Judge Not Under An Unjust Standard: Why An Investment Adviser’s Fiduciary Duty As To Fees Under Section 36(B) Of The Investment Company Act Of 1940 Is Illusory And Unjust Until An Adjudicated Case Illustrates A Breach Of The Fiduciary Duty
Tory L. Lucas
Liberty University School of Law
Yarra Square Partners returned 19.5% net in 2020, outperforming its benchmark, the S&P 500, which returned 18.4% throughout the year. According to a copy of the firm's fourth-quarter and full-year letter to investors, which ValueWalk has been able to review, 2020 was a year of two halves for the investment manager. Q1 2021 hedge fund Read More
Liberty University Law Review, Vol. 9, No. 3, Pp. 469, Summer 2015
Investment companies manage trillions of dollars of other people’s money, and they charge significant fees for their services. In building wealth, the amount paid for investment fees matters. This Article discusses the federal regulation of the fees that investment advisers charge to investments like mutual funds. Specifically, this Article analyzes the federally imposed fiduciary duty that regulates investment advisers as they extract fees from their customers. Believe it or not, even though trillions of dollars have been entrusted by hundreds of millions of Americans to investment advisers for decades, no court has found that even a single investment adviser has violated its fiduciary duty with respect to advisory fees.
The wealthiest 400 Americans are worth a breathtaking $2.3 trillion. The combined wealth of America’s two richest billionaires, Bill Gates and Warren Buffett, totals $130.5 billion. Whether thinking about the $2.3 trillion number or the substantially smaller $130.5 billion number, these astonishing sums of money pale when compared to how much wealth is being managed by investment companies through products such as mutual funds on behalf of millions of Americans. At the end of 2013, 98 million Americans entrusted $17.1 trillion of their wealth to U.S.-registered investment companies, who managed 22 percent of the financial assets of American households, more than tenfold the 2 percent they managed in 1980. Investment advisers charge lower fees to the wealthiest Americans than they do to average Americans. While the wealthiest Americans freely and fiercely bargain with investment advisers over services and fees, this bargaining power is noticeably absent from the captive retail mutual funds that are available to millions of average Americans.
This Article focuses on those mutual funds, which are not self-operated, but instead are normally formed, sold, and managed by investment advisers. These investment advisers select the investments for and operate the day-to-day business of the funds in exchange for a staggering amount of advisory fees. The relationship between a mutual fund and its investment adviser is unlike the normal business relationship between buyers and sellers. The uniqueness stems from the fund’s organizational structure under which the investment adviser provides the fund with most management services, while the fund investors purchase shares in the fund and rely exclusively on the investment adviser’s services. As a practical matter, a mutual fund cannot sever its relationship with the investment adviser. The captive nature of this relationship spawns conflicts of interest such that arm’s-length bargaining does not work in the mutual fund industry as in other sectors of the American economy. Without free-market forces that promote competition and bargaining, captive funds often lack the ability to seek lower advisory fees.
In response to the structural conflicts of interest in the mutual fund industry, the captive nature of many mutual funds, and the massive amounts of money in this sector of the economy, Congress enacted section 36(b) of the Investment Company Act of 1940 to protect mutual fund shareholders. It imposes a fiduciary duty on a mutual fund’s investment adviser with respect to its receipt of compensation. The governing standard that determines whether an investment adviser has breached its fiduciary duty with respect to the receipt of compensation has been well known for decades: the adviser “must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” This so-called Gartenberg standard seems pretty straightforward and should be easy to apply to facts to reach a legal conclusion as to when an investment adviser has breached its fiduciary duty. Tragically, that is not the case and might never be the case. In the forty-five years in which section 36(b) has provided federal protection for mutual fund shareholders against excessive fees by investment advisers, not a single adjudicated case reports a shareholder victory when an investment adviser breached its fiduciary duty with respect to the receipt of compensation.
