nor do we subscribe to the district court's suggestion that because ' 36(b) was
adopted in response to public concern over fees charged to investors in front-end load
equity funds, the standard for determining whether there has been a breach of duty in
avoiding excessive fees should be different or lower for managers of no-load money
market funds, which are a recent, post-statute phenomenon. A potential for abuse of
fiduciary relationship regarding fees charged for management and advisory services
exists with respect to both types of fund since the adviser-manager's fee remains
insignificant to each shareholder, whether or not a load factor inhibits redemption of
Application of the foregoing standards to this case confirms that plaintiffs
have failed to meet their burden of proving that the fees charged by the Manager to
the Fund were so excessive or unfair as to amount to a breach of fiduciary duty
within the meaning of ' 36(b). There is no evidence that the services rendered by the
Manager have not been of the highest quality, bringing to bear the expertise and
facilities of the huge, far-flung Merrill Lynch organization. The average investor in
the Fund, while not realizing the highest possible yield for his investment, has
enjoyed a better-than-average return.
The substantial increase in the Manager's fee, from $1,578,476 in 1977 to
$39,369,587 for the year ending June 1981, resulted from the tremendous increase in
the size of the Fund, from $428 million to over $19 billion during the same period.
This increase multiplied the number of customers, daily transactions and other
activities which the Manager and the Merrill Lynch organization handled as part of
the service for the fee, thereby increasing costs proportionately. The orders
processed annually by the Manager for the Fund increased from 2,486,782 in 1979 to
6,096,537 for the 12-month period ending June 30, 1981. Appellants' contention that
since the Manager's own administrative expenses did not increase proportionately
during the period after 1978, its profit margin was 96% for the 12-month period
ending September 30, 1981, is unrealistic and was properly rejected by the district
court. Proceeding on the erroneous theory that only the administrative costs incurred
by the Manager itself may be considered, appellants ignore the heavy costs incurred
by other Merrill Lynch affiliates in processing the increased volume of purchases and
redemptions of Fund shares which were under the Manager's guidance. Since the
Manager and Broker were divisions of one economic unit, the district court was
entitled to deduct these costs in calculating the Manager's net profits. To limit
3 Appellants' argument that the lower fees charged by investment advisers to
large pension funds should be used as a criterion for determining fair advisory fees
for money market funds must also be rejected. The nature and extent of the services
required by each type of fund differ sharply. As the district court recognized, the
pension fund does not face the myriad of daily purchases and redemptions throughout
the nation which must be handled by the Fund, in which a purchaser may invest for
only a few days.
consideration to the Manager's own administrative expenses would be to exalt form
over substance and disregard the expressed Congressional intent that "all the facts in
connection with the determination and receipt of such compensation" be considered.
Although the court reduced the after-tax profits by determining the Manager's
tax liability before deducting the processing costs, deduction of the costs before
determining after-tax liability would nevertheless result in profits that could hardly be
labelled so excessive as to constitute a breach of fiduciary duty. For instance, when
processing costs are deducted before determining tax liability, the Manager's fee of
$39,369,587 for the year ending June 30, 1981, would result in a 38.4% after-tax
profit if the Fitz-Gerald estimate of processing costs were adopted, 9.8% after-tax
profit under the Diemer estimate and a $7.7 million loss under the PMM estimate. 4
4 These percentages were arrived at by the following calculations:
Fitz-Gerald Diemer Using PMM
Estimate of Estimate of Estimate of
Processing Processing Processing
Costs Costs Costs
$39,369,587 $39,369,587 $39,369,587
Less direct costs
1,567,847 1,567,847 1,567,847
Less processing costs
10,534,805 30,848,477 45,541,131
----------- ----------- ------------
Pre-tax profit (loss)
27,266,935 6,953,263 (7,739,391)
Less tax at 44.5%
12,133,786 3,094,202 --
After tax profit
15,133,149 3,859,061 --
Percentage of adviser's fee that goes to after-tax profit
38.4% 9.8% --
. . . Merrill Lynch & Co. allocates its overall tax liability to its subsidiaries,
including the Fund; the overall Merrill Lynch 1980 tax rate of 44.5% has therefore
been applied to all of these profit figures.
Appellants' contention that the PMM cost study improperly included selling
or distribution expenses that may not be taken into consideration in determining
whether the Manager's fee was excessive, see SEC Rule 12b-1, 17 C.F.R. '
270.12b-1, must be rejected, since the latter is limited to promotional expenses (e.g.,
advertising, sales literature) designed to create new sales of no benefit to existing
shareholders and the record reveals no such promotion of Fund sales by the Merrill
No cost studies showing a higher after-tax profit were offered by appellants, who had
the burden of proof. Moreover, after good-faith bargaining at arm's length between
the 6 independent Fund trustees and the Manager, the latter's rate was graduated
downward to reflect the economies that might be realized from the increase in value
of the net assets. In view of these circumstances we cannot label clearly erroneous
the district court's finding that no breach of fiduciary duty was shown.
Faced with these facts appellants respond that the Fund and the Manager, by
having the processing of purchasing and redemption orders done by the Broker, were
wastefully duplicating the services of its transfer agent, the Bank of New York,
which was obligated, among its other duties, to accept Fund purchase and redemption
orders. For these services the Bank of New York charged the Fund $13 per
shareholder's account per year regardless of the number of transactions. For its
services as transfer agent in the year 1980 the bank received $12,404,444 from the
Fund. The services rendered to shareholders by the Merrill Lynch organization,
however, greatly exceeded those that could be furnished by the Bank of New York,
which performs the duties required of it as Transfer Agent under its agreement with
the Fund at only one main office located in New York City. Purchasers of shares are
attracted to the Fund by the convenience and flexibility of the huge Merrill Lynch
Broker's organization with its network of over 400 offices and 7,000 account
executives in the United States alone. A simple telephone call or visit by a Fund
customer to an account executive in the nearest Merrill Lynch branch office is all that
is needed to effectuate in-person Fund services. Most of the transactions through the
bank, on the other hand, apparently are effectuated by mail or wire and involve other
complications. Thus, although customers could open Fund accounts through the
Bank of New York, approximately 80% of the 1980 Fund purchase and redemption
orders were initiated through the Broker and approximately 99% of the half-million
new Fund accounts in 1980 were opened through the Broker's branch office system.
If the Fund did not have the Broker's network to provide the in-person services
sought by customers and to handle the millions of orders executed annually but
instead were restricted to use of the limited facilities of the Bank of New York, it
would be unable to function effectively at its present high-volume level. There is no
evidence that the Bank of New York is prepared to expand its location and services to
the level provided by the Broker.
