Mutual Funds: Solving The Shortcomings of The Independent Director Response To Advisory Self-Dealing Through Use of The Undue Influence Standard

Mutual Funds: Solving the Shortcomings of the Independent Director Response to Advisory
Self-Dealing through Use of the Undue Influence Standard

Author(s): Samuel S. Kim
Source: Columbia Law Review, Vol. 98, No. 2 (Mar., 1998), pp. 474-509
Published by: Columbia Law Review Association, Inc.
Stable URL: http://www.jstor.org/stable/1123412
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NOTE
MUTUAL FUNDS: SOLVING THE SHORTCOMINGS OF

THE INDEPENDENT DIRECTOR RESPONSE TO
ADVISORY SELF-DEALING THROUGH USE OF
THE UNDUE INFLUENCE STANDARD
Samuel S. Kim
Because of their astounding success in the past few decades,mutual

funds are playing an increasinglyprominentrole in the lives and savings
behaviorof U.S. citizens. Recentfund expensestudieshave shown, however,
that the independentdirectorsof mutualfunds, to whomCongressentrusted
the duty of safeguardingfund shareholderinterestsagainst self-dealingby
investmentadvisers,may not besuccessfullyperformingtheirfunction. This
Note examinesthe potential conflict of interestbetweenmutualfunds and
theirinvestmentadvisersand the various approachesemployedby Congress,
thecourts,and theSECfor dealingwith such conflict. Theauthorconcludes
that the approacheshave proveddisappointingbecausetoo muchfaith has
beenplaced in the discretionof the independentdirectors.He recommends
using the recentfund expensestudy results to reinvigoratean alreadyex-
isting court conceptin the contextof mutual fund litigation-the undue
influencestandard-in orderto betterensurethat investmentadvisersand
independentdirectors fulfill theirstatutorilyimposedfiduciarydutiestofund
shareholders.
INTRODUCTION
Mutual fund shares are rapidly becoming the investment of choice

for the average American. As of November 1995, approximately 30 mil-
lion U.S. households invested an average of $10,000 in mutual funds.'
From 1980 to 1995, the assets of the mutual fund industry ballooned
from $95 billion to $2.5 trillion, reflecting an astonishing annual growth
rate of twenty-four percent.2 From 1975 to 1992, the percentage share of
U.S. corporate stocks held by mutual funds more than doubled,3 and the
growth rate shows few signs of slowing down.4
1. See Management Practice Inc., Only 2,500 Independent Trustees Oversee the
Mutual Fund Investments of 75 Million Americans, Mgmt. Prac. Bull., Nov. 1995, para. 1
<http://www.mpiweb.com/bull/nov95.html> (on file with the Columbia Law Review)
[hereinafter 2,500 Independent Trustees].
2. See Robert Slater, John Bogle and the Vanguard Experiment 139 (1997).
3. See Richard W. Jennings et al., Securities Regulation: Cases and Materials 11 (7th
ed. Supp. 1997).
4. The inflow of money into mutual funds during the first half of 1996 matched the
inflow for the entire year of 1995 and exceeded total personal savings. See Doug
Henwood, Wall Street 84 (1997).
474
1998] UNDUE INFLUENCE & ADVISORYSELF-DEALING 475
Clearly, decisions made by mutual funds have the growing potential

to affect deeply the savings and investment capital of their shareholder
constituencies as well as the stock market as a whole.
The popularity of mutual funds stems largely from their providing
investors with much greater buying power through the pooling of re-
sources, as well as concomitant opportunities to make safe, diversified,
and flexible investments.5 Furthermore, many noninstitutional mutual
fund investors are paying for the privilege of having expert, professional
managers make their investment decisions for them at relatively modest
cost.6 There are indications, however, that the rosy picture presented by
the success of mutual funds over the last few decades has caused those
responsible for the oversight of the industry-the courts and the SEC-to
underestimate the potential for abuse created by the unusual managerial
structure of mutual funds. There is an ironic quality to this willful blind-
ness given that people are entrusting their hard-earned retirement sav-
ings to mutual funds on the basis of their reputation for safety and rela-
tive freedom from risk.
Mutual funds are generally the creatures of their investment advis-
ers.7 The adviser is usually the party sponsoring and creating the fund,
which pools assets for investment from a large number of shareholders.8
The corporate structure of mutual funds is unique, however, in that the
adviser, which manages the fund, tends to be a business entity indepen-
dent of the fund, possessing its own board of directors and shareholders.9
The adviser derives its compensation as a percentage fee,10 called an advi-
5. See id. at 20; Kenneth M. Morris & Alan M. Siegel, The Wall Street Journal Guide
to Understanding Money & Investing 104-05 (1993).
6. However, the popular index and money market funds do not, by their very nature,
invoke the decisionmaking abilities of professional managers.
7. See Division of Inv. Management, SEC, Protecting Investors: A Half-Century of
Investment Company Regulation 264 (1992) [hereinafter Protecting Investors].
8. See William P. Rogers & James N. Benedict, Money Market Fund Management
Fees: How Much Is Too Much?, 57 N.Y.U. L. Rev. 1059, 1063 (1982).
9. See id. Hereinafter, all references to "directors" and "the board" will be to those of
the funds themselves unless otherwise specified.
10. Throughout this Note, "fee" and "expense" shall be used interchangeably.
Although management fees tend to refer to the amount paid explicitly to the investment
adviser for management of the fund, additional expenses-including shareholder service,
salaries for administrative staff, and investor centers-which are also determined as a
percentage of the fund's net assets indirectly benefit advisers because they would be
responsible for these charges otherwise. Calculating such expenses (which do not include
loads or one-time changes paid to buy into or exit a fund) separately from management
fees permits investment advisers to assess a lower management fee, thereby leading some
investors to think they are receiving a bargain, when in fact the total amount to be paid has
not changed. The "total expense ratio takes into account all of the fees [or expenses] that
apply to any fund," but the "variety can mean added confusion for investors," which may in
fact be the intent. Morris & Siegel, supra note 5, at 116-17; cf. Carole Gould, Keeping
Funds Honest About Expenses, N.Y. Times, May 21, 1995, ? 3, at 7 (discussing SEC
proposal to force funds to disclose in their expense ratios the cost of certain services
received in kind).
476 COLUMBIALAW REVIEW [Vol. 98:474
sory or management fee, of the fund's net assets."

Because of the combined effect of their independence from, and
managerial capacity over, funds in their charge, investment advisers are
subject to a conflict between their own interests and the interests of fund
shareholders.12 As one commentator has noted, "the potential for self-
dealing will always arise when a person has the power to influence the
terms of a transaction between two parties and has a greater interest in
the welfare of one of the parties than the other."13
The Investment Company Act of 1940 (the 1940 Act),14 which was
enacted to regulate mutual funds and other investment companies,
sought to provide safeguards against self-dealing by requiring the pres-
ence of "independent" or outside directors on the fund's board of direc-
tors who would serve as watchdogs for shareholder interests against any
adviser misconduct.15 The efficacy of such directors was called into ques-
tion during the 1960s in reports submitted by the Wharton School of
Finance and Commercel6 and the Securities and Exchange Commission
(SEC).17 The essence of the reports was that existing safeguards, that is,
the independent directors, were not sufficient to constrain advisory fees
because mutual funds were under their advisers' "effective control."'8 In
other words, directors generally did not feel at liberty to fire their adviser
11. See Richard W. Jennings & Harold Marsh, Jr., Securities Regulation: Cases and
Materials 1398 (5th ed. 1982). The major exception to the adviser-based mutual fund is
the Vanguard Group, whose funds are controlled by a board of directors that selects and
periodically changes the investment adviser; incidentally, it is worth noting that Vanguard
has the lowest cost structure of any family of mutual funds. See Slater, supra note 2, at 150,
226.
12. See Michael Mulvihill, A Question of Trust, Morningstar Mutual Funds, Aug. 30,
1996, at S1, S1. In terms of "managerial capacity," the potential for self-dealing by the
investment adviser is exacerbated by the fact that mutual funds generally cannot fire their
advisers. See infra note 49 and accompanying text.
13. Bevis Longstreth & Ivan E. Mattei, Organizational Freedom for Banks: The Case
in Support, 97 Colum. L. Rev. 1895, 1903 (1997) (citing Robert C. Clark, The Regulation
of Financial Holding Companies, 92 Harv. L. Rev. 787, 841 (1979)).
14. Ch. 686, 54 Stat. 789 (1940).
15. See 15 U.S.C. ? 80a-10(a) (1994).
16. See Wharton Sch. of Fin. & Commerce, A Study of Mutual Funds, H.R. Rep. No.
87-2274, at 27-36 (1962), reprinted in Committee on Interstate & Foreign Commerce, A
Study of Mutual Funds (1982) [hereinafter Wharton Study].
17. See SEC, Public Policy Implications of Investment Company Growth, H.R. Rep.
No. 89-2337, at 130-31 (1966) [hereinafter 1966 SEC Report].
18. See id. at 10-12; Wharton Study, supra note 16, at 30. The Wharton study
provided the following observations:
[T]here appear to be very few, if any, instances of boards of directors giving
serious consideration to changing investment advisers or merging their fund into
one with a clearly superior performance record.
These findings suggest that the special structural characteristics of this
industry, with an external adviser closely affiliated with the management of the
mutual fund, tend to weaken the bargaining position of the fund in the
establishment of advisory fee rates.
Id.
since it had so much to do with the fund's creation and their dealings
were not at arm's length. As a result, the market for investment manage-
ment clients was not competitive.
In response to these reports, in 1970 Congress passed a series of
amendments to the 1940 Act;19 however, political compromise prompted
Congress to preserve and, in some ways, increase the dependence on in-
dependent directors rather than provide courts with jurisdiction to de-
cide whether an adviser's fee was reasonable20 from a cost or services-
provided perspective.21 Strangely, although nothing seemed to have
changed to make the earlier findings depicting the inadequacy of the
independent directors untrue (if anything, the recent phenomenal
growth of funds provided greater incentives for the adviser to self-deal
and for the independent directors to let them get away with it), both the
courts and the SEC have heartily embraced the enhanced role of the in-
dependent directors during the last few decades, despite the lack of hard
data indicating their efficacy both before and after the 1970 amend-
ments.22 No courts have held any adviser's fee to be excessive. Indeed,
very few cases have been litigated to their full extent under the amended
1940 Act,23 possibly because plaintiffs perceive little real hope of success.
In the past several years, Morningstar Mutual Funds, a Chicago news-
letter for investors, has published the results of several studies, apparently
19. Investment Company Act, Pub. L. No. 91-547, 84 Stat. 1413-1430 (1970).
20. Hereinafter, for the sake of simplicity, a standard of "reasonableness" (not to be
confused with reasonable business judgment) shall be deemed to connote a direct legal
inquiry into the fairness of a fee based on relative costs and similar factors, regardless of
whether the standard's proponent or source is the SEC, courts interpreting the 1940 Act,
or the common law. See infra text accompanying notes 61-62.
21. See 15 U.S.C. ? 80a-15(c) (requiring approval of management agreement by a
majority of the independent directors); Mutual Fund Amendments: Hearings on H.R.
11,995, S. 2224, H.R. 13,754, and H.R. 14,737 Before the Subcomm. on Commerce and
Fin. of the House Comm. on Interstate and Foreign Commerce, 91st Cong. 441 (1969)
[hereinafter 1969 Hearings] (letter from Robert L. Augenblick, President and Gen.
Counsel, Investment Company Institute, to Rep. John Moss, Chairman, Subcomm. on
Commerce and Fin. of the House Comm. on Interstate and Foreign Commerce)
(indicating industry's concern that "reasonableness" standard would cause courts to
substitute their business judgment for that of mutual fund directors); Rogers & Benedict,
supra note 8, at 1082-90.
22. See Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923, 928 (2d
Cir. 1982) (indicating that the court cannot "'substitute its business judgment for that of a
mutual fund's board of directors in the area of management fees"' (quoting S. Rep. No.
91-184, at 6-7 (1970), reprinted in 1970 U.S.C.C.A.N. 4897, 4902-03)); Protecting
Investors, supra note 7, at 265-66 (SEC agreement with view that it "is uniquely
appropriate [for] independent directors of investment companies [to] take an active role
in their governance"); Werner Renberg, Sixth Men or Fifth Wheels: Do Fund Directors
Earn Their Paychecks?, Barron's, Aug. 12, 1991, at M14 ("Whenever judges have
commented at all in opinions on these [suits against investment advisers for 'breach of
fiduciary duty'], they have complimented independent directors.").
23. See Rogers & Benedict, supra note 8, at 1101 (as of 1982, "[o]nly two cases
challenging management fees as excessive ha[d] been tried on the merits under section
36(b)").
confirming the continued presence of the problems identified in the

