The opinion of the court was delivered by: POLLACK
Over 1,100,000 persons and institutions were at the time of trial herein shareholders in a money market fund whose net assets at that time exceeded $ 19 billion, known as the "Merrill Lynch Ready Assets Trust" (the "Fund" hereafter). Two individual shareholders, Irving Gartenberg and Simone Andre, have brought this suit under Section 36(b) of the Investment Act of 1940, 15 U.S.C. Section 80a-35(b) (the "Act") complaining of the size of the annual compensation paid to the Fund's Investment Adviser in 1980-81 under its percentage contract with the Fund. The fee paid to the Adviser, "Merrill Lynch Asset Management, Inc." ("MLAM" hereafter) is contingent on the average daily value of the net assets of the Fund during the period; the annual compensation amounted to 0.288% or slightly above 1/4 of one percent of those net assets.
The Gartenberg complaint names as defendants, i) the Fund, ii) MLAM, a wholly-owned subsidiary of Merrill Lynch & Co., Inc. ("Merrill Lynch"), which supplies the Fund with investment management, administration and required services, and iii) "Merrill Lynch, Pierce, Fenner & Smith Incorporated" (MLPF&S) another wholly-owned subsidiary of Merrill Lynch, which processes the vast bulk of the daily orders of the Fund's shareholders. The Andre complaint names only the Fund and MLAM as defendants.
There is no claim by the plaintiffs that the shareholders individually did not receive their money's worth from MLAM, i.e., that the services supplied were not worth the fractional percentage attributable to the net assets they had in the Fund. Rather, the plaintiffs claim that because of the size of the Fund, MLAM made too much money from the application of the agreed percentage.
As of December 31, 1980, plaintiff Gartenberg held 986 shares (valued at $ 1 per share) of the Fund and plaintiff Andre held 2,850 shares and they have continued to hold those shares together with additional shares received daily as dividends.
The Fund and the Merrill Lynch organization
The Fund was organized in 1975 as an unincorporated business trust under the laws of Massachusetts and registered with the Securities and Exchange Commission ("SEC") as a diversified, open-end investment company. It is a no-load money market mutual fund (meaning that there is no cost to purchase its shares) and invests primarily in short-term money market securities.
The Fund's Board of Trustees is comprised of eight Trustees, two of whom are "interested persons" as defined in the Act. The six "non-interested" or "unaffiliated" Trustees make up the Audit Committee of the Fund. The Fund has no employees of its own. Its business is conducted from the offices of MLAM as is the business of other Merrill Lynch investment companies.
MLAM, a Delaware corporation, has served as the Investment Advisor of the Fund since June 1976. MLAM also acts as the investment adviser for four other mutual funds sponsored by Merrill Lynch. MLAM selects the Fund's investments and trades in money market securities for the Fund's account. MLAM performs or provides the administrative and management services for the Fund and provides the Fund with office space and facilities, equipment and personnel. It imports the services of its affiliate, defendant MLPF&S, the brokerage subsidiary of Merrill Lynch, to process the principal volume of the huge number of daily orders of the Fund shareholders for the deposit and withdrawal of money to and from the Fund. MLAM also provides investment management services to individuals and institutions. The services performed for the Fund by MLAM and its affiliates can be divided into three categories: portfolio management; general administrative services; and money market fund shareholder services.
The Merrill Lynch brokerage branch office system consists of 408 domestic offices in which its more than 7,000 account executives are located, all of whom are available to process shareholder orders and administer shareholder accounts for the Fund without any commission. An average of more than 30,000 shareholder orders per day are processed in that way by MLPF&S involving the purchase and redemption of shares of the Fund and other services. Much of the success of the Fund in terms of its acceptance by shareholders can be attributed to the fulsome shareholder service provided by that system.
In making its investment decisions, MLAM has access to the advice and expertise of all Merrill Lynch affiliates, and particularly Merrill Lynch Economics, Inc., Merrill Lynch Government Securities, Inc. and MLPF&S. The first of these affiliates provides basic economic research and forecasting; the second is one of the largest dealers in United States Government securities and Government Agency securities; and MLPF&S is the largest registered broker-dealer in the United States and provides fundamental research on bank and other corporate issuers.