A more serious problem is posed by appellants' claim that in negotiating the
Manager's fee the Merrill Lynch Fund and Manager failed to take into account that
the Merrill Lynch Broker has gained large "fall-out" financial benefits annually in the
form of commissions on non-Fund securities business generated by Fund customers
and interest income on funds (known as the "float") held by the Broker from the date
when a redemption check is issued by the Fund to its customer until the date it clears.
If these benefits were taken into consideration, the argument goes, they would
constitute a very substantial offset calling for a lower fee to the Manager than that
paid by the Fund. Therefore, appellants contend, the Manager and the Fund, by
failing to offset these benefits, were guilty of a breach of fiduciary duty in violation
of ' 36(b).
The record reveals that a large percentage of persons who opened accounts
with the Broker as Fund customers, e.g., some 38% of those who opened such
accounts in the third quarter of 1979, later did some non-Fund business with Merrill
Lynch, generating commissions for the Broker. Robert Diemer, the Broker's Director
of Financial Services, testified that processing of Fund accounts helped to attract new
equity security business which increased the Broker's commission revenue. These
benefits to an affiliate in the Merrill Lynch organization, to the extent quantifiable,
should be taken into account in determining whether the Manager's fee meets the
standard of ' 36(b). Although the independent trustees may have been aware of these
benefits, we are unpersuaded by the district court's suggestion that they cannot be
measured or quantified because of inability to determine "whether customers who
normally did an above-average level of brokerage business also tended to have Fund
accounts" or to ascertain "what portion of the [increased brokerage business]
would ... have gone to Merrill Lynch in any event." It would not seem impossible,
through use of today's sophisticated computer equipment and statistical techniques, to
obtain estimates of such "fall-out" and "float benefits" which, while not precise, could
be a factor of sufficient substance to give the Funds' trustees a sound basis for
negotiating a lower Manager's fee. However, the burden was on appellants, not the
defendants, to adduce evidence demonstrating that the benefits were so substantial
that they rendered the Manager's fee so disproportionately large as to label its
negotiation a "breach of fiduciary duty" within the meaning of ' 36(b). Since appel-
lants failed to offer such evidence, the dismissal of their contention must be affirmed.
Since the district court properly took into consideration the fact that the
Merrill Lynch organization's costs of processing Fund orders are substantial and the
record fails to show that the Manager's profits were so disproportionately large as to
amount to a breach of fiduciary duty, we find no merit in appellants' further argument
that the Manager violated ' 36(b) by failing to disclose to the Fund's trustees relevant
cost information and potential benefits. As Judge Pollack found, the Trustees were
aware of or could obtain the essential facts needed to negotiate a reasonable fee.
Similarly the Fund stockholders, before approving the management agreement
between the Manager and the Fund, were made aware through proxy materials that
the non-affiliated Fund trustees, who were the shareholders' watchdog representa-
tives, had considered extensive relevant information before continuing in effect the
Fund's agreement with the Manager. Since the trustees have the primary
responsibility under the Act, ' 36(b) does not require that the Fund shareholders be
furnished with additional information over and above that provided.
Our affirmance is not a holding that the fee contract between the Fund and the
Manager is fair and reasonable. We merely conclude that on this record appellants
failed to prove by a preponderance of the evidence a breach of fiduciary duty.
Whether a violation of ' 36(b) might be established through more probative evidence
of (1) the Broker's processing costs, (2) the offsetting commission benefits realized
by the Broker from non-Fund securities business generated by Fund accounts, and (3)
the "float" interest income gained by the Broker from its method of handling payment
on Fund redemptions, must therefore remain a matter of speculation. Indeed, the
independent trustees of the Fund might well be advised, in the interests of Fund
investors, to initiate such studies.
Jones v. Harris Associates, L.P.
---- F.3d ---, 2008 WL 2080753 (7th Cir. May 19, 2008)
EASTERBROOK, Chief Judge.
Harris Associates advises the Oakmark complex of mutual funds. These open-end
funds (an open-end fund is one that buys back its shares at current asset value) have
grown in recent years because their net returns have exceeded the market average,
and the investment adviser's compensation has grown apace. Plaintiffs, who own
shares in several of the Oakmark funds, contend that the fees are too high and thus
violate § 36(b) of the Investment Company Act of 1940, a provision added in 1970.
The district court concluded that Harris Associates had not violated the Act and
granted summary judgment in its favor.
The district court followed Gartenberg v. Merrill Lynch Asset Management, Inc., 694
F.2d 923 (2d Cir.1982), and concluded that Harris Associates must prevail because
its fees are ordinary. Gartenberg articulated two variations on a theme:
[T]he test is essentially 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
[t]o be guilty of a violation of § 36(b) ... the adviser-manager 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.
Oakmark Fund paid Harris Associates 1% (per year) of the first $2 billion of the
fund's assets, 0.9% of the next $1 billion, 0.8% of the next $2 billion, and 0.75% of
anything over $5 billion. The district court's opinion sets out the fees for the other
funds; they are similar. It is undisputed that these fees are roughly the same (in both
level and breakpoints) as those that other funds of similar size and investment goals
pay their advisers, and that the fee structure is lawful under the Investment Advisers
Act. See [Investment Advisers Act § 205]. The Oakmark funds have grown more
than the norm for comparable pools, which implies that Harris Associates has
delivered value for money.
Plaintiffs contend that we should not follow Gartenberg, for two principal reasons:
first, that the second circuit relies too much on market prices as the benchmark of
reasonable fees, which plaintiffs insist is inappropriate because fees are set
incestuously rather than by competition; second, that if any market should be used as
the benchmark, it is the market for advisory services to unaffiliated institutional
clients. The first argument stems from the fact that investment advisers create mutual
funds, which they dominate notwithstanding the statutory requirement that 40% of
trustees be disinterested. Few mutual funds ever change advisers, and plaintiffs
conclude from this that the market for advisers is not competitive. The second
argument rests on the fact that Harris Associates, like many other investment
advisers, has institutional clients (such as pension funds) that pay less. For a client
with investment goals similar to Oakmark Fund, Harris Associates charges 0.75% of
the first $15 million under management and 0.35% of the amount over $500 million,
with intermediate break-points. Plaintiffs maintain that a fiduciary may charge its
controlled clients no more than its independent clients.
Like the plaintiffs, the second circuit in Gartenberg expressed some skepticism of
competition's power to constrain investment advisers' fees.
Competition between [mutual] funds for shareholder business does not support an
inference that competition must therefore also exist between adviser-managers for
fund business. The former may be vigorous even though the latter is virtually non-
existent. Each is governed by different forces.