Wharton study. The results depict a rise in average expenses despite
huge increases in assets (which would normally produce cost savings asso-
ciated with economies of scale) and a positive correlation between direc-
tor salaries and expenses.24 The Morningstar report belies the recent
confidence of the SEC and the courts in the independent directors' abil-
ity to safeguard fund shareholder interests. Both sets of data indicate that
independent directors, at the very least, are not successfully performing
their function, and at the worst, are being dominated by their advisers
through the promise of large directors' fees.25 This information, dire for
investors, requires action. Although the SEC understandably may be re-
luctant to "rock the boat"-especially considering how "bullish" the mar-
ket has been of late-if left unchecked, expenses assessed by advisers to
funds in their charge could easily outweigh the perceived advantages that
funds offer to investors.
One of the more important doctrines to emerge under existing case
law has been that of undue influence: If, in the context of advisory fee
negotiations, the independent directors of a fund are deemed not to
have been dominated or unduly influenced by the adviser (and if the
adviser reasonably informed them of relevant facts), then the courts gen-
erally seem to presume that the directors have made a reasonable busi-
ness judgment and that the adviser has satisfied its fiduciary duty under
section 36(b) of the 1940 Act.26 Ultimately, and ironically, perhaps the
most fruitful course of action will be to work within the present legal
framework and view Morningstar-type data as evidence of undue influ-
24. See Jonathan Clements, Keeping an Eye on Mutual Fund Costs Can Pay Large
Dividends for Investors, Wall St.J., Aug. 27, 1996, at Cl; Mulvihill, supra note 12, at S1-S2.
25. See Mulvihill, supra note 12, at S2.
26. Courts have varied in the degree to which they expressly consider independent
director approval an important factor in assessing the fairness of advisory contracts. The
district court in Gartenbergv. Merrill Lynch Asset Management, Inc., felt that "the approval of
the advisory fee by the board of trustees of the Fund should be weighted heavily," in large
part because "[t]heir independence and their competence as trustees were not questioned
. . . and they have been free of domination or undue influence." 528 F. Supp. 1038, 1058
(S.D.N.Y. 1981), aff'd, 694 F.2d 923 (2d Cir. 1982). The court of appeals in Gartenberg,
however, opined that "an adviser-manager's fee could be so disproportionately large as to
amount to a breach of fiduciary duty in violation of ? 36(b)." 694 F.2d at 930.
Nonetheless, the basic framework that courts have used to assess the conduct of a fiduciary
and that they applied in the context of the original section 36 of the 1940 Act is as follows:
[A] decision . . . did not violate the fiduciary obligations of either the Fund's
adviser or directors under section 36 of the Investment Company Act if the
independent directors (1) were not dominated or unduly influenced by the
investment adviser; (2) were fully informed by the adviser and interested directors
. . . and (3) fully aware of this information, reached a reasonable business
decision . . . after a thorough review of all relevant factors.
Tannenbaum v. Zeller, 552 F.2d 402, 418-19 (2d Cir. 1977); see ArthurJ. Brown, Role of
Independent Directors in Mutual Fund Mergers and Advisory Contract Assignments 205,
216 (PLI Corporate Law & Practice Course Handbook Series No. 786, 1992); Rogers &
Benedict, supra note 8, at 1115-16.
ence, thereby preventing advisers from being protected by directors' rea-

sonable business judgments and triggering a more rigorous scrutiny of
their fees based on a reasonableness standard.
Part I of this Note discusses the conflict of interest to which invest-
ment advisers are subject regarding the compensation that they derive for
advising mutual funds in their charge. This Part then considers
Congress's solution to the conflict of interest problem-the independent
directors-set forth in the Investment Company Act of 1940, and the
studies which exposed the solution's shortcomings, prompting a set of
amendments to the Act in 1970. Next, Part II examines the scope of the
1970 amendments to the 1940 Act, taking into account interpretative dis-
positions by courts of, and the SEC's attitude toward, the amended provi-
sions. This discussion is followed by the presentation of recent data on
fund expenses, promulgated by Morningstar and other sources, which
tend to undermine the assumptions on which the 1970 amendments were
based and emphasize the need for yet another change in approach to the
problem of advisory self-dealing. Finally, Part III concludes that this
change in approach should take place in the courtroom. This Part dis-
cusses the doctrine of "undue influence" that has developed in other ar-
eas of the law to show that the Morningstar data can be used to reinvigo-
rate the "undue influence" standard currently existing in mutual fund
cases, so as to more effectively reduce advisory self-dealing and make the
industry more competitive and responsive to shareholder needs.
I. ADVISORY SELF-DEALING AND THE LEGISLATIVE SOLUTION
It is not through lack of early recognition that the conflict of interest

exists between fund shareholders and their investment advisers. Part I
first defines the problem, identified in the Investment Company Act of
1940, as a function of the structure of mutual funds. Next, the 1940 Act's
solution to the conflict of interest problem-independent directors-is
examined. Finally, this Part recounts how studies by Wharton and the
SEC exposed weaknesses of the independent director solution and how
Congress ultimately failed to follow the studies' recommendations when
it passed the 1970 amendments to the Investment Company Act.
A. The Investment CompanyAct and IndependentDirectors

Mutual funds are defined as funds operated by investment compa-
nies that gather money from shareholders to invest in stocks, bonds, and
other securities.27 Mutual funds are governed primarily by the
Investment Company Act of 1940.28 The Act defines open-end invest-
27. See John Downes & Jordan Elliot Goodman, Barron's Financial Guides:
Dictionary of Finance and Investment Terms 352 (4th ed. 1995).
28. 15 U.S.C. ?? 80a-1 to -64 (1994). For purposes of this Note, the Act has not been
significantly revised since 1970. See Investment Company Amendments Act of 1970, Pub.
L. No. 91-547, 84 Stat. 1413.
ment companies, commonly known as mutual funds, as those which offer

to the public redeemable shares in a portfolio of securities.29 A mutual
fund offers such shares continually at a price reflecting the current net
asset value of the fund (i.e., the market value of the portfolio divided by
the number of outstanding shares of the fund)30 and will redeem the
shares at any time, also at net asset value, at the behest of the
shareholder.31
Although mutual funds tend to assume a corporate form, they are
unique in that they are usually managed by external investment advisers,
which, although typically responsible for organizing or sponsoring the
funds, tend to be corporate entities legally separate from the funds they
manage.32 As independent entities, investment advisers charge a per-
centage fee to their advisee funds for management services rendered.33
However, given their extensive influence over the internal management
of their advisee funds (due in large part to their status as creators of the
funds), advisers are in a position to determine and effectively approve
what they get paid by the funds without being held accountable to fund
shareholders-a classic example of a conflict of interest. Advisers that do
act on this conflict are likely to proceed in a subtle manner, eschewing
the direct and periodic manipulation of their fees in favor of recom-
mending courses of action to their funds designed to increase their wind-
fall profits at the relative expense of fund investors. Therefore, unlike an
in-house adviser, whose salary compensation is transparent and subject to
immediate review by a fund's board of directors and shareholders, an
external adviser to a fund can manipulate its form of compensation and
have the arrangement approved easily by the fund since such compensa-
tion is usually difficult to comprehend (nontransparent) and tends to be
inextricably tied to the sorts of decisions that funds expect advisers to
make anyway and for which they are afforded considerable discretion.
One example of such conflict that has occurred in the past and
which might help to illustrate the problem is when an adviser permits a
previously successful fund to grow indefinitely in size despite evidence
that portfolio performance is either unrelated or inversely related (be-
cause of the negative consequences of inflexibility associated with large
29. See 15 U.S.C. ?? 80a-3(a), a-4(3), a-5(a).

30. See Downes & Goodman, supra note 27, at 361-62.
31. See Louis Loss &Joel Seligman, Securities Regulation 245 (3d ed. 1989). "Open-
end funds," i.e., mutual funds, in contrast to the other major type of investment
company-the "closed-end fund"-continuously offer new shares to investors and redeem
existing shares at net asset value, whereas closed-end funds offer a fixed number of shares
at an initial public offering so that share price, like that of the average stock, is at the mercy
of subsequent demand and trading in the secondary markets. See Slater, supra note 2, at
10-11. Indeed, since the great stock market decline of 1929-1932, most closed-end fund
shares have traded at a discount from the underlying market value of the investments held
by the funds. See id.
32. See Rogers & Benedict, supra note 8, at 1063.
33. See id. at 1063-64.
size) to the size of a fund.34 Letting a fund grow means keeping it open
so that additional investors can buy shares of the fund. This may not
seem like such a bad thing since one of the major purposes of a fund is to
allow the investors' pooled assets to amass so that investor risk is diversi-
fied and buying power is enhanced.35 Fund size, however, can reach a
point at which additional gains from diversification are far outweighed by
the fact that the fund manager cannot purchase enough additional
shares of the stocks whose high returns have made the fund successful or
of suitable replacement stocks with similarly high returns to maintain the
fund's rate of return to shareholders (which presumably is the reason
that additional prospective investors want to buy fund shares and cause
the fund to grow in the first place).36 As a result, the fund's net asset
value per share drops, and the fund's pregrowth shareholders are made
worse off by the increase in size. Advisers, on the other hand, clearly
benefit because their fee percentage is applied to a larger net asset
amount.
Another problem for shareholders resulting from growth in fund
size arises when advisers fail to add breakpoints to accompany such
growth. Breakpoints are net asset levels which, when reached, trigger a
drop in fee percentage. In other words, the only possible benefits reaped
by existing investors from a fund size increase are reduced expenses re-
sulting from economies of scale (manifested by the breakpoints) since
larger funds are not significantly more costly to manage than smaller
funds.37 As one study noted, "[w]ithout a scaled management fee rate
the advantage of such growth to the shareholders in the form of cost
reductions is sharply restricted."38 In the absence of breakpoints, the re-
sulting unnecessarily high expenses afford windfall profits to the adviser
that would instead have been provided to fund shareholders in the form
34. See Wharton Study, supra note 16, at 31-32. One observer writes:
To close or not to close a large, popular fund is an issue that tests the integrity of
a fund company, says Vanguard Chairman John C. Bogle. He believes that
keeping a large fund open hurts shareholders because the manager either runs
out of good stocks to buy or can't buy enough of the good ones to boost returns
much. "While it's in the interest of the shareholder to close a big fund, that is in
the cosmic opposite interest of the investment adviser, because his fees stop
growing," Mr. Bogle says.
James S. Hirsch, Trimming Its Sails: Magellan, the Flagship of Fidelity, Will Close to Most
New Investors, Wall St. J., Aug. 27, 1997, at Al.
35. See supra text accompanying note 5.
36. See supra text accompanying note 5. These problems underlie the recent
popularity of "concentrated funds," which are "funds that have concentrated portfolios of a
limited number of stocks or, alternatively, have the majority of their assets invested in a
small number of holdings. The assumption is that there are only a handful of real
winners." Standard & Poor's, Concentrated Funds: Do They Make Sense?, Hot Fund
Strategies, Oct. 27, 1997, para. 1 (visited Nov. 3, 1997) <http://quicken.webcrawler.com/
investments/articles/876685573_20996> (on file with the Columbia Law Review).
37. See Wharton Study, supra note 16, at 31-32.
38. Id. at 31.
of lower expenses if the adviser did not have the de facto authority to
approve its own self-interested recommendations.
Congress did not fail to take note of the potential conflict of interest
between advisers and fund investors over adviser compensation.39 The
1940 Act itself was largely a measure to curb managerial abuses perceived
to be prevalent in investment companies, including mutual funds, during
the Great Depression.40 In a provision directed primarily at self-dealing,
the 1940 Act mandated that forty percent of an investment company's
board of directors be composed of persons not "affiliated" with, inter alia,
the fund's investment adviser.41 This provision was intended to ensure
that the fund's board of directors or trustees,42 which unlike the adviser is
directly accountable to fund shareholders and responsible for safeguard-
ing their interests, was not entirely composed of individuals meeting the
statutory definition of a direct, insider relationship to the adviser and
who presumably would be partial to the adviser's decisions. In Congress's
view, these "independent" or outside directors could serve as watchdogs
for shareholder interests against any misconduct on the part of the ad-
viser stemming from its conflict of interest.43
In so doing, Congress avoided the task of directly regulating the fee
itself, instead enacting prophylactic provisions, such as requiring ap-
proval by a majority of the unaffiliated directors for advisory contract re-
newal.44 The unaffiliated directors were afforded tremendous discretion
and "were to be the first line of defense against self-dealing by investment
39. See Investment CompanyAct of 1940, Pub. L. No. 76-768, ? 1 (b) (2), 54 Stat. 789,
790 (codified at 15 U.S.C. ? 80a-1(b) (2) (1994)). But see Protecting Investors,supra note
7, at 257 n.14 ("Whensection 15 was enacted in 1940, Congress and the Commissionwere
not concerned with the magnitude of advisory fees.").
41. See ? 10(a), 54 Stat. at 806 (codified as amended at 15 U.S.C. ? 80a-10(a)). Other
affiliated persons include persons owning or controlling 5% of the voting stock of another
person, persons controlling or under common control with another person, and any
officer, director, partner or employee of another person. See id. Congress amended this
provision in 1970 in an effort to increase director independence; the provision now
mandates that 40% of the board be "disinterested," a slightly more stringent requirement
than the earlier "unaffiliated" standard (expanded to include such categories of persons as
family members, broker-dealers, legal counsel, and trustees). See 15 U.S.C. ? 80a-2(a) (3),
(19). The revised provision states that no more than 60% of an investment company's
board of directors may be "interested persons of the company." 15 U.S.C. ? 80a-10(a). As
an example of the faith that Congress had in such disinterested directors, in order to
safeguard shareholder interests in the context of advisory contract assignment, it added a
new section 15(f) to the Act in 1975 that provided that "for a period of three years after the
time of such [assignment], at least 75 per centum of the members of the board of directors
of such registered company. . . are not (i) interested persons of the investment adviser of
such company ... or (ii) interested persons of the predecessor investment adviser." Id.
? 80a-15(f).
42. For the purposes of this Note, the terms "trustee" and "director" are synonymous.
43. See 15 U.S.C. ? 80a-10(a).
44. See ? 15(a), (c), 54 Stat. at 812-13 (codified as amended at 15 U.S.C. ? 80a-15(a),
(c)).
advisers."45 The Act eschewed placing any kind of qualitative limits on

the management fee itself.
From the beginning, however, the 1940 Act had built-in enforcement
difficulties. Under the Act, the SEC had little regulatory clout other than
to bring an action to remove an investment adviser, director, or under-
writer for "gross misconduct," which effectively protected the regulatees
since the SEC was generally unwilling to invoke this option due to the
unduly harsh stigma associated with it.46 The adviser was also protected
by the standard set forth by Saxe v. Brady and its progeny, which held that
in an action against the adviser and/or directors for self-dealing, if share-
holders or directors have approved an advisory fee, the plaintiff must
demonstrate that the fee is so excessive as to constitute corporate waste.47
B. The 1962 Wharton Study and the 1966 SEC Report

