The approach in the United States provides some useful comparisons to the new UK regime. The US fund governance model requires under Section 15c of the US Investment Companies Act 1940 for US fund boards to conduct an assessment on the fund managers using a number of factors commonly known as the Gartenberg Principles.
WHAT ARE THE US REQUIREMENTS?
In the United States, the investment adviser of a mutual fund operated under the Investment Company Act 1940 has a fiduciary duty under Section 36 with respect to the receipt of compensation for services paid by the mutual fund or by the security holders of the mutual fund to such investment adviser. An action may be brought by investors for breach of the fiduciary duty. A breach is considered to have occurred where a fee is charged 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.
Additionally, under Section 15(c), advisory contracts must be approved by a majority of the fund’s independent directors, and shareholder reports must detail any material considerations of the Board in the decision to appoint the advisory contract. While much of the information can be provided by the fund manager, there is a requirement to do a level of peer-group comparison. The output is a large, typically private, document which is reviewed each year, with a brief synopsis of the methodology and results published in the shareholder report. This typically covers the governance structure, performance, charges, service quality and any economies of scale.
Little guidance on how the analysis should be prepared was provided until the requirements came before the US courts.
“To 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.” – Gartenberg v. Merrill Lynch Asset Mgmt.
6 principles, known as the ‘Gartenberg Principles’ were established from the Gartenberg vs Merrill Lynch Asset Management court case in 1982.
These principles, similar to the FCA’s Assessment of Value seven ( 7 ) criteria, provide six factors to be considered to establish fair value and whether the fiduciary duty under Section 36 has been breached:
- The nature and quality of services provided
- The profitability of the mutual fund to the advisor-manager
- Any “fall-out” benefits to the adviser
- Economies of scale
- How the fee structure compares of those of other similar funds
- The independence and conscientiousness of the fund’s independent directors
From the above it is clear to see that the FCA has built on the Gartenberg principles, which are based on US case law to identify ‘excessive fees’, to define the AoV framework here in the UK. Although there are distinct differences between the US and the UK models, both the US and UK have a list of factors that must be considered when assessing value, both requirements tend to address quality of service, performance, level of charges and economies of scale. Although the initial Gartenberg principles did not include comparable market rates, further case law has introduced the factor into US practice as outlined below.
In contrast to the Gartenberg principles, the FCA’s initial “Value for Money” rules were considered too focused on the AFMs’ costs rather than the full value proposition of funds. Taking this on board, the FCA redrafted the rules to encompass a wider interpretation of value – the final “FCA Assessment of Value” rule is closer to the Gartenberg principles.
In the U.S., the Gartenberg test had been largely unchallenged for over twenty-five years, and had been utilized by courts, the SEC, mutual fund boards, and investment advisers in analysing an adviser’s fiduciary obligations under Section 36(b). This however changed when Gartenberg was initially rejected in Jones v Harris Associates.
In Jones v Harris Associates, the U.S. Court of Appeals for the Seventh Circuit held that Section 36(b) did not permit judicial regulation of mutual fund management fees. It acknowledged that management had a fiduciary duty to investors, but that did not imply judicial regulation of management fees was appropriate. Rather, the court stated that market forces were best able to determine the appropriateness of fees. The court provided that so long as the fee is adequately disclosed and no deception is involved, the directors’ decision as to whether the adviser’s fee is appropriate will not be disturbed.
Following the rejection of the Gartenberg Principles by the Seventh Circuit, the case progressed all the way to the U.S. Supreme Court where they affirmed the Gartenberg Principles as the standard upon which mutual fund boards should rely when considering the fees that a mutual fund pays to its investment adviser.
Furthermore, the Supreme Court provided precedent on economies of scale and the treatment of retail vs institutional mandates. The Court stated that because the 1940 Act requires consideration of all relevant factors, there can be no “categorical rule” on the comparison of fees charged to different clients, such as those charged by an adviser to its “captive” mutual fund and the fees it charges to its “independent clients”. The Supreme Court noted that there may be significant differences between the services provided by an investment adviser to a mutual fund and those it provides to a pension fund which are attributable to the greater frequency of shareholder redemptions in a mutual fund, the higher turnover of mutual fund assets, the more burdensome regulatory and legal obligations, and higher marketing costs
Jones was a strong affirmation of the Gartenberg principles and solidified it as the standard for determining investment advisers’ compliance with §36(b) in the United States.
HAS THE US APPROACH BEEN A SUCCESS?
The principles have resulted in positive change and numerous cases have underscored the importance of an independent, conscientious, well-informed fund board, and a robust Section 15(c) process during which information regarding the Gartenberg factors is clearly and thoughtfully outlined for the board.
However, although the Gartenberg Principles have resulted in positive change, as recently as November 2019, the SEC Office of Compliance Inspections and Examinations (OCIE) included the Section 15(c) processes on their list of deficiencies and weaknesses they had observed. The OCIE observed that fund boards were in many instances not requesting or considering information reasonably necessary to evaluate the fund’s investment advisory agreement. For example, certain boards did not appear to consider relevant information such as information related to the profitability of the fund to the adviser, economies of scale, or peer group comparisons for the advisory fee. The staff also observed fund boards that received incomplete materials, but did not request the omitted information, such as performance data for the fund and other accounts managed by the adviser and profitability reports.
Additionally, during the OCIE observation period, the found that many funds’ shareholder reports did not appear to discuss adequately the material factors and conclusions that formed the basis for the board’s approval of an investment advisory contract. Staff also observed in some instances, funds not keeping copies of written materials the board considered in approving advisory contracts. In other instances, because of the lack of supporting documentation, such as board minutes, it was unclear what information fund boards requested and considered.
It is clear that there have been some fund failures in the area and that the OCIE is now focused on the responsibilities of board members to evaluate investment advisory contracts. To the benefit of investors, this new focus by the SEC will provide further incentive for firms to review their own internal practices and ensure compliance with the legislation.