The second circuit did not explain why this is so, however. It was content to rely on
the observation that mutual funds rarely advertise the level of their management fees,
as distinct from the funds' total expenses as a percentage of assets (a widely
Holding costs down is vital in competition, when investors are seeking maximum
return net of expenses-and as management fees are a substantial component of
administrative costs, mutual funds have a powerful reason to keep them low unless
higher fees are associated with higher return on investment. A difference of 0.1% per
annum in total administrative expenses adds up by compounding over time and is
enough to induce many investors to change mutual funds. That mutual funds are
“captives” of investment advisers does not curtail this competition. An adviser can't
make money from its captive fund if high fees drive investors away.
So just as plaintiffs are skeptical of Gartenberg because it relies too heavily on
markets, we are skeptical about Gartenberg because it relies too little on markets. . . .
Two courts of appeals (in addition to the second circuit) have addressed claims
against the advisers of open-end mutual funds. One circuit has followed
Gartenberg.See Midgal v. Rowe Price-Fleming International, Inc., 248 F.3d 321 (4th
Cir.2001). The other has concluded that adherence to the statutory procedures, rather
than the level of price, is the right way to understand the “fiduciary” obligation
created by § 36(b). See Green v. Fund Asset Management, L.P., 286 F.3d 682 (3d
Cir.2002). Our own Green opinion, though it dealt with the obligations of advisers to
closed-end funds, indicated sympathy for the third circuit's position.
Having had another chance to study this question, we now disapprove the Gartenberg
approach. A fiduciary duty differs from rate regulation. A fiduciary must make full
disclosure and play no tricks but 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.
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. That is a
familiar word; to use it is to summon up the law of trusts. . . . And 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. . . . When the trust instrument is silent
about compensation, the trustee may petition a court for an award, and then the court
will ask what is “reasonable”; but when the settlor or the persons charged with the
trust's administration make a decision, it is conclusive. . . . It is possible to imagine
compensation so unusual that a court will infer that deceit must have occurred, or that
the persons responsible for decision have abdicated-for example, if a university's
board of trustees decides to pay the president $50 million a year, when no other
president of a comparable institution receives more than $2 million-but no court
would inquire whether a salary normal among similar institutions is excessive.
Things work the same way for business corporations, which though not trusts are
managed by persons who owe fiduciary duties of loyalty to investors. This does not
prevent them from demanding substantial compensation and bargaining hard to get it.
Publicly traded corporations use the same basic procedures as mutual funds: a
committee of independent directors sets the top managers' compensation. No court
has held that this procedure implies judicial review for “reasonableness” of the
resulting salary, bonus, and stock options. These are constrained by competition in
several markets-firms that pay too much to managers have trouble raising money,
because net profits available for distribution to investors are lower, and these firms
also suffer in product markets because they must charge more and consumers turn
elsewhere. Competitive processes are imperfect but remain superior to a “just price”
system administered by the judiciary. However weak competition may be at weeding
out errors, the judicial process is worse-for judges can't be turned out of office or
have their salaries cut if they display poor business judgment.
Lawyers have fiduciary duties to their clients but are free to negotiate for high hourly
wages or compensation from any judgment. Rates over $500 an hour and contingent
fees exceeding a third of any recovery are common. The existence of the fiduciary
duty does not imply judicial review for reasonableness; the question a court will ask,
if the fee is contested, is whether the client made a voluntary choice ex ante with the
benefit of adequate information. Competition rather than litigation determines the
fee-and, when judges must set fees, they try to follow the market rather than demand
that attorneys' compensation conform to the judges' preferences. . . . A lawyer cannot
deceive his client or take strategic advantage of the dependence that develops once
representation begins, but hard bargaining and seemingly steep rates are lawful.
The list could be extended, but the point has been made. Judicial price-setting does
not accompany fiduciary duties. Section 36(b) does not call for a departure from this
norm. Plaintiffs ask us to look beyond the statute's text to its legislative history, but
that history, which Gartenberg explores, is like many legislative histories in
containing expressions that seem to support every possible position. Some members
of Congress equated fiduciary duty with review for reasonableness; others did not
(language that would have authorized review of rates for reasonableness was voted
down); the Senate committee report disclaimed any link between fiduciary duty and
reasonableness of fees. . . .
Statements made during the debates between 1968 and 1970 rest on beliefs about the
structure of the mutual-fund market at the time, and plaintiffs say that because many
members of Congress deemed competition inadequate (and regulation essential) in
1970, we must act as if competition remains weak today. Why? Congress did not
enact its members' beliefs; it enacted a text. A text authorizing the SEC or the
judiciary to set rates would be binding no matter how market conditions change.
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. A lot has happened in the last 38 years.
Today thousands of mutual funds compete. The pages of the Wall Street Journal
teem with listings. People can search for and trade funds over the Internet, with
negligible transactions costs. “At the end of World War II, there were 73 mutual
funds registered with the Securities and Exchange Commission holding $1.2 billion
in assets. By the end of 2002, over 8,000 mutual funds held more than $6 trillion in
assets.” . . . Some mutual funds, such as those that track market indexes, do not have
investment advisers and thus avoid all advisory fees. (Total expenses of the Vanguard
500 Index Fund, for example, are under 0.10% of assets; the same figure for the
Oakmark Fund in 2007 was 1.01%.) Mutual funds rarely fire their investment
advisers, but investors can and do “fire” advisers cheaply and easily by moving their
money elsewhere. Investors do this not when the advisers' fees are “too high” in the
abstract, but when they are excessive in relation to the results-and what is “excessive”
depends on the results available from other investment vehicles, rather than any
absolute level of compensation.
New entry is common, and funds can attract money only by offering a combination
of service and management that investors value, at a price they are willing to pay.
Mutual funds come much closer to the model of atomistic competition than do most
other markets. Judges would not dream of regulating the price of automobiles, which
are produced by roughly a dozen large firms; why then should 8,000 mutual funds
seem “too few” to put competitive pressure on advisory fees? A recent, careful study
concludes that thousands of mutual funds are plenty, that investors can and do protect
their interests by shopping, and that regulating advisory fees through litigation is
unlikely to do more good than harm. See John C. Coates & R. Glenn Hubbard,
Competition in the Mutual Fund Industry: Evidence and Implications for Policy, 33
Iowa J. Corp. L. 151 (2007).
It won't do to reply that most investors are unsophisticated and don't compare prices.
The sophisticated investors who do shop create a competitive pressure that protects
the rest. . . . As it happens, the most substantial and sophisticated investors choose to
pay substantially more for investment advice than advisers subject to § 36(b) receive.
A fund that allows only “accredited investors” (i.e., the wealthy) to own non-
redeemable shares is exempt from the Investment Company Act. See Investment
Company Act § 6(a)(5)(A)(iii).1 Investment pools that take advantage of this
exemption, commonly called hedge funds, regularly pay their advisers more than 1%
of the pool's asset value, plus a substantial portion of any gains from successful
strategies. . . . When persons who have the most to invest, and who act through
professional advisers, place their assets in pools whose managers receive more than
Harris Associates, it is hard to conclude that Harris's fees must be excessive.