Prior to the 1970 amendments to the Investment Company Act, the
SEC and some members of Congress began to view the "unaffiliated" di-
rector measures as inadequate to deal with the problem of advisory self-
dealing because, for one, in almost all cases advisers continued to select
all the directors, including the unaffiliated ones, on a fund's board, mak-
ing it unlikely that the directors could bargain at arm's length with the
advisers over management fees.48 Nor, generally, did mutual funds,
which in most instances were created by their advisers, feel that it was
appropriate to fire their advisers;49 thus, fund directors lacked a powerful
45. Rogers & Benedict, supra note 8, at 1070. Compare the SEC's current position on
independent directors: "The independent directors, in particular, are expected to look
after the interests of shareholders by 'furnishing an independent check upon
management,' especially with respect to fees paid to the investment company's sponsor."
Protecting Investors, supra note 7, at 255-56 (quoting Burks v. Lasker, 441 U.S. 471, 484
(1979)). But see infra Part II.B.
46. See infra note 73.
47. 184 A.2d 602, 610 (Del. Ch. 1962). In Saxe, plaintiff shareholders sued for excess
advisory fees under section 36 of the original Investment Company Act. See id. at 604. In
assessing the fee, the court compared it to those of similar funds but placed great emphasis
on approval of the fee by, and proper disclosure of fee information to, fund shareholders
and directors. See id. at 610-11. The court stated that, in light of the presence of these
factors in Saxe, the defendants did not have to show fairness of the fee, and the burden of
proof shifted to plaintiffs "to convince the court that no person of ordinary, sound business
judgment would be expected to entertain the view that the consideration [of advisory
services rendered] was a fair exchange for the value which was given." Id. at 610.
48. See Rogers & Benedict, supra note 8, at 1072-73. These arguments continue to
be recognized by the SEC as part of the ongoing debate concerning the role of
independent directors despite its current position in support of the independent director
provisions. See Protecting Investors, supra note 7, at 264 ("Because an investment
company usually is managed by its sponsor or an affiliate, [critics] argue, the independent
directors are not truly independent, and have little choice but to approve the fee levels that
the adviser deems necessary to operate the company and market its shares.").
49. The Vanguard Group is the one major family of funds that has exercised its
option of firing its investment adviser. See supra note 11; see also Renberg, supra note 22,
at M13 ("Certainly, directors have seldom booted an investment adviser, no matter how
484 LAW REVIEW
COLJUMBIA [Vol. 98:474
bargaining chip in their negotiations over management fees-that of

ending the fund's relations with its adviser-by which they could enforce
performance standards and keep expenses low. The market for invest-
ment advisers did not appear to be competitive. For these reasons, the
outside directors could not fulfill their mandate-to protect fund share-
holders from advisory self-dealing through arm's length, disinterested ne-
gotiations with the adviser, keeping the shareholders' best interests in
mind.
A 1962 study commissioned by the SEC and conducted by the
Wharton School of Finance and Commerce of the University of
Pennsylvania confirmed many of the concerns about the efficacy of unaf-
filiated directors.50 The study described advisory rates as being "relatively
high" and observed that they did "not appear to be a consequence of
extensive services rendered to, or expenses incurred on behalf of, mutual
funds."51 The authors based this conclusion in large part on
breakpoint52 evidence: Despite the rapid growth in mutual funds, fund
shareholders were not receiving the benefits of economies of scale that
one might expect from such growth.53 Investment advisers were still
charging fees without breakpoints to their funds; as a result, their fees
ended up being much higher than what the same advisers would charge
their noninvestment company clients for managing similar levels of
assets.54
Prompted by the Wharton study findings, the SEC embarked upon
its own examination of mutual funds, from which it concluded that mu-
tual funds tended to be "under the effective control of their advisers,"55
and as a result, the 1940 Act failed to offer sufficient protection to share-
holders.56 The report also made the critical observation that sharehold-
ers disgruntled with an advisor's excessive management fee were not free
to vote with their feet (a factor which took on greater importance when it
became apparent that the 1940 Act's provisions were not working): Capi-
tal gains tax and sunk costs, such as up-front sales loads,57 effectively dis-
lousy a fund's performance."); cf. Slater, supra note 2, at 150 (describing how Vanguard
had retained 14 different external investment advisers for its stock funds as of 1995).
50. See Wharton Study, supra note 16, at 27-36.
51. Id. at 29.
52. See supra text accompanying notes 37-38.
53. See Wharton Study, supra note 16, at 28-29. Economies of scale should have
been realized because advisers do not incur much additional cost when managing large as
opposed to small funds. See Rogers & Benedict, supra note 8, at 1080. A central premise
of this Note is that the problems identified by the Wharton study continue to exist at
similar or even greater levels today. For instance, the rapid growth of mutual funds
observed in 1962 is trivial compared to what has happened to the industry in recent years.
Of course, higher growth rates simply make shareholder protection more critical.
54. See Wharton Study, supra note 16, at 29.
55. 1966 SEC Report, supra note 17, at 12.
56. See id.
57. A sales load is a one-time, initial sales charge paid to a brokerage house by fund
investors in return for certain kinds of investment advice.
couraged shareholders from leaving a fund for another with a lower cost
structure.58 Price collusion-most advisers and hence mutual funds were
charging their shareholders the same high expense rates-probably
served to restrict shareholder choice even further. As was done in the
Wharton study, the SEC compared mutual fund advisory fees to the lower
ones of bank and pension funds to illustrate the greater level of competi-
tion for investment management clients in the advisory markets for the
latter two types of institutional funds.59 The report also pointed out the
58. See 1966 SEC Report, supra note 17, at 126. Another factor favoring shareholder
inaction in the face of an excessive management fee is the collective action problem
alluded to by SEC Commissioner Steven Wallman. According to Wallman, the problem is
one that the SEC is far more suited to eradicate than the individual investor:
[T]he fact that many investors have not pushed this issue is precisely why I am
raising it here today .... Smaller investors ... suffer from what I view as a classic
collective action problem of organizing to pursue what is in their interests. While
the amount at stake in any individual case may not be substantial, the costs saved
for these investors by a lower trading increment would be significant in the
aggregate .... In a very real sense, this is where government-and self-
regulators-become most important, in looking out for the interests of those who
do not have the wherewithal to look out for themselves.
Steven M.H. Wallman, Technology and Our Markets: Time to Decimalize, Remarks Before
the Center for the Study of Equity Markets 12 (Sept. 25, 1996) (on file with the Columbia
Law Review) (discussing collective action problem for investors in the context of
fractionalized share prices). Critics might suggest that the existence of this collective
action problem for shareholders would render ineffectual the court-oriented solution to
advisory self-dealing proposed in Part III. The immediate response is that a "de minimis
expense" is a relative concept (some may recall the Christian parable of the widow's mite),
and the popularity of no-load funds attests to the fact that even average individual investors
for whom expenses are arguably insubstantial care about costs.
Second, with heightened public awareness or "cost transparency" (through
informational disseminations such as the Morningstar report), fund shareholders will
place greater pressure on the SEC to sue or will themselves derivatively sue funds when it
becomes obvious that advisers are making an undeserved windfall. Such self-dealing is not
the type of behavior that shareholders want to observe or encourage, regardless of whether
they are only paying de minimis sums as a result of it. Moreover, institutional investors,
whose ownership of mutual fund shares has skyrocketed, do not suffer from a collective
action problem due to the huge amounts that they invest, and will most assuredly welcome
reductions in inappropriate expenses. Also in periods of economic downturn, disgruntled
fund shareholders are less likely to tolerate such windfall profits because, from their
perspective, there will have been no good returns to show for the expensive professional
advice for which they have paid. Indeed, Fidelity Investments recently closed its popular
Magellan Fund largely in response to criticisms from customersthat "the fund had grown
too big to be managed effectively and was being kept open to generate higher
management fees at the expense of existing shareholders." Hirsch, supra note 34, at Al.
Finally, this type of collective action problem seems one for which class actions suits are
specifically designed.
59. See 1966 SEC Report, supra note 17, at 114. The SEC did acknowledge that
differences existed among mutual, bank, and pension funds, but it felt that these could not
account for the degree to which management fee levels varied among them. See id. at
116-18.
generally lower cost structure of the few investment companies that did
not utilize the services of an "external" investment adviser.60
In its report, the SEC recommended amending the 1940 Act to in-
clude a provision through which advisory fees could be judged by a
straight reasonableness standard.6' In other words, instead of the 1940
Act's approach of leaving adviser compensation entirely to the discretion
of a fund's board of directors, the SEC wanted to give courts the authority
to determine whether a fee was reasonable in light of "all relevant fac-
tors," such as the qualitative services provided by the adviser and the man-
agement fees that similar entities, including investment companies other
than mutual funds, were paying under comparable circumstances.62 In
essence, the SEC wanted to create a legal environment that mimicked a
competitive market for investment management clients.
In passing the 1970 amendments to the Investment Company Act,
however, Congress rejected the SEC's proposed explicit reasonableness
standard in favor of a fiduciary duty standard for investment advisers with
respect to compensation for their managerial services.63 The rationale
for this outcome appears to be that since external investment advisers are
not accountable to a fund's directors and shareholders, as an internal
adviser would be, why not make the former legally bound to the fund
through a statutorily imposed duty? Nonetheless, there were political rea-
sons for Congress to "choose" a fiduciary duty standard as well; members
of the securities industry were opposed to a reasonableness standard be-
cause they felt it would "'inappropriately emphasize the actions of direc-
tors rather than those of fund advisers',64 and lead courts to substitute
their business judgments for those of directors, preclude advisers from
making profits, or assess fees on the basis of costs rather than the pres-
ence of advisory misconduct.65
Although the fiduciary duty concept may have made sense in theory,
in practice, the SEC and the securities industry ultimately agreed on the
fiduciary duty standard without resolving what the statutory language
60. See id. at 102-04. It is worth noting that the 1966 SEC report has been criticized
for concluding that mutual fund advisory fees were inflated strictly on the basis of costs
without any allowance being made for the entrepreneurial risk that an investment adviser
takes-essentially a service for which the adviser deserves to be compensated. See 2 Tamar
Frankel, The Regulation of Money Managers 253 (1978); Rogers & Benedict, supra note 8,
at 1080-81.
61. See 1966 SEC Report, supra note 17, at 144.
62. See id.
63. See Investment Company Act of 1940 ? 36 (b), 15 U.S.C. ? 80(a)-35(b) (1994);
see also Rogers & Benedict, supra note 8, at 1082-89 (discussing legislative history behind
shift from "reasonableness" to fiduciary duty standard).
64. Rogers & Benedict, supra note 8, at 1084 (quoting 1969 Hearings, supra note 21,
at 441).
65. See id. at 1083-86; see also 1969 Hearings, supra note 21, at 441 (securities
industry members concerned that "in applying the 'reasonable' standard the courts might
feel called upon to substitute their business judgment for that of the directors of the
fund").
used really meant substantively (which lends further credence to the

political motivation hypothesis); in other words, the term "fiduciary duty"
begged the question of whether the standard by which advisory fees
would be judged was in effect a reasonableness one.66 Section 36(b), on
its face, does not describe the manner in which to measure the adviser's
fiduciary duty.67 Notably, the bill incorporating the SEC's original rea-
sonableness proposal was amended during Senate debate to create a re-
buttable presumption that advisory fees were fair if approved by fund
shareholders or a majority of the independent directors.68 Many mem-
bers of Congress were opposed to this amendment, arguing that it effec-
tively abrogated the more substantive "reasonableness" standard, and as
amended, the bill ultimately failed to pass through the House of
Representatives.69 Such sentiment suggests that a significant part of
Congress believed that independent directors, left to their own discre-
tion, would not adequately protect fund shareholder interests. However,
Congress presumably left further explanation of what the statutory fiduci-
ary duty standard entailed to the courts.
C. The 1970 Amendmentsto the Investment CompanyAct