The compensation attributable to the individual shareholder for the services provided by MLAM and its affiliates was far below the cost of any available alternative for similar service. The administrative services provided for the Fund by MLAM amply serve the Fund's requirements and go well beyond mere office matters. Substantial efforts are necessary to maintain compliance with SEC and state regulatory requirements, including recordkeeping and reporting requirements. MLAM renders these services to the Fund. Additionally Merrill Lynch Funds Distributor, Inc. (MLFD), which is a 100% owned subsidiary of MLAM, acts as distributor of Fund shares and maintains a staffed answer-telephone for inquiries from shareholders. MLFD has waived its right to commissions on the sale of Fund shares.
The Money Fund Industry and the Growth of the Fund
Money market funds make available to small investors and short term cash depositors substantially higher interest rates than are obtainable through bank deposits. They offer redeemable participations in terms of shares in a portfolio of securities. The first such fund was started in 1972.
The money market fund industry has experienced extraordinary growth in the last few years. New money market funds have been sprouting up regularly-there is no difficulty in entering the field. In 1975, there were 32 money market funds. By 1978 there were 54 and today there are 1394a such funds. The assets under management in all the money market funds have likewise grown enormously and dramatically. In June 1978 there was a total of about $ 6.8 billion of assets in money market funds; today their assets total more than $ 185 billion-a 25-fold growth. The Fund involved herein is by far the largest money market fund in existence.
The principal reason for the prodigious growth of the Fund under MLAM's supervision, from $ 100 million to over $ 19 billion in just a few years, has been the spectacular surge in interest rates and the availability of the Merrill Lynch system to cope with the processing services required-to administer the dramatic growth of the Fund and to satisfy the daily orders and other demands of its shareholders. It was conceded by plaintiffs' expert that there is no adequate substitute readily available for the Merrill Lynch system to handle the Fund. The enormous gap between interest rates paid by banks and money funds renders the Fund an attractive short-term investment for high daily income returns, in a medium available without any cost to the customer to buy or sell the investment, by easy means of deposits and withdrawals in every geographical area of the United States (and beyond), subject to simple check withdrawals, as frequently as desired by the shareholder, with relative security of the principal meanwhile.
The net asset value of shares of the Fund remains constant at $ 1 per share and net income (including realized and unrealized gains and losses of the Fund's portfolio) is credited daily to shareholder accounts in the form of dividend shares declared daily. Thus, the fluctuations in the value of a shareholder's investment in the Fund are reflected in the number of shares held in the shareholder's account.
The deposits and withdrawals by participants in the Fund are somewhat euphemistically styled as purchases and sales of shares of the value of those deposits and withdrawals. In a very real sense, an account in a money market fund is more like a bank account than a traditional investment in securities; and unlike an equity stock investment or other types of securities. The funds in a money market fund are not tied up for a fixed or long time.
The Investment Advisory Agreement
The Fund commenced operations on February 18, 1975 as the "Lionel D. Edie Ready Assets Trust". The initial investment advisory agreement provided for an advisory fee of 0.50% of the net average daily assets.
MLAM was formed in 1976 as the investment management subsidiary of Merrill Lynch so that a single Merrill Lynch company could utilize the vast resources of the entire Merrill Lynch organization in determining and achieving the specific investment objectives of institutional portfolios.
On April 29, 1976, the Fund Trustees approved the first investment advisory agreement with MLAM. It provided for a schedule of contingent advisory fees starting with an annual charge of 0.50% of the first $ 500 million of average daily net assets, and followed by reduced percentages at a series of breakpoints as the net assets of the Fund increased. At the time the net assets of the Fund were just over $ 100 million. In June 1976, MLAM began acting as investment advisor to the Fund pursuant to their first advisory agreement, and the name of the Fund was changed to the "Merrill Lynch Ready Assets Trust".
The following year, on April 28, 1977, the Trustees approved continuance of the same investment advisory agreement. The Fund's assets were then approximately $ 288 million. One year later the assets of the Fund had grown to approximately $ 750 million, and MLAM proposed a revised fee schedule that would have continued the 1977 rates at existing breakpoints but would have added an additional breakpoint providing for an annual fee of 0.375% on assets in excess of $ 1 billion. The independent Trustees accepted MLAM's proposal to add a new breakpoint at the $ 1 billion level, but insisted on reducing the proposed fee rate to 0.425% and 0.375% on assets in excess of $ 500 million and $ 750 million respectively and to 0.35% at the new $ 1 billion level. Although MLAM was opposed to these revisions in its fee schedule, it accepted the Trustees' decision and on April 27, 1978, the Trustees approved an agreement containing the fee reductions as initiated by the independent Trustees.