Harris Associates charges a lower percentage of assets to other clients, but this does
not imply that it must be charging too much to the Oakmark funds. Different clients
call for different commitments of time. Pension funds have low (and predictable)
turnover of assets. Mutual funds may grow or shrink quickly and must hold some
assets in high-liquidity instruments to facilitate redemptions. That complicates an
adviser's task. Joint costs likewise make it hard to draw inferences from fee levels.
Some tasks in research, valuation, and portfolio design will have benefits for several
clients. In competition those joint costs are apportioned among paying customers
according to their elasticity of demand, not according to any rule of equal treatment.
Federal securities laws, of which the Investment Company Act is one component,
work largely by requiring disclosure and then allowing price to be set by competition
in which investors make their own choices. Plaintiffs do not contend that Harris
Associates pulled the wool over the eyes of the disinterested trustees or otherwise
hindered their ability to negotiate a favorable price for advisory services. The fees are
1 [Professor Bradford’s Note: This is incorrect. Hedge funds are excepted from the definition of
“investment company” by either § 3(c)(1) or § 3(c)(7) of the Investment Company Act.]
not hidden from investors-and the Oakmark funds' net return has attracted new
investment rather than driving investors away. 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.
Green v. Nuveen Advisory Corp.
295 F.3d 738 (7th Cir. 2002)
OPINION OF THE COURT
The plaintiffs in this case are common shareholders of six closed-end, tax-
exempt municipal bond funds. They allege that Nuveen, the funds' investment
adviser, breached its fiduciary duty under ' 36(b) of the Investment Company Act of
1940 ("ICA" or "the Act") by receiving compensation based on a percentage of the
daily net assets of the funds. Such an arrangement, plaintiffs contend, creates an
inherent conflict of interest in violation of the Act. The district court granted
summary judgment in favor of the defendant, finding that the plaintiffs failed to
produce evidence establishing a breach of fiduciary duty under ' 36(b). For the
reasons stated herein, we affirm the decision of the district court.
The six funds at issue are closed-end,1 tax-exempt, leveraged2 companies that
invest in tax-free municipal bonds. The stated primary objective of the funds is to
provide shareholders current income exempt from regular federal income tax. The
stated secondary objective is to enhance portfolio value relative to the municipal
bond market "through investments in tax-exempt Municipal Obligations that, in the
opinion of the adviser, are underrated or undervalued or that represent municipal
market sectors that are undervalued."
Each of the funds uses leverage to increase the amount of current income
generated. That is, each of the funds issues preferred stock, used as a leveraging tool,
as well as common stock. The sale of common stock provides the majority of the
capital with which the funds purchase long-term municipal bonds. The proceeds
from the sale of preferred stock, sold at a dividend rate that is based upon short-term
tax-exempt interest rates, are invested into additional long-term municipal bonds that
1 A closed-end investment company, unlike a traditional open-end mutual fund,
has fixed capitalization and may sell only the number of shares of its own stock as
originally authorized. It does not redeem its securities at the option of the
shareholder. Shares of a closed-end fund are traded on a secondary market; that is,
its stock, like that of any publicly owned corporation, is usually listed on a national
exchange. The most pertinent difference between open-and closed-end investment
companies is that closed-end funds are authorized under the ICA to use leverage to
increase the stream of current income through the sale of preferred stock . . . .
2 Leverage exists "when an investor achieves the right to a return on a capital
base that exceeds the investment which he has personally contributed to the entity or
instrument achieving a return."
pay rates of return that exceed the preferred-share dividend amount. The difference
between the dividend paid to the preferred shareholders and these long-term interest
rates amounts to additional income to common shareholders. So long as the long-
term rates exceed the short-term dividend rates, which they do under normal market
conditions, common shareholders receive greater current income than they would if
the identical fund were not leveraged. It is undisputed in this case that the long-term
always exceeded the short-term rates. The Nuveen funds were leveraged for the
entire time period in question.
Being a common shareholder of a leveraged investment company is not
without risks. The dividends and values of preferred shares are set; the holders of
preferred shares always have a prior claim on the funds' assets. Therefore, a decrease
in the value of those assets is borne only by the holders of common shares.
Generally, the more highly leveraged the fund, the greater the risk of loss resulting
from decreased portfolio value. Each of the six funds' prospectuses informed its
common shareholders that leverage creates increased volatility in the value of their
Under the ICA, each investment company must have a board of directors, at
least 40% of which is disinterested from the fund and its advisers. A majority of the
directors of each of the funds at issue in this case is unaffiliated with Nuveen. The
directors maintained ultimate control over the extent of the funds' leverage and the
decisions as to whether to deleverage at a given time; they did, however, rely upon
Nuveen for recommendations on leverage decisions.
Nuveen operates and manages the funds in question. Its compensation is
based on a percentage of the daily net assets of the funds, including the value of
assets attributable to outstanding preferred shares. Thus, assuming the number of
outstanding common shares remains fixed, the more highly leveraged the fund, the
higher Nuveen's compensation. The six funds issued preferred shares equaling
approximately 35% of the funds' total assets to create leverage. Because an adviser's
services and costs increase, to some extent, as its fund's assets increase, almost all
investment companies and 100% of the 202 current closed end, leveraged municipal
bond funds, base adviser compensation on net or total assets.
The logic of the plaintiffs' underlying contention is easy to understand, but
their conclusion is ultimately false. With the current compensation structure, the
more highly leveraged a closed-end fund, the more compensation its advisers receive.
A fund's interests may not always be best served by being highly leveraged. 7
Therefore, the plaintiffs conclude, assuming that the funds' advisers are the decision
makers -- an assumption that has proven incorrect in this case, as will be discussed
7 As discussed above, plaintiffs have produced no evidence that, in this case, the
funds' objectives actually would have been better served by deleveraging.
below -- the advisers have a personal monetary incentive to act in a manner that may
not be best for the common shareholders of the funds, creating an impermissible
conflict of interest.
This incentive alone, the plaintiffs argue, violates the ICA ' 36(b). Under this
provision, an investment company's adviser owes the shareholders a fiduciary duty
"with respect to the receipt of compensation for services." Two primary issues arise
with regard to this contention: first, does the alleged conflict of interest alone violate
' 36(b) of the Act, and second, does such a conflict exist in this case. The district
court answered both questions in the negative.