The 1970 amendments to the Investment Company Act provided a
new subsection (b) to section 36 concerned with the fiduciary duties of
an investment adviser with respect to its compensation (section 36(a)
deals with the fiduciary duties generally of parties associated with regis-
tered investment companies). The new subsection states 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, 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 per-
son of such investment adviser.70
The subsection also states that the SEC or a shareholder suing derivatively
on behalf of the fund can bring an action for breach of this duty against
the adviser as well as any fund officer, director, or advisory board mem-
ber, among others.71
The general purpose behind the amendments was to make it easier
for shareholders or the SEC to sue the adviser.72 Under a section 36(b)
66. See Rogers & Benedict, supra note 8, at 1084. Not surprisingly, the SEC
maintained that "the effect of the shift in language from 'reasonableness' to 'breach [of]
fiduciary duty' is primarily procedural not substantive. It was designed to assure
reasonable fees just as the original language of S. 34 was meant to do." 1969 Hearings,
supra note 21, at 189-90.
68. See id. at 1083.
69. See id.
70. Investment Company Act of 1940 ? 36(b), 15 U.S.C. ? 80(a)-35(b) (1994).
71. See id.
action, it is no longer necessary to provide proof of any kind of miscon-

duct on the part of the defendant (although a showing of "personal mis-
conduct" is required in a section 36(a) suit).73 Section 36(b) also over-
rules the standard set forth in Saxe v. Brady, which held that plaintiffs had
to demonstrate corporate waste once fund shareholders or directors had
approved an adviser's fee.74 To alleviate the burden that the Saxe stan-
dard imposes upon plaintiffs, Congress included in the new section 36(b)
a provision stating: "[A]pproval by the board of directors of such invest-
ment company of such compensation or payments ... and ratification or
approval of such compensation or payments ... by the shareholders of
such investment company, shall be given such consideration by the court
as is deemed appropriate under all the circumstances."75
Congress also took steps to increase the likelihood that independent
directors would make informed and impartial decisions regarding man-
agement fees. Section 15(c) was amended to require fund directors to
request and evaluate, and investment advisers to furnish "such informa-
tion as may be reasonably necessary to evaluate the terms of any contract
whereby a person undertakes regularly to serve or act as investment ad-
viser of such company."76 In addition, Congress changed the definition
of independence required for outside directors from "unaffiliated" to the
more stringent "disinterested."77
Unfortunately, the amended provisions contain several inconsisten-
cies and ambiguities. For example, though a director can theoretically be
sued under section 36(b), subsection (3) requires that "[n]o such action
shall be brought or maintained against any person other than the recipi-
ent of such compensation or payments."78 This provision would appear
to restrict all such actions to investment advisers, the only recipients of
management fees. In addition, as discussed previously, the 1970 amend-
73. See 15 U.S.C. ? 80a-35(a), (b). As noted earlier, the original section 36 of the
1940 Act simply authorized the SEC to bring an action to remove any investment adviser,
director, or underwriter for "gross misconduct or gross abuse of trust in respect of any
registered investment company." Investment Company Act of 1940, Pub. L. No. 76-768,
? 36, 54 Stat. 789, 841 (codified as amended at 15 U.S.C. ? 80a-35(a)) ("gross misconduct"
being a more stringent standard than "personal misconduct"); see supra text
accompanying note 46. Under this standard, the SEC was unwilling to bring suits against
advisers for fear that such "gross misconduct" charges could unnecessarily stigmatize
advisers. See 1966 SEC Report, supra note 17, at 143; Rogers & Benedict, supra note 8, at
1073. This concern for the interests of the regulatees currently characterizes the SEC's
position generally, and in particular, its stance on mutual fund industry reform with
questionable results for fund shareholders. See infra note 108 and accompanying text.
74. 184 A.2d 602 (Del. Ch. 1962); see text accompanying note 47.
75. 15 U.S.C. ? 80a-35(b) (2).
76. Id. ? 80a-15(c).
77. See supra note 41.
78. 15 U.S.C. ? 80a-35(b)(3). The provision further stipulates that any award of
damages "shall in no event exceed the amount of compensation or payments received
from such investment company, or the security holders thereof, by such recipient." Id.
This would seem to reinforce the notion that section 36(b) actions may only be brought
against investment advisers.
ments provide little guidance of the extent to which the adviser now
could avoid discussion of the reasonableness of its fees by pointing to the
requisite director or shareholder approval (as it could do under the origi-
nal 1940 Act). The amended section 36(b) accords to such approval only
such consideration "as is deemed appropriate under all of the circum-
stances," but does not clarify further.79 By rejecting the Senate proposal
to create an explicit, rebuttable presumption that advisory fees are rea-
sonable if approved by fund shareholders or a majority of the independ-
ent directors,80 Congress appeared to want to afford plaintiffs an oppor-
tunity to demonstrate that advisory fees are unreasonable. It is unclear
what limits the ultimately agreed upon statutory language regarding di-
rector approval-"appropriate under all of the circumstances"-places
on this opportunity. Taken as a whole, the measures designed to increase
director independence lend themselves to the conclusion that the limits
are significant indeed.81
The amendments, to the extent that they were not simply political
compromise, reflected Congress's belief that the unique structure of the
mutual fund industry, in particular the close relationship between a fund
and its adviser, continued to impede the "forces of arm's-length bargain-
ing," despite the 1940 Act's independent director provisions.82 Perhaps
the most direct way Congress could have rectified the situation would
have been to require, in all cases, a reasonableness83 or cost-plus84 type
standard for management fees that would have mimicked the functioning
of a competitive market for investment management clients. Instead,
Congress chose to apply an indirect fiduciary duty standard to investment
advisers, which begs the question of the existing advisory fee standard
and is characterized by concessions.85 Although no doubt influenced by
the Wharton and SEC reports on the inefficacy of the independent direc-
tors and as a result shifting some of the legal scrutiny onto the investment
advisers themselves,86 Congress nevertheless has left room for courts to
reaffirm reliance on the judgment of the directors. It attempted to justify
this course of action by adopting measures designed to increase the inde-
79. Id. ? 80a-35(b)(2).

80. See supra notes 68-69 and accompanying text.
82. S. Rep. No. 91-184, at 5 (1970), reprinted in 1970 U.S.C.C.A.N. 4897, 4901
[hereinafter 1969 Senate Report]; see Rogers & Benedict, supra note 8, at 1091-92.
84. Under a cost-plus standard, an advisory fee would be fair if it equaled actual
management expenses plus some reasonable profit margin. The mutual fund industrywas
understandably reluctant to allow courts to engage in such a time-consuming, fact-
intensive, and expensive inquiry.
85. Much of the problem with the amendments stemmed from the fact that they were
the result of a political compromise that the SEChad struckwith the mutual fund industry,
which desired less regulation or even self-regulation. See supra notes 65-66 and
accompanying text.
86. See Investment Company Act of 1940 ? 36(b), 15 U.S.C. ? 80a-35(b) (1994)
(fiduciaryduty of investment advisers).
pendence of and disclosure to such individuals.87 Despite the skepticism

and critical data that gave rise to the pressures to amend the 1940 Act in
the first place, in the 1970 amendments Congress reinforced the 1940
Act's previous approach of avoiding any direct, substantive fee regulation
given approval of the fee by a fund's directors or shareholders and left as
much as possible to the business judgment of the fund directors.88
II. ADVISORYSELF-DEALING AND THE INADEQUACIES OF THE

LEGISLATIVE SOLUTION
This Part depicts how, after the 1970 amendments to the Investment
Company Act, both the courts and the SEC followed Congress's lead in
placing trust in the ability of the independent directors to safeguard
shareholder interests, despite the lack of compelling reasons to do so.
This faith has been called into question by recent studies, discussed later
in this Part, showing the possible existence of improper influence exer-
cised by investment advisers over the independent directors who are sup-
posed to be watching them.
A. Case Law: Tannenbaum, Gartenberg, and the Undue Influence

Standard
Since the 1970 amendments left some matters for the courts, it is not
surprising that the courts have played a primary role in shaping the duties
and standards to which fund directors and advisers are held. The great
majority of cases involving challenges to management fees have been set-
tled.89 Only a few such cases have been tried on their merits under sec-
87. See supra note 41 and accompanying text (describing Congress's attempt to
increase the independence of directors by requiring them to be "disinterested" and not
merely "unaffiliated"). Indeed, the legislative history behind the 1970 amendments to the
Investment Company Act states that section 36(b) was "designed to strengthen the ability
of the unaffiliated directors to deal with [management fee] matters and to provide a
means by which the Federal Courts can effectively enforce the federally created fiduciary
duty with respect to management compensation." 1969 Senate Report, supra note 82, at 7,
reprinted in 1970 U.S.C.C.A.N. 4897, 4903.
88. See supra notes 41-45 and accompanying text. The legislative history of the 1970
amendments expressly indicates "Congress' desire that courts not 'second-guess' the
business judgment of a mutual fund's board of directors." Rogers & Benedict, supra note
8, at 1093; see also 1969 Senate Report, supra note 82, at 7, reprinted in 1970 U.S.C.C.A.N.
4897, 4903 ("[This] section is not intended to shift responsibility for managing an
investment company in the best interest of its shareholders from the directors of such
company to the judiciary.").
tion 36(b).90 Notably, plaintiffs have never brought a successful action

against a fund's directors or adviser for excessive management fees.91
The cases tried under section 36(b) have utilized several different
approaches. The first such approach was set forth by the Second Circuit
in Tannenbaum v. Zeller.92 Tannenbaum did not directly involve excessive
management fees but instead concerned a decision by a fund's board of
directors not to recapture excess brokerage commissions (which could
have been used to offset some of the adviser's management fees). The
court upheld the decision because it found that the independent direc-
tors satisfied the following three-part inquiry: (1) the directors "were not
dominated or unduly influenced by the adviser"; (2) they had been "fully
informed by the adviser and interested directors of the possibility of re-
capture"; and (3) in light of this information, they made a "reasonable
business decision to forego recapture" after a review of the relevant
factors.93
Assuming that the directors have been informed, the keystone of this
inquiry rests on the first prong-whether the directors were unduly influ-
enced by the adviser.94 The Tannenbaum court, in holding that the first
prong was satisfied, pointed to the fact that the independent directors
had scrutinized the available sources of information and did more than
"rubber-stamp" the adviser's recommendations.95 Nonetheless, the par-
ties had also stipulated that the independent directors were neither "in-
90. See, e.g., Krinsk v. Fund Asset Management, Inc., 875 F.2d 404 (2d Cir. 1989);
Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1222 (S.D.N.Y. 1990), aff'd, 928 F.2d 590 (2d
Cir. 1991); Gartenberg v. Merrill Lynch Asset Management, Inc., 573 F. Supp. 1293
(S.D.N.Y. 1983), affd, 740 F.2d 190 (2d Cir. 1984); Gartenberg v. Merrill Lynch Asset
Management, Inc., 528 F. Supp. 1038 (S.D.N.Y. 1981), afftd, 694 F.2d 923 (2d Cir. 1982).
91. See Renberg, supra note 22, at M14 ("Shareholders have often sued investment
advisers for 'breach of fiduciary duty' over the level of advisory fees. To date, shareholders
have lost every case . . . .").
92. 552 F.2d 402 (2d Cir. 1977). Although the 1970 amendments preceded
Tannenbaum, the plaintiffs in the case brought their claims under the preamendment
version of ? 36. The court, however, had previously held that ? 36(b) merely made explicit
the adviser's fiduciary duty regarding its compensation that the court had considered
implicit in the preamended section. See Fogel v. Chestnutt, 533 F.2d 731, 745 (2d Cir.
1975); Rogers & Benedict, supra note 8, at 1096 n.219. In fact, the Tannenbaum court
considered the analytical framework that it chose to apply to be a synthesis of the
approaches used by the leading cases interpreting ? 36(b) at the time. See 552 F.2d at 419
n.24; Rogers & Benedict, supra note 8, at 1096 n.220.
93. See Tannenbaum, 552 F.2d at 418-19.
94. It will be presumed that once the no undue influence requirement has been
satisfied, it is generally difficult to prove that a business decision made by nondominated
persons is unreasonable. Such an assumption is in accordance with other "rational"- or
"reasonable"-type standards, and further consideration of the matter is beyond the scope
of this Note.
95. See 552 F.2d at 427. In practice, today, outside directors meet this criterion and
demonstrate their "independence" by producing an enormous trail of papers which they
ostensibly reviewed-making any challenge extremely difficult-even though in many
cases they effectively rubber-stamp the adviser's decision.
terested" nor "affiliated," making the court's undue influence analysis less
central to its decision.96
Another approach was utilized by the district court in the major ex-
cessive fees case to be tried fully on the merits under section 36(b)-
Gartenbergv. Merrill Lynch Asset Management, Inc.97 In Gartenberg,two de-
rivative fund shareholders sued the investment adviser for breach of fidu-
ciary duty with respect to its compensation. The plaintiffs argued that,
given the fund's size and growth, the adviser's profits were excessive due
to its disproportionate fee.98 In holding that the adviser's fee was fair and
dismissing the plaintiffs' claim for failure to meet their burden of proof,
the court explained that, in its view, the legislative history behind the
1970 amendments indicated that Congress rejected a reasonableness or
cost-plus standard for assessing management fees and a court substituting
its judgment for that of fund directors.99 The district court acknowl-
edged the political compromise that had produced the fiduciary stan-
dard, which the court construed as consisting not of rate regulation but
of an inquiry into adequate disclosure and a comparison of fees to indus-
trywide figures.100 Its focus on disclosure and its explicit language reveal
the court's emphasis, like that of the Tannenbaum court, on approval by
the fund's independent directors: "[T]he approval of the advisory fee by
the board of trustees of the Fund should be weighted heavily ... [because
t]heir independence and their competence as trustees were not ques-
tioned . . . and they have been free of domination or undue influence
"101
In upholding the district court's decision, the Second Circuit in