During late 1978, the assets of the Fund increased substantially. On January 24, 1979, while the 1978 agreement was still in effect, MLAM again voluntarily reduced its fee by introducing two additional breakpoints at the $ 1.5 and $ 2 billion levels. These additional breakpoints reduced the advisory fee to 0.325% of assets over $ 1.5 billion and 0.30% of assets over $ 2 billion. At that time the Fund had net assets of approximately $ 2 billion.
The Fund continued to grow rapidly during 1979, and in May its assets reached $ 3.5 billion. On May 8, 1979, the Trustees approved an advisory agreement, which added yet another breakpoint at the.$ 2.5 billion asset level.
The schedule of advisory fees payable to MLAM under the 1979 and subsequent agreements is set forth in the table below:
This fee schedule was reviewed and approved by the Trustees of the Fund for another year on April 24, 1980, when the size of the Fund was $ 9.8 billion, and again on May 7, 1981, when the size of the Fund was $ 17 billion. At the trial date level of over $ 19 billion, the effective rate of the fee under the above schedule approximated 0.288%, or $ 2.88 annually for each $ 1,000 invested. This rate is among the lowest in the industry for a Fund of this type and, at the trial date level of the Fund, the average of the size of shareholders' accounts (approximately $ 15,500) incurs an annual charge, for advisory and deposit and withdrawal services, of about $ 45.
Processing Orders for the Fund
A Fund account may be opened at the option of the customer either through MLPF&S, the Broker affiliate, or directly through The Bank of New York, the Fund's custodian and transfer agent, which is under contract as such to the Fund. A depositor in the Fund has the option of placing orders to purchase or redeem shares of the Fund through the Broker or directly through the transfer agent.
MLPF&S (the Broker affiliate) during the period under review received and processed approximately 80% of the orders for purchases of shares made by the shareholders of the Fund. When an investor purchases or redeems shares of the Fund through the Broker, such transactions are processed through a brokerage account with the Broker which is opened either specifically for purposes of deposits in the Fund, i.e., purchase of Fund shares, or through an account previously opened in connection with transactions in other securities. No charge is made to the Fund's customer for accepting the deposit, opening and maintaining the securities brokerage account, or for the shares obtained by the deposit, or for redemptions, even if an account is opened and utilized solely for purposes of transactions in Fund shares. Orders for the purchase or redemption of Fund shares placed through the Broker are transmitted from the branch offices by wire to computer facilities and administrative personnel in the Merrill Lynch home office.
Plaintiffs claim that Congress intended to limit the fees of Advisers to fair charges and that the compensation to MLAM is unreasonably high and disproportionate to the services rendered and their costs.
Plaintiffs offer as an apt comparison for the compensation payable by the Fund, the compensation (unspecified) that pension fund managers are paid which plaintiffs say is only a fraction of the compensation which the Fund pays. Turning from the price paid by the Fund, the plaintiffs claim that the costs of servicing the contract by MLAM should be considered in evaluating the fairness of its compensation but should not include the expense incurred by MLAM's affiliate, MLPF&S, in the handling of the service requirements of the Fund investors and shareholders. They claim that the Broker is "unnecessarily" rendering such services and that the Transfer Agent, The Bank of New York, is allegedly capable and should perform them. They claim that the fall-out benefits to the Broker from opening accounts and servicing the money market fund needs of the investors should be considered as an offset to the expense of the Broker in processing the orders of the shareholders of the Fund. Additionally, plaintiffs attack the studies made of the costs of those services, studies made by Merrill Lynch staff as well as by independent cost accounting experts, which quantified the processing costs; they characterize those studies as improperly performed and vastly overstating the real expense incurred. Plaintiffs add, that at all events, such expenses in reality should be considered as a cost of distribution of securities and in their view, the federal statute and regulations do not permit a mutual fund to pass along such an expense to the shareholders.