Congress enacted the ICA in 1940 to provide a comprehensive federal
program to address mismanagement and abuse of investment companies that had
become prevalent in the depression era. Because Congress recognized the potential
for a fund's adviser to self-deal under a compensation scheme based on a percentage
of fund assets, it mandated that forty percent of a fund's board of directors be
unaffiliated with the fund's adviser. These independent directors were directly
accountable to shareholders and were, among other duties, responsible for
determining adviser compensation and approving, by majority, all agreements with
advisers. In 1970, recognizing that the potential for abuse called for greater and more
easily enforced protection for investors, Congress amended the Act. The ICA, as
amended, included ' 36(b) which created a statutorily imposed fiduciary duty upon
advisers regarding their compensation.
Plaintiffs argue that this provision prohibits a closed-end fund's adviser from
receiving fees that are based upon a percentage of the fund's assets because the
inherent conflict of interest in such an arrangement breaches its fiduciary duty.
Nuveen had a duty, they contend, to avoid a fee structure that creates an incentive to
consider its own interests when making leverage decisions for the funds. We
disagree. First, while an abuse of this inherent conflict may violate ' 36(b), its mere
existence does not. This holding comports with congressional intent as well as the
case law that has developed interpreting the Act. Second, the evidence shows that
Nuveen did not have the authority to make final leveraging decisions for the funds.
Although ' 36(b) does not explain the term "fiduciary duty," the legislative
history surrounding the ICA's 1970 amendment makes clear that the enactment of the
provision was not "intended to provide a basis . . . to undertake a general revision of
the practices or structures of the investment company industry." H.R. Rep. No.
91-1382 (1970). Congress was well aware, when it amended the Act, that the most
common investment company adviser compensation scheme was based on a
percentage of assets. "[Advisers'] fees are usually calculated at a percentage of the
funds' net assets and fluctuate with the value of the funds' portfolio." S. Rep. No.
91-184 (1969). The very awareness of this structure, and the potential for abuse
carried with it by creating various monetary incentives for advisers, prompted
Congress to impose a fiduciary duty. By passing ' 36(b), it attempted to diminish the
risk of adviser self-dealing under the predominant industry practice, not to
fundamentally revise the system itself. Moreover, Congress has amended the Act,
including ' 36(b), several times, never indicating that the fee structure as applied to
leveraged, closed-end funds was impermissible. The existence of a compensation
scheme that could create an incentive for advisers to keep an investment fund
leveraged to an extent that may not be best for the fund's common shareholders does
not, by itself, create a breach of fiduciary duty under ICA ' 36(b).8 Congress enacted
' 36(b) to provide a narrow federal remedy that "is significantly more circumscribed
than common law fiduciary duty doctrines . . . ." For example, a shareholder may
sue only the recipient of the fees in question and has the burden of proving the breach
of duty; recovery is limited to actual damages; and damages are recoverable only for
the one-year period before the filing of the action. Although the existence of a
potential conflict like the one plaintiffs assert may create a valid breach of fiduciary
duty claim under the common law standard -- a question we do not entertain -- it does
not violate ICA ' 36(b).
Moreover, ' 205 of the Investment Advisers Act, a companion statute to the
ICA, expressly approves of investment compensation contracts which, like this one,
are "based upon the total value of a fund over a definite period." . . .
The plaintiffs in this case produce no evidence showing that Nuveen actually
abused its position, thus breaching its ' 36(b) fiduciary duty. Although they attempt
in a secondary argument to show an actual conflict resulting from a leveraging
decision in 1994, this time period was before they were shareholders, and before the
Act's recoverable one-year period began. This contention, therefore, carries no
weight. Moreover, even if these procedural bars were ignored, plaintiffs fail to show
that an actual conflict existed. They assert that the advisers received compensation in
breach of their fiduciary duty by maintaining preferred share leverage to increase
their fees, resulting in a decrease in portfolio value. They do not dispute, however,
that any loss was unrealized, offset by leveraged-enhanced gains the following year,
8 8We note that although two of our sister circuits have held that ' 36(b) is limited
to allegations of excessive fees relative to services provided, Migdal v. Rowe Price-
Fleming Int'l, Inc., 248 F.3d 321 (4th Cir. 2001); Gartenberg v. Merrill Lynch Asset
Mgmt., 694 F.2d 923 (2d Cir. 1982), we, like the Third Circuit, see Green v. Fund
Asset Mgmt., 286 F.3d 682 [3rd Cir. 2002], view the provision slightly more broadly.
For example, in the improbable case that: 1) the adviser to a closed-end, equity-
leveraged fund with an asset-based compensation scheme received additional fees by
increasing or maintaining leverage when it predicted that short-term interest rates
would exceed long-term rates for a protracted period of time, causing the common
shareholders to lose current income; and 2) the adviser, not the board of directors,
made final leveraging decisions, a common shareholder's ' 36(b) claim might survive
summary judgment. Even in that case, it is important to remember, the receipt of
fees and the compensation structure, not the leveraging decision, would be at issue,
and damages would be limited to the amount of compensation received. . . . Because
the question raised by the hypothetical case above is not before us today, however,
we decline to address the merits of the issue.
that they would have sacrificed additional income had the funds been deleveraged,
that even in the year they reference, the funds outperformed taxable bond funds that
did reduce leverage, and that the funds' prospectuses adequately informed them that
the funds use leverage which creates increased volatility in portfolio value. The
funds each have a secondary objective of enhancing portfolio value through investing
in underrated or undervalued municipal bonds, not through leverage decisions.
Moreover, the plaintiffs fail to show that Nuveen predicted the interest rate changes
when the funds decided to maintain leverage in 1994; therefore, its argument that the
advisers made a decision that negatively impacted the common shareholders in order
to increase compensation must fail. . . .
Throughout this litigation, the plaintiffs have maintained that if the advisers
controlled the use of leverage, the fee structure itself would violate ICA ' 36(b)
because of the impermissible incentive it creates. Even if we agreed with this
contention, the undisputed facts show that it was not Nuveen who controlled the use
of leverage, but the funds' directors. The allegedly improper incentive, therefore, is
minimal. The plaintiffs do not dispute the fact that the board of directors, the
majority of whom were unaffiliated with Nuveen, had ultimate control over the
extent of the funds' leverage; they contend only that the directors relied on Nuveen's
recommendations. Assuming that this is true, however, it remains undisputed that
Nuveen did not have the authority to increase or decrease leverage -- that power lay
only with the independent board of directors. Summary judgment was appropriate
based on this reason alone.
Finally, for each applicable year, the disinterested directors for each of the
funds approved the advisory compensation agreements at issue. Because Congress
expressly ordered that we give board of director approval "such consideration ... as is
deemed appropriate under all the circumstances," [' 36](b)(2), we find that this factor,
too, supports the district court's summary judgment ruling. . . .