Gartenbergadopted yet a third method of interpreting section 36(b). As
the district court had done, the court of appeals attempted to clarify the
meaning of the fiduciary duty standard, but it concluded from the legisla-
tive history that "the substitution of the term 'fiduciary duty' for 'reason-
able,' . . . was a more semantical than substantive compromise, shifting
the focus slightly from the fund directors to the conduct of the invest-
ment adviser-manager."102 However, the standard which the court set on
reasonableness was less favorable to plaintiffs: "To be guilty of a violation
of ? 36(b) ... the adviser-manager must charge a fee that is so dispropor-
tionately large that it bears no reasonable relationship to the services ren-
96. See id. at 426. The court also gave weight to the fact that a subcommittee of
independent directors had reviewed the recapture issue apart from the entire board. See
id. at 427.
97. 528 F. Supp. 1038 (S.D.N.Y. 1981), affd, 694 F.2d 923 (2d Cir. 1982).
98. See id. at 1040.
99. See id. at 1041, 1046.
100. See id. at 1046; Rogers & Benedict, supra note 8, at 1105.
101. 528 F. Supp. at 1058.
102. 694 F.2d at 928.
dered and could not have been the product of arm's-length

bargaining."103
Regarding independent director approval, the court seemed to stick
more closely to the "appropriate circumstances" language of section
36 (b) (2) than did Tannenbaum or the Gartenbergdistrict court. In stating
that even where outside directors had acted responsibly and indepen-
dently, a management fee could still be so large as to violate the adviser's
fiduciary duty under section 36(b), the court discarded the notion that
satisfaction of the Tannenbaum criteria should end the analysis and in-
voke the reasonableness presumption.104 The court considered manage-
ment fee approval by fully-informed, competent, and nondominated di-
rectors an important criterion, but it allowed for consideration of other
factors as well.105 Nonetheless, in deciding in favor of the adviser, the
court seemed to place great weight on the fact that the independent di-
rectors were well-informed and that the shareholders were aware of this
before they approved the management agreement detailing fees between
the adviser and the fund.106
To varying degrees, the cases following Gartenberghave followed one
or another of these approaches.107 None of the approaches definitively
resolves the inherent ambiguities in the statutory language of the 1970
amendments (witness the Gartenbergdistrict court's and court of appeals's
antithetical interpretations of the amendments' legislative history). Each
approach has its substantive shortcomings as well. In light of the
Wharton and SEC report findings, the Tannenbaum court and Gartenberg
district court appear to overemphasize the role and approval of in-
dependent directors. In particular, the Gartenbergdistrict court's empha-
103. Id. Although this standard is clearly a difficult one to satisfy (it bears some
resemblance structurally to the Saxe corporate waste standard, see supra notes 47-74 and
accompanying text), the court justified it in part because the legislative history had failed
to distinguish fully the fiduciary duty and reasonableness standards. See 694 F.2d at 928;
Rogers & Benedict, supra note 8, at 1108-09; supra note 66 and accompanying text.
104. See 694 F.2d at 930.
105. See id. Similar to the SEC's originally proposed reasonableness standard, see
text accompanying notes 61-62, the court of appeals's standard required an examination
of all relevant factors, including the nature and quality of adviser services, the adviser's cost
in providing the services, and any economies of scale, see 694 F.2d at 930. Implicitly
recognizing the SEC and Wharton report findings, the court deemphasized the
importance of industry norms because of "the potentially incestuous relationships between
many advisers and their funds." Id. at 929-30; see Rogers & Benedict, supra note 8, at
1109. Nonetheless, the decision did acknowledge, in accordance with the legislative
history behind the amendments, that the adviser is entitled to profits, that a cost-plus
calculation of management fees is not required, and that courts should not substitute their
own business judgments for those reached by fund directors. See 694 F.2d at 928.
106. See 694 F.2d at 933.
107. See Krinsk v. Fund Asset Management, Inc., 875 F.2d 404, 409 (2d Cir. 1989);
Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1222, 1227 (S.D.N.Y. 1990), affd, 928 F.2d
590 (2d Cir. 1991); Gartenberg v. Merrill Lynch Asset Management, Inc., 573 F. Supp.
1293, 1306 (S.D.N.Y. 1983), affd, 740 F.2d 190, 192 (2d Cir. 1984) (suit involving same
parties as GartenbergI, challenging as excessive fees received by investment fund adviser).
sis on disclosure and industrywide fee figures is meaningless if indepen-

dent directors deal at less than arm's length with their adviser. On the
other hand, the Gartenbergcourt of appeals possibly engages in too much
scrutiny. Not only does the court seem to suggest analyzing in detail
every fee coming before it, but also the reasonableness standard is so
strict that it would prolong a plaintiffs case-in-chief. Some threshold-
level sifting mechanism would be useful.
B. The SEC's Recent Stance

For those concerned with the Wharton report findings, the Second
Circuit's Gartenbergopinion was a step in the right direction. Although a
less than ideal solution, the decision did not, as a matter of course, pre-
sume fairness (i.e., reasonableness) from approval by the independent
directors, but instead left room for subsequent courts to base an advisory
fee's fairness on a greater variety of relevant facts and circumstances.
Since Gartenberg,the SEC's stance has shifted toward greater reliance on
independent directors.108 In addition, no set of plaintiff shareholders
has succeeded yet in showing that their fund's independent directors
were less than independent and conscientious.109
As was the case when Congress passed the 1970 amendments to the
Investment Company Act,"0 the SEC has recently proposed to increase
reliance on outside directors through provisions designed to enhance the
directors' independence."' Among other ideas, the SEC has proposed
to require that fifty percent12 of the board of directors of an investment
company be disinterested (up from forty percent), as defined in section
2(a)(19) of the 1940 Act.113 The Commission has also suggested that
disinterested directors should select their own successors.114
The testimony that the SEC has proffered in support of its recent
proposals evidences a belief in the efficacy of the 1940 Act's independent
director system as a check on investment advisers. In evaluating recent
108. The SEC's Division of Investment Management has "recognize[d] the increased
reliance on independent directors in their oversight role." Brown, supra note 26, at 205,
208. Similarly, Arthur Levitt, the Chairman of the SEC, recently stated that independent
directors are "the frontlines of investor protection" in mutual funds. See Testimony of
Barry P. Barbash Concerning H.R. 1495, The Investment Company Act Amendments of
1995 Before the Subcomm. on Telecomm. and Fin. of the House Comm. on Commerce, 7
n.19 (Oct. 31, 1995) (visited Dec. 23, 1996) <http://www.arc.com/database/SEC/sec-dig/
spch061.txt> (on file with the Columbia Law Review) [hereinafter Barbash Testimony]
(quoting Arthur Levitt, Chairman, SEC, Remarks at the Second Annual Symposium for
Mutual Fund Trustees and Directors, Washington, D.C. (Apr. 11, 1995)).
109. See, e.g., Krinsk, 875 F.2d at 412 ("[T]he district court did not err in finding that
the trustees were independent and that they deliberated conscientiously.").
110. See supra note 87 and accompanying text.
111. See Barbash Testimony, supra note 108, at 3-4.
113. See Brown, supra note 26, at 208.
114. See id. For a discussion of the shortcomings of these additional safeguards, see
infra text accompanying notes 149-150.
proposals to amend the 1940 Act once more, the SEC has stated that the
goals of such amendments are to improve and modernize the 1940 Act
and to remove any unnecessary regulatory burdens on investment compa-
nies, their directors, and advisers.115 Unlike the 1970 amendments, the
recent proposals were motivated not by any widespread recognition of
the inadequacies of integral provisions of the Investment Company
Act,116 but instead by the "opportunity to fine-tune and enhance the Act,
which has been characterized by the fund industry's leading trade associa-
tion as 'a model of effective legislation.'"117 In his testimony before a
House subcommittee on the proposed amendments, Barry Barbash,
Director of the SEC's Division of Investment Management, conceded that
controversy surrounds the independent director provisions and that
some commentators have argued that directors do not provide any real
check on fund management.118 He responded with the simple declara-
tion that "[t]he Commission believes that the core concepts of the gov-
ernance model embodied in the Act are sound and appear to have
worked well."119 Barbash further describes the last several decades for
the fund industry as "successful and safe" because of the 1940 Act's system
of "'checks and balances,'" and he makes favorable mention of the Act's
original provisions and their purposes.120 At no point does he mention
the findings of the Wharton or SEC reports or how they might have been
resolved.
In sum, the SEC is currently arguing for reduction of hands-on regu-
lation of investment companies and related parties by increasing reliance
on disinterested directors while taking some measures to enhance direc-
115. See Barbash Testimony, supra note 108, at 3-4.

116. See supra Part I.B.
117. Barbash Testimony, supra note 108, at 3 (quoting Oversight Hearings on the
Mutual Fund Industry: Hearings Before the Subcomm. on Sec. of the Senate Comm. on
Banking, Hous., and Urban Affairs, 103rd Cong. 94 (1993) (prepared statement of
Matthew P. Fink, President, Investment Company Institute)).
118. See id. at 6.
119. Id. Barbash supports this statement with opinions expressed by representatives
of the industry itself that fund boards have served as important checks on investment
advisers. See id. at 6 n.18. Relying on representatives of the fund industry, which includes
director and management constituencies, begs the question. If outside directors are
dominated by their advisers, of course industry representatives prefer the status quo rather
than proactive amendments to improve protection of shareholder interests.
120. Id. at 6.
tor independence.121 This position is questionable in light of recently

disseminated information on fund expenses.122
C. The EmpiricalEvidence: Recent Studies on Expenses
The SEC's assumption that the last two decades have been "success-
ful and safe" for the fund industry has been called into question by re-
cently promulgated data on fund expenses, in particular by the findings
of Morningstar Mutual Funds, a Chicago newsletter for investors.123
1. The MorningstarData on Fund Expensesand IndependentDirectorCom-
pensation. - Morningstar examined director compensation figures for
eighty-two of the largest fund families and correlated them with their re-
spective fund expense ratios.124 As the premise for its analysis,
Morningstar indicates that independent trustees "are paid specifically to
safeguard shareholders' interests" and that "[o]ne of the simplest ways
for fund trustees to serve investors is to exert pressure on the advisor to
keep expenses modest."125 Contrary to expectations, at funds where
121. Indeed, some industry observers feel that independent directors are working too
hard: "They believe that independent directors are unnecessarily burdened by
requirements to make determinations that call for a high level of involvement in day-to-day
activities requiring directors to 'micro-manage' operational matters or to make detailed
findings of fact." Protecting Investors, supra note 7, at 265. But see Sara Calian & Robert
McGough, Part-Time Bonanza: Mutual Funds' Pay for Directors Is Up, and So Is Criticism,
Wall St. J., May 5, 1995, at Al, giving the following depiction of the life of one outside
director:
How's this for a job? John R. Haire goes to his New York office about twice a
week. He scans a stack of documents, makes a few phone calls, leaves by 3 P.M.
Most days, it's no brain strain, '"justgeneral administrative work," he says.
In addition, the 70-year-old Mr. Haire, who is on the boards of Dean Witter,
Discover & Co. funds, attended six meetings of the full boards last year and 11
more with the other outside directors.
And his pay is unbeatable for a part-time job: $393,574 last year.
Id.
122. See infra Part II.C.I. It has already been shown that the original provisions and
purposes of the 1940 Act were generally regarded as unsuccessful during the period of the
Wharton and 1966 SEC reports. See supra notes 48-73 and accompanying text; see also
infra note 148 and accompanying text (quoting SEC Commissioner Wallman's statement
that just because the U.S. has been the safest country for securities over the past century
does not mean that the SEC did not strive for regulatory perfection during that time or
should not continue to do so in the future).
123. See Mulvihill, supra note 12, at S1. The publisher of Morningstar Mutual Funds,
Morningstar, Inc., whose mutual fund rating system is quoted in the Wall StreetJournal, The
New YorkTimes, and other financial publications, was launched on the "belief that everyone
should have equal access to reliable, comprehensive investment information."
Morningstar, Inc., About Morningstar, Morningstar.Net, para. 2 (visited Nov. 4, 1997)
<http://www.morningstar.net/nd/ndNSAPI.nd/InfoDesk/MInc> (on file with the
Columbia Law Review); see also Downes & Goodman, supra note 27, at 345 (providing
definition of the Morningstar rating system).
124. See Mulvihill, supra note 12, at S1. An expense ratio is the percentage amount
of a fund's net asset value that is devoted to fees or expenses.
125. Id.
trustees received higher salaries, shareholders tended to pay more in ex-