This Article contends that if one cannot illustrate when a legal standard is violated, then there is no legal standard; there is no legal protection. It is illusory. It might set a theoretical or moral obligation, but that obligation cannot be enforced. That has been the state of affairs in section 36(b) litigation for four decades.
The lack of arm’s-length bargaining by millions of Americans results in higher fees and has a direct impact on wealth creation. Between 2012 and 2013, Americans entrusted a staggering $2.3 trillion of additional capital to investment companies. $2.3 trillion also represents the net worth of the 400 wealthiest Americans. These wealthy individuals freely bargain over investment services and fees. Investors in captive retail mutual funds have little bargaining power, and they pay higher fees for investor services. Even if the wealthiest Americans and average Americans get the same performance from investment advisers over time, the wealthiest Americans will see their savings grow more rapidly than what average Americans will enjoy due to the differences in advisory fees. Assume that the 400 wealthiest Americans entrust their $2.3 trillion with an investment adviser who charges .5% of assets under management and delivers 8% per year for forty years while millions of average Americans entrust their $2.3 trillion to the same investment adviser who charges 1% of assets under management and delivers 8% per year for forty years. Without additional investments, average Americans will have suffered over $7 trillion in higher fees for the same investment results. Net fees (and without assuming taxation), the 400 wealthiest Americans’ investment will balloon to over $41 trillion, while the wealth of average Americans will top out at just over $34 trillion. Fees matter in a big way!
Section 36(b)’s fiduciary duty was intended to assuage this negative effect from the lack of spirited competition over fees for captive mutual funds. But it has failed miserably to carry out this intent. This Article exposes the illusory, unjust legal standard that implements section 36(b)’s fiduciary duty under which investment advisers operate. The Article first explains section 36(b)’s legislative text, purpose, and history. Next, the Article showcases the judicial history of section 36(b) litigation, highlighting a massive cavity in four decades of caselaw that has resulted in not a single, adjudicated case in which a mutual fund shareholder has prevailed. Finally, this Article provides some thoughts on how section 36(b)’s fiduciary duty and the accompanying four decades of litigation can be viewed through the lens of Judeo-Christian values.
Judge Not Under An Unjust Standard: Why An Investment Adviser’s Fiduciary Duty As To Fees Under Section 36(B) Of The Investment Company Act Of 1940 Is Illusory And Unjust Until An Adjudicated Case Illustrates A Breach Of The Fiduciary Duty – Legislative Text And Purpose
As mentioned in the Introduction section, section 36(b) of the ICA provides federal protection for mutual fund shareholders by requiring that the fund’s investment adviser meet a fiduciary duty with respect to its receipt of compensation for the services it provides. Specifically, federal law establishes the following fiduciary duty for investment advisers:
the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser.
A violation of this federally protected fiduciary duty can be enforced by bringing a lawsuit against the offending investment adviser by either the Securities and Exchange Commission (“SEC”) or a security holder of the investment company (e.g., mutual fund shareholder). The plaintiff bears the burden to prove a breach of fiduciary duty. If a plaintiff successfully proves that an investment adviser breached its fiduciary duty, an award of damages is limited to a period of one year before the suit was brought and “to the actual damages resulting from the breach of fiduciary duty and shall in no event exceed the amount of compensation or payments received from such investment company, or the security holders thereof, by” the investment adviser.
Congress’s purpose in enacting the ICA was to support “the national public interest and the interest of investors” by ensuring that investors are not “adversely affected when investment companies are organized, operated, managed, or their portfolio securities are selected, in the interest of… investment advisers … rather than in the interest of [share]holders” and “when investment companies . . . are not subjected to adequate independent scrutiny.” Congress “declared that the policy and purposes of … [the ICA] … are to mitigate and, so far as is feasible, to eliminate the conditions.., which adversely affect the national public interest and the interest of investors.” Congress instructed courts to interpret the ICA to carry out these declared policies and purposes.
See full PDF below.