B. Voting Rights
Depositors Investment Trust
Securities and Exchange Commission No-Action Letter
Publicly Available May 7, 1984
1984 SEC NOACT LEXIS 1510
LETTER TO SEC
This office represents Depositors Investment Trust ("DIT") which is a
diversified, open-end, series-type, registered management investment company
currently consisting of three different series of shares, the Capital Growth Fund, the
Aggressive Growth Fund and the Current Income Fund (the "Funds"). . . .
On behalf of DIT we have recently obtained a private letter ruling from the
Internal Revenue Service (the "Ruling") to the effect that, contingent upon amending
the DIT Declaration of Trust as described below, each Fund will be treated as a
separate corporation for federal income tax purposes. . . .
Article V, section 1 of the DIT Declaration of Trust provides that
shareholders shall have the power to vote in the election of trustees and on other
customary matters and provides further, in pertinent part: "On any matter submitted
to a vote of Shareholders, all Shares of the Trust then entitled to vote, irrespective of
series, shall be voted in the aggregate and not by series, except (1) when required by
the 1940 Act, Shares shall be voted by individual series, in which event, unless
otherwise required by the 1940 Act, a vote of Shareholders of all Shares of the Trust,
irrespective of series, shall not be required ... " It is a condition to the effectiveness
of the Ruling that this provision be amended to provide: "On any matter submitted to
a vote of Shareholders, all Shares of the Trust then entitled to vote shall be voted by
individual series, except (1) when required by the 1940 Act, Shares shall be voted in
the aggregate and not by individual series ..." DIT plans to seek shareholder approval
of such an amendment at a meeting of shareholders . . . for the purpose of
considering such amendment, electing trustees and other customary matters.
In discussing the above change in voting rights with representatives of the IRS
the question arose whether the election of Trustees would be on a series-by-series basis
or whether the provisions of the 1940 Act would require that in the election of Trustees
Shares of the Trust vote together and not by individual series. We advised
representatives of the IRS that we were uncertain whether it would be in conformity with
the 1940 Act to require that the Trustees of DIT must be elected by a plurality vote of the
Shareholders of each series. We agreed, however, to seek an interpretation from the
Commission on this question and to conduct series-by-series voting for Trustees if the
Commission concludes that it is permitted under the 1940 Act. Briefly stated, our doubts
concern the proper interpretation of Sections 16(a) and 18(i) of the 1940 Act. Section
16(a) provides in relevant part: "No person shall serve as a director of a registered
investment company unless elected to that office by the owners of the outstanding voting
securities of such company ..." This section appears to indicate an election by all share-
holders of the investment company acting as a single group, but would not seem to
prohibit requiring that no person serve as a trustee unless elected by a plurality vote of
Section 18(i) provides in relevant part: "except ... as otherwise required by law,
every share of stock hereafter issued by a registered management company ... shall be a
voting stock and have equal voting rights with every other outstanding voting stock:
Provided, that this subsection shall not apply to ... shares issued in accordance with any
rules, regulations, or orders which the Commission may make permitting such issue."
(Emphasis added.) Section 2(a)(42) of the 1940 Act defines a voting security as one
which entitles the holder to vote for the election of directors of a company and defines
percentages of the voting securities in terms of a percentage of the aggregate votes which
the holders of all the outstanding voting securities of such company are entitled to cast.
We would appreciate your interpretation regarding the proper application of
Sections 16(a) and 18(i) . . . to the election of the trustees of DIT if the proposed
amendment to its Declaration of Trust is effected. . . .
Section 18(i) of the Investment Company Act of 1940 states, in pertinent part,
that, except as otherwise required by law, every share of stock issued by a registered
management company shall be a voting stock and have equal voting rights with every
other outstanding voting stock. If a series investment company could require its directors
to be elected by the shareholders of each series, and not by the shareholders as a whole,
each voting stock might not have equal voting rights. For example, in an investment
company with two series, one series having 100,000 shares and the other having three,
the vote of two shares in the latter series would have voting power equal to 50,001 shares
of the former series. Thus, we believe that, unless otherwise required by law, section
18(i) requires the election of the trustees of Depositors Investment Trust to be by the
shareholders of the entire investment company as a group.
Sentinel Group Funds, Inc.
Securities and Exchange Commission No-Action Letter
Publicly Available October 27, 1992
1992 SEC NOACT LEXIS 1061
LETTER TO SEC
Sentinel Group Funds, Inc. (the "Company") is an open-end, diversified,
management investment company registered under the Investment Company Act of
1940, as amended (the "1940 Act"). On behalf of the Company, we respectfully request
(i) your concurrence in our position that the voting rights of the several classes of
common stock of the Company, as such voting rights are proposed to be amended, and as
described below, constitute "equal voting rights" as required by section 18(i) of the 1940
Act, and (ii) your assurance that the staff (the "Staff") of the Securities and Exchange
Commission (the "Commission") will not recommend that the Commission institute
enforcement proceedings against the Company if it amends its Articles of Incorporation
to provide for such voting rights.
Description of the Company
The Company . . . currently has six classes of common stock outstanding, each of
which is a separate fund with its own distinct investment objective and policies. The six
current classes of common stock (the "Funds") and their investment objectives are set
Sentinel Growth Fund -- seeks growth of capital through equity participation in
companies having growth potential believed by management to be more favorable than
that of the U.S. economy as a whole.
Sentinel Common Stock Fund -- seeks a combination of growth of principal and
income, current return and relatively low risk through investment in common stocks of
many well-established companies.
Sentinel Balance[d] Fund -- seeks a conservative combination of stability, income
and growth through investments in both stocks and bonds with at least 25% of its net
assets in fixed-income senior securities.
Sentinel Bond Fund -- seeks a high level of continuing income consistent with the
preservation of capital through investments in fixed income securities.
Sentinel Tax-Free Income Fund -- seeks a high level of current income, exempt
from federal income taxes, consistent with the preservation of capital, through
investments primarily in a diversified portfolio of municipal bonds.
Sentinel Government Securities Fund -- seeks a high level of current income
consistent with the preservation of capital through investments primarily in securities
issued or guaranteed by the U.S. Government or its agencies or instrumentalities, and, to
a limited extent, in repurchase agreements with respect to such securities. This Fund
may also invest to a limited extent in high quality money market instruments which are
not issued by a government entity.
. . . The numbers of shares outstanding and the net asset value per share for each
Fund as of August 20, 1991 are set forth below.