penses.126 Specifically, domestic equity fund families that paid their trust-
ees an annual salary of at least $100,000 charged an average of fifteen
basis points127 more in expenses (not including 12b-1 or distribution
fees) than fund families that paid their trustees less than $25,000 a
year.128
From a shareholder's perspective, the higher salaries themselves do
not amount to much additional cost per individual. The problem lies
with the conflict of interest that has been created for independentdirectors
by the inflated salaries:
Trustees' fiduciary duty requires them to hold down fund ex-
penses, but in so doing they may cut into their own pocket-
books. On the other side of the boardroom sit fund advisors. If
higher trustee pay makes the board feel comfortable with an-
other 10 basis points in expenses, an advisor managing $50 bil-
lion would get an extra $50 million in fees. Numerous articles
have pointed to boardrooms where such pressures seem evident.
There's not enough evidence to conclude that this pattern of
behavior is widespread, but if it were, the results would be much
like those found in our research.129
The article, however, does warn that, as is true with all statistical in-
formation, correlation does not equal causation,130 and it acknowledges
that other explanations could exist for the observed correlation.131
Nonetheless, Morningstar did discover that the converse relationship was
true, that, controlling for fund size, the more expensive funds paid their
trustees larger salaries.132 At the very least, the findings suggest that the
matter should be investigated.133 One question that immediately arises is
how much would a director be losing out of his or her total salary (i.e.,
including compensation from other fund directorships or professions) if
he or she were to lose his or her place on the board after opposing the
adviser on a decision regarding advisory fees.134
126. See id.

127. A basis point equals 0.01% or one one-hundredth of a percentage point.
128. See Mulvihill, supra note 12, at SI. The Morningstar study chose to exclude
12b-1 fees from expense ratios because their inclusion would have penalized load families
(which are groups of mutual funds sold for a sales charge). If 12b-1 fees had been
included, the data would have supported the article's conclusion even more strongly since
these same highly paid trustees would probably have approved larger distribution fees in
addition to higher operating expenses. See id.
129. Id. at S2.
130. See id. at S1.
131. One such explanation might be that organizations with higher operating
expenses are more generous with everybody, including trustees. See id. at S2. As the
article indicates, though, "this hypothesis isn't very flattering to trustees, either." Id.
132. See id. at SI. It was necessary to control for fund size since results would have
been skewed by the exorbitant expenses of some of the small fund "boutiques." See id.
133. See id. at S2.
134. One observer has noted that independent directors are "commonly active and
retired executives, educators, physicians, scientists, engineers and lawyers." Renberg, supra
In addition to the disturbing expense-salary correlation observed by

Morningstar, other recent studies have revealed that over the past decade
average fund expenses have grown sharply.135 The structures of such ex-
penses, which tend to come in a bewildering variety of forms, are made
even more difficult to discern during buoyant stock market years such as
1995 and 1996.136 In the past decade, annual expenses at American stock
mutual funds have risen, on average, from 1.21% to 1.41%; similarly, tax-
able bond fund expenses have grown, on average, from 0.89% to
1.01%.137
Two of the factors affecting expenses have been the introduction of
highly expensive, small boutique funds and low-expense funds available
only to institutional investors.138 Excluding these two groups, stock fund
expenses have indeed dipped slightly on average to 1.19% from 1.21%,
but this decrease amounts to only two basis points despite a five-fold in-
crease in average fund assets;139a typical economist would have predicted
a larger decrease in expenses through the economies of scale expected
from such an expansion in the size of the average fund. Bond funds, the
average assets of which failed to grow in the last ten years, actually exhib-
ited an increasein average expenses, from 0.88% to 0.99%, even after ex-
cluding the two extraordinary groups of funds.140 Such costs are crucial
to the shareholder since they are the one element, unlike returns and
risk, within the fund's control-presumably through its disinterested
directors.141
note 22, at Ml 3. Particularlyfor those directors who have retired from other professions,
compensation at a large fund, which can total $100,000, could constitute a significant
fraction of an outside director's total salary,thereby exacerbating the conflict of interest
problem.
135. See Erik R. Sirri & Peter Tufano, Competition and Change in the Mutual Fund
Industry, in Financial Services: Perspectives and Challenges 181, 199-203 (Samuel L.
Hayes, III ed., 1993); Clements, supra note 24, at Cl; Heywood Sloane & Steve Savage,
Some Perspectiveamid the Debate over Expenses, Fin. Plan., Sept. 1992, at 82, 84. Some
analysts believe that shareholders are receiving valuable services in exchange for the
higher expenses they pay, such as automated phone systems, year-end tax statements,
newsletters, and other educational materials. See id. Even assuming that there is some
truth to such observations, given the emergence and popularity of discount and deep
discount brokerage firms, it seems that a large percentage of the investing public do not
necessarilywant such services thrust upon them at their own expense.
136. See Clements, supra note 24, at Cl.
137. See id. These figures contrast sharply with fund expense ratios for Vanguard,
which, when it chooses to employ outside investment advisers,can deal with them at arm's
length and is at libertyto fire an adviserif necessary. In 1995, Vanguard'sexpense ratio for
its funds (which include both stock and bond funds) was 0.31%, which, given Vanguard's
average assets of $154 billion for that year, amounted to a savings of $1.2 billion over the
average industry expense ratio (1.10%). Furthermore, its expense ratio declinedfrom
0.51%-its 1985 level. See Slater, supra note 2, at 253.
138. See Clements, supra note 24, at Cl.
139. See id.
140. See id.
141. See id. John Bogle, Chairman of the Vanguard Group of mutual funds, has
singled out such culprits as 12b-1 fees, which were introduced over the past 10 years to
In a sense, the expense data are not surprising because neither the
1970 amendments nor the related case law proffered changes significant
enough to mitigate the problems for shareholders noted in the Wharton
and SEC reports, which, like the Morningstar report, were based on ex-
tensive empirical examinations of the mutual fund industry.142 Since the
earlier reports, it seems unlikely that the problems have solved them-
selves; indeed, the phenomenal growth of mutual funds would have pres-
sured advisers in the opposite direction.
2. Analysis of the SEC'sRecentStance in Light of the MorningstarData. -
It is not an easy matter to reconcile the views of the SEC143and the recent
expense data. The discrepancy may stem in part from the sheer vacuum
of knowledge about expenses and director compensation that existed un-
til recently.144 In addition, one of the SEC's biggest concerns is investor
safety, and from that point of view, mutual funds have played a tremen-
dous role in allowing the average investor to diversify his portfolio and,
hence, his or her risk to an extent that would have been impossible if
mutual funds did not exist.145 Moreover, investing in a typical fund can
still be a relatively inexpensive process when compared with individual
stock purchases.146 In some respects, mutual funds can justifiably be
characterized as "successful and safe."147 The SEC may be unwilling to
take any action that might jeopardize these benefits to investors.
As a response, SEC Commissioner Wallman's words, though used in
a somewhat different context, are nonetheless apt here:
compensate brokers who sold a fund's shares, as a type of expense that hurts investors
because they are based on a percentage of net asset value, rather than a one-time
commission or load. See id. Furthermore, such percentage fees induce brokers and
investment advisers to cause a fund's assets to grow as much as possible without paying
heed to the wisdom of such actions from the standpoint of investor safety. As mentioned
earlier, this conduct is especially problematic since shareholders have not been reaping the
benefits of increased fund size through economies of scale. Implicit in Bogle's criticism is
the assumption that independent directors are not successfully safeguarding shareholder
interests by keeping such fees reasonable.
142. See supra Parts I.A-B.
143. See supra Part II.B.
144. Disclosure of trustees' aggregate compensation did not occur until January of
1995. See Management Practice Inc., The Next $2.5 Trillion: How an Era of Market
Perception Will Affect Trustees, Mgmt. Prac. Bull., Nov. 1995, para. 8 <http://
www.mpiweb.com/bull/25trill.html> (on file with the Columbia Law Review) [hereinafter
The Next $2.5 Trillion]; cf. Calian & McGough, supra note 121, at Al ("New pay-disclosure
rules imposed by the Securities and Exchange Commission are turning the spotlight on
the cushy lifestyle of fund directors (or 'trustees').").
145. See supra text accompanying note 5; see also Morris & Siegel, supra note 5, at
104 ("[W]hen investors put money into a fund, it's pooled with money from other
investors to create much greater buying power than they would have investing on their
own.").
146. The more efficiently managed funds cost less than one percent in annual fees,
whereas transaction fees and commissions for trading individual stocks and bonds can be
double or triple that amount.
[I]t is true that our markets have performed extremely well

under the [current] system and there is no hue and cry among
investors for [a new system]. However, the claim that our mar-
kets have been performing well could have been made-and
has been made-during every one of the last sixty years. In re-
cent history, our markets have always been the best. The task is
always to make them better. And anything that we can do to
encourage efficient and direct price competition in the markets
is a step forward.148
Moreover, if nothing is done to curb insider self-dealing at mutual funds,
their relative advantages will continue to degenerate as expenses rise un-
checked to the detriment of shareholders.
If the expense studies are valid-there is no reason to think that they
are not-then many of the beliefs held by both the SEC and the courts as
to tlle efficacy of independent directors and the arguments for increased
reliance upon them are called into question.149 Moreover, if indepen-
dent directors have a conflict of interest, as the Morningstar report sug-
gests, then increasing their percentage representation on boards or hav-
ing them pick their successors-as suggested in the SEC's latest round of
proposed reforms to the 1940 Act-will not increase their actual
independence.150
Both of the SEC's proposed measures take the independence of the
outside directors as a given, so that by granting them more authority,
148. Wallman, supra note 58, at 12.

149. In its recent report on investment company regulation, the SEC's Division of
Investment Management alluded to, but did not resolve, the debate over whether outside
directors provide effective oversight. See Protecting Investors, supra note 7, at 264-65.
Instead, the Division merely mentioned some of the arguments on both sides of the issue
and then remarked that, after examining the 1940 Act's requirements and their criticisms,
the SEC had concluded that the Act's corporate regulatory structure is fundamentally
sound. See id. at 264-66. No empirical evidence was proffered in support of this
conclusion. See id. at 266. Instead, the SEC seemed to ease any misgivings it had by
recommending the so-called "independence"-enhancing provisions. See id. at 266-69;
supra notes 110-114 and accompanying text.
150. One commentator has suggested that independent directors' capacity for
independence may diminish
by the investment company, rather than (as was historically the case) by the
adviser, particularly if the directors depend on compensation from the company.
In such circumstances, the adviser's control of the proxy machinery, which in
turn affects the directors' reelection, may hinder the ability of the independent
directors to perform their duties with appropriate detachment.
Protecting Investors, supra note 7, at 264 n.60 (citing Tamar Frankel, Money Market
Funds, Rev. Sec. Reg., May 20, 1981, at 913, 915 n.18). As one of the reasons for the
independence-enhancing provisions, the SEC states that "[i]mplementation of
independence-enhancing measures might also benefit directors in litigation alleging
breaches of fiduciary duty under section 36." Id. at 267 n.66. This suggests that the SEC
may have designed these provisions to be prophylactic or cosmetic in nature, so as to
preempt litigation altogether, thereby quietly relieving directors and advisers of some of
their regulatory burden in accordance with one of its professed goals. See supra text
accompanying note 108.
1998] UNDUE INFLUENCE &' ADVISORYSELF-DEALING 501
either through numbers or selection privileges, their assumed indepen-

dence takes on greater prominence in the control of fund affairs. If the
outside directors have been dominated by the adviser from the start, how-
ever, then it is the adviser's authority that gets enhanced (or at least not
reduced) by these provisions.
III. THE UNDUE INFLUENCE STANDARD FOR ADVISORY SELF-DEALING
If it is accepted that the Morningstar data have raised a valid concern

about the legal system's current ability to curb advisory self-dealing, then
there are a number of possible solutions to consider. The conceptually
simplest solution to insider self-dealing in mutual funds would be to
change the fiduciary standard applied to investment advisers and other
fund affiliates to a reasonableness standard with no presumption of fair-
ness accorded to fees approved by the fund's directors or shareholders.
If Congress were to impose a cost-plus requirement on fees, mandatory
breakpoints, or a similar restriction, then advisers would have to charge
competitive rates where the pressure to do so had been previously lack-
ing.151 Artificial free market conditions would be created as a result. In
addition to its political infeasibility,152 however, the costs of such a stat-
ute-expensive administration and litigation, and the government's noto-
rious inability to generate fair market prices through regulation-would
most likely outweigh its benefits. Advisers, feeling penalized by overregu-
lation, would leave the mutual fund industry for less regulated substitutes
(e.g., bank and pension funds); in the end, shareholders would suffer the
most. The Gartenbergcourt of appeals decision seems to lean toward this
solution (although with reservations),153 and it certainly is subject to the
same concerns about costs and administrability.
As mentioned earlier in conjunction with the Gartenbergcourt of ap-
peals decision, some mechanism to sift out frivolous claims in order to
reduce the costs of applying a Gartenberg-typeanalytical framework might
be an effective solution. Ironically, the recently published director com-
pensation information,154 though ominous for shareholders, may offer
them a way to bring actions against directors and advisers more success-
fully than in the past using one of the existing legal approaches. The line
of cases following Tannenbaum v. Zeller'55that were brought under sec-
tion 36(b) of the 1970 amendments to the Investment Company Act es-
151. "[I]nvestment advisers seldom, if ever, compete with each other for advisory
contracts with mutual funds." 1966 SEC Report, supra note 17, at 126.
152. Cf. supra notes 65-66, 85 and accompanying text (describing the eventual
political compromise that the SEC and the mutual fund industry lobby reached-in the
form of the 1970 amendments-in the wake of the Wharton and SEC reports).
153. See supra note 105.
154. See supra notes 124-134 and accompanying text.
155. 552 F.2d 402 (2d Cir. 1977).
tablished an undue influence standard for independent directors.156 Re-

call that under this standard, if a court finds that an adviser did not
unduly influence the outside directors of a fund, then it is generally pre-
sumed that the directors, if adequately informed, have made a reasonable
business judgment and that the adviser has satisfied its fiduciary duty
under section 36(b) of the 1940 Act.157
Although the outcome has never been observed in cases following
Tannenbaum, the Tannenbaum opinion seems to assume that if an invest-
ment adviser has unduly influenced the independent directors of a fund,
courts should then subject the management fee in question to a far more
rigorous scrutiny based on a reasonableness standard.158 Since this
would be less intrusive to defendants than the approach of the Gartenberg
court of appeals, it seems well within the boundaries of permissible op-
tions and is unlikely to draw political backlash from the mutual fund in-
dustry.159 The only parties who lose under this proposed standard are
156. See, e.g., Gartenberg v. Merrill Lynch Asset Management, Inc., 528 F. Supp.
1038, 1058 (S.D.N.Y. 1981). Section 36(b) of the amended Investment Company Act
instructs courts to give management fee approval by directors and shareholders "such
consideration . . . as is deemed appropriate under all the circumstances." Investment
Company Act of 1940 ? 36(b) (2), 15 U.S.C. ? 80a-35(b) (2) (1994). The Supreme Court
has interpreted this provision to mean that courts, in weighing such approval, must remain
aware that "Congress entrusted to the independent directors of investment companies . . .
the primary responsibility for looking after the interests of the funds' shareholders." Burks
v. Lasker, 441 U.S. 471, 485 (1979).
157. See supra text accompanying notes 93-101; see also Gartenberg,528 F. Supp. at
1058 (holding that "the approval of the advisory fee by the board of trustees of the Fund
should be weighted heavily" because "[t]heir independence and their competence as
trustees were not questioned . . . and they have been free of domination or undue
influence").
158. Indeed, one commentator has argued that if the court concludes that an adviser
has dominated the independent directors, then it should examine the fee for fairness in
light of the following seven factors:
(1) the nature, quality, and extent of services provided by the adviser to the fund
and its shareholders;
(2) the relationship of each shareholder's portion of the advisory fee to the cost
of obtaining equivalent professional services elsewhere in the marketplace;
(3) the size of the advisory fee relative to other advisers' fees for comparable
services and the fund's expense ratio in relation to the industry norm;
(4) the extent to which the adviser has passed on any economies of scale to the
fund and its shareholders relative to the best industry practice;
(5) the performance of the fund relative to the industry as a whole;
(6) the entrepreneurial risk borne by the adviser in organizing the fund, and the
responsibility and liabilities it assumes in managing the money entrusted to it;
and
(7) the income received by the adviser after subtracting the costs of services
provided to the fund and its shareholders.
Rogers & Benedict, supra note 8, at 1116-19. (footnotes omitted).
159. Indeed, this proposed standard is essentially the one suggested by several
commentators criticizing the Second Circuit's opinion in Gartenbergfor encouraging fee
plaintiffs bringing frivolous lawsuits, and the elimination of these claims

could increase the likelihood of sympathy from the courts, hitherto
mostly absent, for the claims of the remaining types of plaintiffs. Thus,
the issue becomes whether the courts can plausibly construe the
Morningstar and other expense data as evidence that an investment ad-
viser has dominated or unduly influenced a fund's independent
directors.
A. How the Undue Influence Standard Functions Outside the Investment

Advisory Context
Since the cases in the mutual fund context do not really elaborate on
the "undue influence" standard,160 it is necessary to look elsewhere in the
law for clarification. At first glance, the standard seems rather vague. For
instance, in Francois v. Francois the Third Circuit stated: "[U]ndue influ-
ence is not a concept susceptible of unitary definition. The essence of
the idea is the subversion of another person's free will in order to obtain
assent to an agreement."161 The Francois opinion also stated that the de-
gree of persuasion required to make a claim of undue influence varies
with the circumstances of a case.162 The court did require that the alleg-
edly unfair result be produced by domination of the will of the victim by
the party exerting undue influence (i.e., a causal connection).163 The
Francois court relied in part on the fact that the terms of the agreement in
question were financially unfavorable for the plaintiff to decide that the
defendant had exerted undue influence over him.164
In Lyle v. Bentley the Fifth Circuit declared: "'It is not possible to
frame a definition of undue influence which embraces all forms and
phases of the term. Every case is different from every other case, and
litigation and diminishing the role envisioned by Congress for independent directors. See
id. at 1111.
160. See supra Part II.A.
161. 599 F.2d 1286, 1292 (3d Cir. 1979).
162. See id.
163. See id.
164. See id. at 1293. But see North Am. Rayon Corp. v. Commissioner, 12 F.3d 583,
590 (6th Cir. 1993) (holding that the unfairness of the result is a factor to be taken into
consideration but is not alone controlling). In the mutual fund context, the favorable
financial incentives are themselves part of the undue influence that the adviser exerts over
the outside directors. Furthermore, the adviser is not attempting to dominate the
shareholders, who are the beneficiaries of its fiduciary duty; instead, the adviser is exerting
undue influence over the independent directors-themselves fiduciaries representing
shareholder interests-so as to entice the directors to approve management contracts
containing terms beneficial to the adviser but not the shareholders. This discrepancy
supports the notion that the burden of proving undue influence in the mutual fund
context should be lower than in testator cases since directors are not being influenced to
impair their own interests (which intuitively would seem more difficult), but instead, those
of another party-the shareholders.
must depend largely on its own facts and circumstances.' "165 In addition,
the Lyle court noted that since direct evidence of undue influence is usu-
ally unavailable, circumstantial evidence, usually substantiating a history
of dealings between parties over an extended period of time, can be used
to establish undue influence.166
More specifically, the court set forth the following criteria that a liti-
gant must show to prove undue influence: (1) the existence and exertion
of influence; (2) the effective operation of such influence so as to subvert
or overpower the mind of a party at the time of the execution of the
contract; and (3) the execution of a contract which a party thereof would
not have executed but for such influence.167 The court further stressed
that the party alleging undue influence must demonstrate some evidence,
direct or circumstantial, to show that such influence was actually exerted;
a mere showing of opportunity would not carry the burden of proof.'68
In Board of Regents of the University of Texas v. Yarbrough,the Texas
Court of Appeals defined undue influence to mean the following:
[T] here was such dominion and control exercised over the
mind of the person . . . under facts and circumstances then ex-
isting, as to overcome his free agency and free will, and to substi-
tute the will of another so as to cause him to do what he would
not otherwise have done but for such dominion and control.169
This standard or some version like it has been adopted by a majority
of the states.170
The concept of undue influence is perhaps most developed in the
context of testation. Broadly speaking, courts presume that a testator has
been free of undue influence, so a contestant must prove such influence
by a preponderance of evidence to set aside a will.171 Proof of undue
165. 406 F.2d 325, 328 (5th Cir. 1969) (quoting Long v. Long, 125 S.W.2d 1034, 1035
(Tex. 1939)).
166. See id.
167. See id. at 329 (citing Rothermel v. Duncan, 369 S.W.2d 917, 922 (Tex. 1963)).
The language of the criteria has been generalized from the testation context in which they
originally appeared.
168. See id.
169. 470 S.W.2d 86, 92 (Tex. Civ. App. 1971).
170. See, e.g., Rae v. Geier, No. 1393, 1996 WL 531591, at *2 (Ohio Ct. App. Sept. 20,
1996) (defining undue influence as "'any improper or wrongful constraint, machination,
or urgency of persuasion whereby the will of a person is overpowered and he is induced to
do or forbear an act which he would not do or would do if left to act freely."' (quoting Ross
v. Barker, 656 N.E.2d 363, 367 (Ohio Ct. App. 1995))); Croslin v. Croslin, No. 01A01-9607-
CV-00297, 1997 WL 44394, at *5 (Tenn. Ct. App. Feb. 5, 1997) (defining undue influence
as that "'which controls the mental operations of the one influenced by overcoming his
power of resistance and thus obliging him to adopt the will of another, thereby producing
a disposition of property of the performance of some act by the influenced person which
he otherwise would not have done"' (quoting Scott v. Pulley, 705 S.W.2d 666, 669 (Tenn.
Ct. App. 1985))).
171. See Trent J. Thornley, Note, The Caring Influence: Beyond Autonomy as the
Foundation of Undue Influence, 71 Ind. LJ. 513, 517 (1996); see, e.g., Leimbach v. Allen,
976 F.2d 912, 917 (4th Cir. 1992); Peterson v. Peterson, 432 N.W.2d 231, 236 (Neb. 1988).
1998] SELF-DEALING
UNDUEINFLUENCE& ADVISORY 505
influence need not require any direct evidence of coercion, physical

force, or explicit threats172but can include "evidence of subtle pressures,
such as manipulation or persuasion."173
In testator cases, there are a number of factors that plaintiffs may
show to meet their burden of proof, the relevant ones being opportunity,
motive, and susceptibility.174Opportunity implicates issues such as the
influencer's access to the influenced, the latter's dependence on the for-
mer, and the existence of any close, personal relationship between
them.175 To show motive, a plaintiff must demonstrate that the defen-
dant had something to gain from the use of influence.176 Susceptibility
implies that the influencer had a position of control or advantage over
the influenced.177
Many courts employ a presumption of undue influence to shift the
burden of proof of fairness to the defendant upon a finding of one or two
of the factors above.178 This presumption is not available in every state,
and where it is, the proof needed to establish it varies;generally, however,
both opportunityl79and susceptibility180must be present to trigger it. To
rebut such a presumption, many courts hold defendants to a clear and
convincing evidence standard,181while others require a preponderance
of evidence182or even proof beyond a reasonable doubt.183 A few courts
maintain that once a presumption has been established, an inference of
undue influence cannot be rebutted and must remain throughout for the
jury to consider.184
172. See Thompson v. Gammon, 769 P.2d 150, 154 (Okla. 1989); Thornley, supra
note 171, at 517-18; supra text accompanying note 166.
173. Thornley, supra note 171, at 518; see, e.g., Knutsenv. Krippendorf,862 P.2d 509,
515 (Or. Ct. App. 1993).
174. See Leimbach, 976 F.2d at 918; Thornley, supra note 171, at 518. Courtshave also
employed another factor, naturalness,which lacks a parallel concept in the relationships
among the investment adviser, outside directors, and fund shareholders. See Thornley,
supra note 171, at 518.
175. See Thornley, supra note 171, at 518.
176. See id.
177. See id. at 519.
178. See id. at 520 ("The presumption of undue influence is a judicial tool courts use
to counter the fact that undue influence is difficult to prove directly. A presumption of
undue influence arises when characteristicsof relationships that the law does not want to
reward are present . . . ." (footnote omitted)).
179. In the testation context, opportunity usually indicates the presence of suspicious
circumstancessurrounding the preparation of a will, such as the benefactor/influencer's
participation in its formulation; this is usually an easy evidentiaryburden to meet. See id.
at 521.
180. Here, susceptibility typically implies a confidential relationship (e.g., lawyer-
client or trustee-beneficiary)in which one party has a position of superiority over the
other. See id.
181. See, e.g., Whitworthv. Kines, 604 So.2d 225, 230 (Miss. 1992).
182. See, e.g., Winston v. Gibbs, 270 Cal. Rptr. 560, 563 (Cal. Ct. App. 1990).
183. See, e.g., Smith v. Welch, 597 S.W.2d 593, 595 (Ark. 1980).
184. See Nemeth v. Banhalmi, 466 N.E.2d 977, 993 (Ill. App. Ct. 1984); Thornley,
supra note 171, at 522.
B. Applying Undue Influence to Mutual Funds
In light of these definitions of undue influence taken from other