Fund Outstanding Per Share
Sentinel Growth Fund 3,500,000 $16.19
Sentinel Common Stock Fund 23,326,932 26.82
Sentinel Balanced Fund 6,269,509 13.75
Sentinel Bond Fund 6,405,146 6.32
Sentinel Tax-Free Income Fund 2,304,831 12.60
Sentinel Government Securities Fund 4,219,351 9.85
The Proposed Acquisition and Amendment of Voting Rights
The Company currently proposes to acquire all of the assets, and assume all of
the liabilities (the "Acquisition"), of Sentinel Cash Management Fund, Inc., a no-load
money market mutual fund (the "Cash Fund"), in exchange for shares of a proposed new
series, Sentinel 100% U.S. Treasury Money Market Fund (the "New Money Market
Fund"). The investment objective of the proposed New Money Market Fund is to seek a
high level of current income consistent with the preservation of capital and the
maintenance of liquidity by investing exclusively in direct obligations of the U.S.
Treasury which have remaining maturities of 397 days or less. The New Money Market
Fund will seek to maintain its net asset value at a constant $1.00 per share. As the Cash
Fund had 57,413,357 shares outstanding as of August 20, 1991, it is anticipated that the
New Money Market Fund will issue approximately 60,000,000 shares at the closing of
Sentinel Advisors, Inc. ("SAI"), investment adviser to both the Company and the
Cash Fund, believes that it is in the best interests of the Cash Fund's shareholders to
amend the Cash Fund's investment objective and policies to restrict its investments to
U.S. Treasury money market instruments. In connection with this change, SAI believes
that making the Cash Fund a series of the Company, rather than a separate corporation,
will benefit Cash Fund shareholders in several significant ways. As a Fund of the
Company, many of the operating expenses of the New Money Market Fund will be lower
than the operating expenses of the Cash Fund, potentially reducing the expense ratio of
the New Money Market Fund as compared to the Cash Fund. Such expense savings will
be due in part to the lower advisory fee charged by the Company at certain higher net
asset levels. In addition, the costs of printing and mailing separate prospectuses,
statements of additional information and shareholder reports will be significantly
reduced. Other fixed costs will be allocated among the Funds in proportion to the assets
or the number of shareholder accounts, in accordance with the policies of the Company.
Moreover, the Company will continue to offer full exchange rights between the Funds,
including the New Money Market Fund . . . .
In connection with the Acquisition, the Company proposes to submit to its
shareholders, with each Fund voting as a separate class, a proposal to amend its Articles
to provide that each share will have, instead of one vote, one vote for each dollar of net
asset value per share. As a result, on issues in which the various Funds vote together as a
single class, such as the election of directors and selection of independent accountants,
voting power would be allocated in proportion to the value of each shareholder's
investment, rather than in proportion to the number of shares held. Of course, on matters
on which each Fund votes as a separate class, this change is not meaningful, since the net
asset value of all shares within a given Fund is equal.
Because the New Money Market Fund's net asset value per share will ordinarily
be $1.00, if the Acquisition were to be effected without the change in voting rights,
voting power would be dramatically and unfairly skewed in favor of the New Money
Market Fund class. Recognizing this problem, the Board of Directors of the Company
conditioned its approval of the Acquisition on the approval by the Company's
shareholders of the proposed amendments to the Articles which change the relative
voting rights. . . .
It is our view that the proposed change in voting rights of the various classes of
common stock described above would not contravene what is meant by "equal voting
rights" as such term is used in section 18(i) of the 1940 Act. Section 18(i) provides in
relevant part that:
"every share of stock hereafter issued by a registered management investment
company ... shall be a voting stock and have equal voting rights with every other
voting stock ..."
The 1940 Act does not contain a specific definition of, and there is no legislative
history discussing the meaning of, "equal voting rights" in Section 18(i). . . . The
Commission [has] established a principle of reasonableness for determining the meaning
of "equal voting right" within the context of Section 18(i) in particular and the 1940 Act
in general. . . .
In the Company's case, we believe that amending the Articles to provide for one
vote for each dollar of net asset value per share ("dollar-based voting") will provide a
more equitable distribution of voting rights to the Company's shareholders than the one-
share-one-vote system currently in effect. Open-end investment companies issue and
redeem large numbers of their shares each day, and frequently shares are freely
exchangeable among funds at relative net asset values. No investor makes his investment
with the idea that he will acquire a certain fixed percentage of the investment company's
voting power. Rather, he expects that his voting power will be proportionate to his
economic interest. In the case of a series fund, the net asset values of each series diverge
over time, perhaps very widely as in the case of the Company. In this context, dollar-
based voting provides shareholders, in substance, with "equal voting rights" while one-
vote-one-share voting may not.
For example, on August 20, 1991, the offering price of a share of the Sentinel
Common Stock Fund of the Company was approximately $30 per share and the net asset
value was approximately $27 per share. If the New Money Market Fund had been a
series of the Company on that date, an investor who had $30 to invest could have
purchased 30 shares of the New Money Market Fund or one share of the Common Stock
Fund. Under the one-share-one-vote voting system, an investor who chose to invest $30
in the New Money Market Fund would have received 30 times the voting power received
by an investor who chose to invest $30 in the Common Stock Fund. Under the dollar-
based voting system, the Common Stock Fund investor would receive 27 votes for his
$30 investment (with approximately $3 being applied to the sales load) and the New
Money Market Fund investor would receive 30 votes for his $30 investment. Surely the
more equitable result is for two shareholders who invest the same amount of money on
the same day to have approximately equivalent relative voting power. Similarly, under a
one-share-one-vote rule, an existing Common Stock Fund shareholder who exchanged
his shares into shares of the New Money Market Fund would, by the exchange alone, and
without any new investment, increase his relative voting power 30- fold. Again, it would
be more equitable for a shareholder to have the same relative voting power regardless of
the extent to which he exercises his exchange rights.
If the Acquisition had taken place on August 20, 1991, the outstanding shares of
the New Money Market Fund would have accounted for approximately 55.5% of the
outstanding shares of the Company but would have accounted for only approximately
6.1% of the net asset value of the Company. Thus, after the Acquisition, voting rights
for the Company's shareholders would be much more equitably allocated on a dollar-
based voting basis than on a one-share-one-vote basis.
As noted above, the Company will submit the amendment to the Articles to the
shareholders of each Fund as a separate class. To amend the Articles, each Fund must
vote, by at least a majority of its outstanding shares, to approve the amendment. The
proposed amendment will not dramatically change the existing balance of voting power,
and so cannot be seen as disenfranchising any existing voting group. Set forth below is a
comparison of the relative voting power of each class, with assets and number of shares
as of August 20, 1991, before and after the Acquisition and amendment of the Articles:
Sentinel Growth Fund 7.6% 6.0%
Sentinel Common Stock Fund 50.7% 66.8%
Sentinel Balanced Fund 13.6% 9.2%
Sentinel Bond Fund 13.9% 4.3%
Sentinel Tax-Free Income Fund 5.0% 3.1%
Sentinel Government Securities Fund 9.2% 4.4%
Sentinel 100% U.S. Treasury Money Fund -- 6.1%
The Acquisition will also be submitted for approval by at least a majority of the
outstanding shares of the Cash Fund. The proxy materials will discuss the fact that if the
Cash Fund shareholders approve the Acquisition, they will lose the power to vote as a
separate body on certain issues, and that they must weigh this loss of separate voting
power against the benefits of the Acquisition.