areas of the law, the issue of whether the recent expense study results
might constitute undue influence of outside directors by advisers be-
comes more manageable. By introducing historical and comparative ex-
pense information on a fund, plaintiffs can arguably demonstrate the
presence of the three factors-opportunity, motive, and susceptibility-
and thereby satisfy the evidentiary burden for showing undue influence
or establishing its presumption. Since the great majority of mutual funds
are created and managed by the investment adviser, proving opportunity
by demonstrating the dependence of outside directors on the adviser or
the close, working ties between the directors and advisers185 should be
fairly simple for plaintiffs in appropriate circumstances. Because of the
percentage nature of management fees, advisers have sufficient motive to
exert dominating influence over directors so as to cause them to approve
advisory contracts that benefit the advisers but hurt fund investors.186
The expense results are useful both to show that outside directors
are susceptible to the adviser because of the position of control that the
latter possesses over the former and to demonstrate the actual exertion of
undue influence by the adviser over the directors as required by some
courts.187 For a fund whose historical expenses and director salary infor-
mation constitute egregious examples of the disturbing patterns present
in the Morningstar studies, plaintiff shareholders can presumably intro-
duce such information as evidence of the adviser's position and exertion
of controlling influence over the independent directors.
The Morningstar results suggest that advisers are essentially paying
independent directors to be amenable to their recommendations,188 and
this should constitute economic duress or undue influence. Naturally,
the success of an individual plaintiffs allegation of undue influence will
depend on the particular facts of the case, and the plaintiffs burden
should not erode to the point that advisers are routinely forced to defend
against a host of frivolous claims (or the point of employing the threshold
Tannenbaum inquiry would be defeated). However, the data (most likely
in combination with other, similarly circumstantial evidence), for those
instances which are suspicious enough to warrant further investigation,
provide an evidentiary framework that has not been previously utilized
and to which courts might be more responsive. It should be remembered
185. Outside and inside directors work closely as colleagues on the fund's board of
directors. By definition, inside directors may be persons in a direct control relationship
with the investment adviser. See Investment Company Act of 1940 ? 2(a) (3), 15 U.S.C.
? 80a-2(a)(3) (1994).
186. See supra text accompanying notes 32-38 (describing investment adviser's
conflict of interest).
187. See North Am. Rayon Corp. v. Commissioner, 12 F.3d 583, 590 (6th Cir. 1993);
Lyle v. Bentley, 406 F.2d 325, 329 (5th Cir. 1969); supra text accompanying note 168.
188. See supra Part II.C.1.
that, until now, advisers had little incentive to remain totally honest since
plaintiffs have never successfully demonstrated undue influence even if it
existed; nor have plaintiffs ever shown a management fee to be "so dis-
proportionately large as to amount to a breach of fiduciary duty in viola-
tion of ? 36(b)."189 Plaintiffs need to possess a plausible threat of litiga-
tion to wield against those unscrupulous advisers who choose to act on
their conflict of interest with fund shareholders.
Under the proposed standard, if plaintiffs can establish a prima facie
showing of undue influence by the adviser then the next step is for courts
to engage in a more rigorous scrutiny of the advisory fee based on reason-
ableness principles in order to determine whether it is fair to fund share-
holders despite the adviser's having unduly influenced the outside direc-
tors.190 Shareholders will benefit from a more rigorous, direct'91
examination of the advisory fee by the courts, probably through some
sort of reasonableness inquiry, to see whether the fee or form of compen-
sation is objectively in the best interest of shareholders.192 At the same
189. Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923, 930 (2d Cir.
1982); see supra note 91 and accompanying text.
190. See text accompanying notes 181-183. The Francois court relied on sections 497
and 498 of the Restatement of Contracts to find that in fiduciary relations, the burden of
proof of an agreement's fairness shifts to the party benefitting from the transaction and
such fairness must be shown by clear and convincing evidence. See Francois v. Francois,
599 F.2d 1286, 1291-92 (3d Cir. 1979). However, the 1970 amendments to the Investment
Company Act allocate the burden of proving that the adviser has breached its fiduciary
"
duty to the plaintiff: [T] he plaintiff shall have the burden of proving a breach of fiduciary
duty." 15 U.S.C. ? 80(a)-35(b). This means either that plaintiffs have a burden of
persuasion or of production. See Steven H. Gifis, Law Dictionary 57 (3rd. ed. 1991)
(defining burden of proof in civil cases). The statute does not elaborate. Under corporate
law generally, if a majority of a board's directors have a conflict of interest, once a plaintiff
has established a prima facie case of overreaching-i.e., the plaintiff has gone forward with
the evidence-then the burden shifts to the defendants to establish the transaction's
fairness, and the courts subject the transaction to a rigorous scrutiny to ascertain its
fairness and reasonableness for the company and its shareholders. See Jennings & Marsh,
supra note 11, at 1401. Jennings and Marsh postulate that even ratification of an advisory
compensation scheme should not "shift the ultimate burden of proof [of the adviser's
breach of fiduciary duty] (as distinguished from the burden of going forward with the
evidence) back to the plaintiff" in light of the adviser's conflict of interests and its
dominance and influence over fund directors and shareholders. Id. at 1402.
Thus, from the standpoints of both legal precedent and fairness, there is some logic to
assuming that the 1970 amendments permit either a shift to the defendant or the
satisfaction of the plaintiff's burden of proving an adviser's breach of fiduciary duty
regarding compensation upon a showing of the adviser's undue influence over the fund's
independent directors.
In any case, the expense data should allow plaintiffs at least the full opportunity to
demonstrate the unreasonableness of the advisor's fees without the court early on deeming
the fees to be reasonable using the "appropriate circumstances" (i.e., independent director
approval) language of section 36(b) (2). See supra text accompanying note 79.
191. The term "direct" is used here in opposition to the 1940 Act's prophylactic
measures consisting of the adviser's fiduciary duty and the outside directors' watchdog
function. See supra notes 44-45 and accompanying text.
time, this system will avoid the costs of a statutorily imposed reasonable-
ness standard on advisory fees since the courts and the SEC will not auto-
matically engage in an expensive cost-plus inquiry for every case that
comes before them.193 To this end, the fact that the expense studies
demonstrate a correlative and not causative relationship between fees
and independent director salaries restricts use of the data to egregious
instances, ensuring that proper limits are placed on the scope of this
solution.
Significantly, the expense results are being used to reinvigorate an
already existing case law precept. The 1970 amendments to the
Investment Company Act left a resolution of the meaning of the invest-
ment adviser's fiduciary duty to the courts,194 and it is the courts' prerog-
ative and duty to clarify statutory ambiguity and to declare what the law is.
Legislative history demonstrates that Congress enacted the 1940 Act to
curtail advisory self-dealing caused by the adviser's conflict of interest
with fund shareholders. Recent empirical evidence suggests that, given
the amounts of investor capital at stake, the self-dealing problem is, if
anything, greater than it has ever been. The courts may and should re-
solve the statute's ambiguities in a manner sufficient to cure its present
defects in light of its original, worthy purpose. Absent political recourse
by fund management, the proposed strategy, if successful, should pro-
voke an industry-wide reduction in management fees by advisers and
boards of directors anxious to avoid expensive litigation and damages, at
which point the strategy will become unnecessary.
As suggested earlier, the object of this legal approach-or any pro-
posed reform-should not be to overregulate investment advisers,
prompting them to take their talents to other forms of institutional inves-
tors.195 Mutual funds have been an extremely favorable development for
the average investor. However, their benefits do not justify investment
advisers taking undeserved windfall gains out of the investment capital of
others. As long as fund shareholders are fully informed of expense infor-
mation and can plausibly sue their adviser if wronged through advisory
self-dealing, advisers most likely will stay honest. Indeed, for some promi-
nent fund companies, such as Fidelity Investments, for whom reputation
is crucial to maintaining market share, customer complaints may be suffi-
cient to induce concessions from the advisers,196 even though in the
courts investment advisers would appear to be clearly favored based on
their undefeated track record.

196. See supra note 58 (discussing how Fidelity closed its flagship Magellan Fund to
new investors, thereby foregoing large revenues, in response to customer criticism that the
fund had grown too large to be managed effectively).
CONCLUSION
The popularity of mutual funds is continually growing. One source

projects that by 1998 the mutual fund industry will garner its five tril-
lionth dollar.197 For the average shareholder with $10,000 invested in a
fund, an extra ten basis points in expenses will amount to $10 annually-
a figure not cutting an impressive swathe. Ten basis points of $5 trillion,
however, means an extra $5 billion annually for the mutual fund advisory
industry as a whole, amounting to an impressive $13.9 million on average
for each of the advisers of the 360 major fund families.198 Nor does in-
flated director compensation affect shareholders much directly. For ex-
ample, assuming a net asset value of $50 billion, the salaries of six outside
directors at $250,000 each totals only three one-thousandths of a basis
point. If, for an extra $85,000 each, these same directors are willing to
approve ten additional basis points in expenses, then the adviser is receiv-
ing $50 million more in fees at the cost of about one one-thousandth of a
basis point or $510,000. The adviser is certainly not entitled to this unde-
served windfall.
This example demonstrates the conflicts of interest that the invest-
ment adviser and the outside directors potentially face in attempting to
vigilantly safeguard shareholder interests. Unfortunately, the
Morningstar and other studies seem to suggest that advisers and directors
are not living up to their fiduciary duties. Until the emergence of the
results of these studies, Congress, the courts, and the SEC were willing to
assume that independent directors were succeeding at their appointed
task since the mutual fund industry as a whole was performing spectacu-
larly. Now that the problem has partially been uncovered, it cannot be
ignored but must be dealt with swiftly and fairly. The recommended rein-
vigoration of the undue influence standard offers a solution that will not
be diluted by political compromise, allows the courts to remain consistent
with past doctrine, and avoids the unnecessary waste of time and re-
sources that an overinclusive measure would entail. Most important, the
standard probably will have the effect of causing advisers to disgorge their
ill-gotten gains, thereby making investors whole again.
197. See The Next $2.5 Trillion, supra note 144, para. 1.
198. See 2,500 Independent Trustees, supra note 1, para. 1.

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MUTUAL FUNDS: SOLVING THE SHORTCOMINGS OF

Because of their astounding success in the past few decades,mutual

Mutual fund shares are rapidly becoming the investment of choice

Clearly, decisions made by mutual funds have the growing potential

sory or management fee, of the fund's net assets."

confirming the continued presence of the problems identified in the

ence, thereby preventing advisers from being protected by directors' rea-

I. ADVISORY SELF-DEALING AND THE LEGISLATIVE SOLUTION

It is not through lack of early recognition that the conflict of interest

A. The Investment CompanyAct and IndependentDirectors

ment companies, commonly known as mutual funds, as those which offer

29. See 15 U.S.C. ?? 80a-3(a), a-4(3), a-5(a).

advisers."45 The Act eschewed placing any kind of qualitative limits on

B. The 1962 Wharton Study and the 1966 SEC Report

bargaining chip in their negotiations over management fees-that of

used really meant substantively (which lends further credence to the

C. The 1970 Amendmentsto the Investment CompanyAct

action, it is no longer necessary to provide proof of any kind of miscon-

79. Id. ? 80a-35(b)(2).

pendence of and disclosure to such individuals.87 Despite the skepticism

II. ADVISORYSELF-DEALING AND THE INADEQUACIES OF THE

A. Case Law: Tannenbaum, Gartenberg, and the Undue Influence

tion 36(b).90 Notably, plaintiffs have never brought a successful action

In upholding the district court's decision, the Second Circuit in

dered and could not have been the product of arm's-length

sis on disclosure and industrywide fee figures is meaningless if indepen-

B. The SEC's Recent Stance

115. See Barbash Testimony, supra note 108, at 3-4.

tor independence.121 This position is questionable in light of recently

C. The EmpiricalEvidence: Recent Studies on Expenses

trustees received higher salaries, shareholders tended to pay more in ex-

126. See id.

In addition to the disturbing expense-salary correlation observed by

[I]t is true that our markets have performed extremely well

148. Wallman, supra note 58, at 12.

either through numbers or selection privileges, their assumed indepen-

III. THE UNDUE INFLUENCE STANDARD FOR ADVISORY SELF-DEALING

If it is accepted that the Morningstar data have raised a valid concern

tablished an undue influence standard for independent directors.156 Re-

plaintiffs bringing frivolous lawsuits, and the elimination of these claims

A. How the Undue Influence Standard Functions Outside the Investment

influence need not require any direct evidence of coercion, physical

B. Applying Undue Influence to Mutual Funds

In light of these definitions of undue influence taken from other

193. See supra text accompanying note 152.

The popularity of mutual funds is continually growing. One source

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