Your letter of September 5, 1991, requests our assurance that we would not
recommend enforcement action to the Commission under Section 18(i) of the Investment
Company Act of 1940 (the "1940 Act") if Sentinel Group Funds, Inc. ("Company")
amends its articles of incorporation to provide shareholders with one vote for each dollar
of net asset value per share.
You state that the proposed reallocation of voting rights of the various classes
would not violate the equal voting rights requirement of Section 18(i). The 1940 Act
does not define "equal voting rights," and the legislative history does not discuss the
meaning of that phrase. The Commission stated that, given the absence of any definition
or discussion at the Congressional hearings as to the meaning of the equal voting rights
requirement, the general purposes of the statute should guide the determination whether a
given proposal violates that requirement. The Commission further stated that "an inflexi-
ble adherence to any rigid interpretation could produce grave distortions of the apparent
intent of Congress ... and that each such case must be decided on the particular factors
On the basis of the facts and representations in your letter, we would not
recommend enforcement action to the Commission under Section 18(i), if the Company
amends its articles of incorporation to provide for dollar-based voting as described in
your letter. Because our position is based on the facts and representations in your letter,
you should note that different facts or circumstances may require a different conclusion.
Further, this response expresses the Division's position on enforcement action only and
does not purport to express any legal conclusion on the issues presented.
New America Fund, Inc.
Securities and Exchange Commission No-Action Letter
Publicly Available July 8, 1972
1972 SEC NOACT LEXIS 2754
LETTER TO SEC
This firm acts as special counsel to New America Fund, Inc. ("Fund") a registered
closed-end diversified management (investment) company . . . . Fund Management
Corporation (formerly known as Letter Management Corporation) ("Advisor") has been
Manager and Investment Adviser to the Fund since September 20, 1968, the effective
date of a Registration Statement filed under the Securities Act of 1933, as amended, (the
"1933 Act") covering the initial public offering of the Fund's shares. No other
registration statements have been filed on behalf of the Fund since September, 1968.
. . . [The Prospectus for] the Fund dated September 20, 1968 ("Prospectus"),
pursuant to which 6,000,000 shares of the Fund were offered and sold to the public[,]
sets forth . . . certain policies and investment restrictions applicable to the operations of
the Fund and states that "none [of these policies and investment restrictions] may be
changed without the prior consent or vote of the holders of a majority of [the fund's]
outstanding voting securities." One such restriction states (on page 10 of the Prospectus)
that the Fund "will not invest more than five per cent of its total assets . . . in the
securities of any one issuer and will not purchase more than ten per cent of the
outstanding voting securities of any one issuer." . . .
The principal investment objective of the Fund at the time of the public offering
was to invest at least 80% of the total value of its assets in Restricted Securities.I At the
Annual Meeting of Stockholders held on December 16, 1971, stockholders of the Fund
voted to adopt a proposal modifying the principal investment objective and investment
policy of the Fund to permit the Fund to invest up to 100% of its total assets in freely
marketable securities. The Fund has, as at 12/31/71, assets of $29,239,448.
During the past year, management of the Fund has been evaluating alternatives
for expanding financial service opportunities which would enable the Fund to participate
in a program for the enhancement of positive social goals. Management believes that the
programs established by the Small Business Administration afford such an opportunity
and, accordingly is contemplating formation of a Small Business Investment Company
("SBIC") whose primary purpose will be the making of long-term loans and the
providing of equity capital to small business concerns. We have been advised that in the
course of the organization of the SBIC, all of the outstanding stock of the SBIC will
consist of one class of common stock which will be owned by the Fund and will be
I IEditor's note: Restricted securities are defined as securities that are not acquired in
a public offering and/or that are subject to resale restrictions. See 17 C.F.R. ' 230.144(a)
capitalized by an investment by the Fund of $1,250,000 (5% of the value of the present
assets of the Fund).
A license application has been filed and is pending with the Small Business
Administration to obtain the necessary authority to complete the formation and licensing
of the SBIC. . . . The SBIC will not in the immediate future utilize the services of an
investment advisor. The Fund intends to advise its stockholders in advance of the
completion of the formation of the SBIC of the Fund's intent to form and capitalize the
SBIC as a wholly-owned subsidiary.
The principle problem which has necessitated this letter pertains to the investment
policy enunciated in the Fund's Prospectus dated September 20, 1968 with regard to the
limitations placed on investments by the Fund both as to amount of money and
percentage of voting securities in/or of any one issuer and, as a result of this restriction,
the necessity of obtaining stockholder approval for the formation of the SBIC by the
Fund. . . .
. . . [W]e are of the opinion that nothing contained in the [Investment Company]
Act or the rules and regulations promulgated thereunder would prohibit the Fund from
proceeding with the formation of the SBIC without the necessity of obtaining
stockholder approval for the following reasons:
1. The Fund does not intend to otherwise change its investment policy as
originally enunciated (except as modified by stockholders of the Fund in
December, 1971); that is, except for the Fund's ownership of 100% of the issued
and outstanding stock of the SBIC (purchased at a cost equal to [5%] of the value
of the Funds assets), the Fund will continue its policy of not investing more than
5% of its assets in the securities of any issuer and will not purchase more than
10% of the outstanding voting securities of any one issuer.
2. Stockholders of the Fund will be apprised of the Fund's intention to complete
the formation of the SBIC well in advance of actual capitalization of the SBIC
and the time at which it will commence doing business so that any stockholder
who either originally or subsequent to the initial public offering, purchased shares
of the Fund in reliance on this particular restriction on Fund investment, will have
an opportunity to dispose of their shares should they desire to do so.
5. The necessity of obtaining stockholder approval to the formation of the SBIC
would be a timely and expensive procedure requiring either a special meeting of
stockholders of the Fund or a delay in the formation of the SBIC until the next
annual meeting of stockholders in December, 1972.
Based on all of the facts set forth herein it is our opinion that . . . the Fund is not
required to obtain the approval of its stockholders pursuant to Section 8(b)(2) and 13(a)
(3) of the [Investment Company Act] for the formation of the SBIC and the purchase of
100% of the common stock of the SBIC at a cost not to exceed 5% of the value of the
total assets of the Fund at the time of the purchase.I
I Editor's note: Section 8(b) of the Investment Company Act reads as follows:
Every registered investment company shall file with the