Plaintiffs also challenge the approvals of the fees to MLAM by the Trustees and the shareholders of the Fund and assert that in considering whether the compensation received was in breach of fiduciary duty, no weight should be given by the Court to their respective approvals of the advisory fee, because the Trustees allegedly failed to consider critical facts and allegedly were misled and because the shareholders were not provided with correct or adequate information on which to make a knowledgeable ratification.
A critical examination of the actual and relevant facts concerning the issue of whether the compensation received by MLAM constituted a breach of fiduciary duty exposes the unreality and invalidity of each of plaintiffs' contentions.
Section 36(b) of the Investment Company Act of 1940 provides that
"the investment adviser ... shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser."
The statute expressly provides that "plaintiff shall have the burden of proving a breach of fiduciary duty."
Section 36(b) was added to the Act in 1970. Its enactment was precipitated as the result of the abuses which Congress had perceived with respect to equity load funds during the 1960's. See generally S.Rep.No. 184, 91st Cong., 1st Sess., accompanying S. 2224, reprinted in (1970) U.S. Code Cong. & Ad. News 4897 (hereinafter "Senate Report"). Money market funds were not in existence at that time. It seems clear from that fact that Congress had in mind front-end load equity funds and not today's money market funds which are no-load and in which a shareholder can redeem his shares without the payment of any penalty or tax consequences, and freely invest his funds without expense, on virtually the same terms, in any one of the large number of other funds available in the market place.
The basic contention of plaintiffs in these cases is that MLAM is making "too much" money and that this, in and of itself, constitutes a violation of the fiduciary duty imposed upon investment advisers by Section 36(b). However, Congress explicitly, recognized "the fact that the investment adviser is entitled to make a profit. Nothing in the bill is intended to imply otherwise ..." Senate Report at 6, U.S. Code Cong. & Admin. News 1970, p. 4902. The price charged for the service is the key fact-the cost to the fiduciary of rendering the service is of relative unimportance.
Congress has made it very clear in the legislative history that it rejected any concept that Section 36(b) should impose a "cost plus" basis as a standard or that the Court should engage in rate-making.
The Senate Report cited above accompanying the 1970 amendments makes it evident that Congress did not intend the Courts to "second-guess" the business judgment of the independent trustees with respect to the size of the investment advisory fee:
Nothing in the bill is intended to ... suggest that a "cost-plus" type of contract would be required. It is not intended to introduce general concepts of rate regulation as applied to public utilities.
This section is not intended to authorize a Court to substitute its business judgment for that of the mutual fund's board of directors in the area of management fees.
Th(is) section is not intended to shift the responsibility for managing an investment company in the best interest of its shareholders from the directors of such company to the judiciary. Senate Report at 6-7, U.S. Code Cong. & Admin. News 1970, p. 4902. (Emphasis supplied).
As one commentator pointed out, Congress moved away from testing the amount of the compensation and focused instead on the adviser's conduct:
The deletion of the reasonableness standard and substitution of the adviser's fiduciary obligation changed not only the standard of judicial review but the method for testing management's compensation. The test no longer modified the fee in Sec. 15 but was made part of the adviser's duties under Sec. 36.
Nutt, A Study of Mutual Fund Independent Directors, 120 U.Pa.L.Rev. 179, 190 n. 61 (1971).
The Second Circuit, in its opinion affirming this Court's decision to strike plaintiff's jury demand, specifically adopted the Pennsylvania Law Review analysis:
The original bills introduced in the Senate and the House provided that the propriety of charges should be determined by the test of "reasonableness". (Citations omitted). Influenced in part by industry opposition to the "reasonableness" standard, Congress shifted, to the standard of "fiduciary duty" that is in the present act.
The Congress was not precise in delineating the test for compliance with the fiduciary standard by which to judge the acceptability of compensation to a money market fund advisor. The fiduciary standard "imposes a high degree of legal commitment to treat the fund with utmost fairness." 116 Cong.Rec. 33282 (1970) (remarks of Rep. Springer.) Some members of Congress left open the possibility that in certain limited circumstances, the fee, considered by itself, might be enough to prove a breach of the Section 36(b) standard. Senator Bennett, in his remarks on the bill, stated that the section authorized lawsuits "in the event that the fee received is claimed to be so excessive as to constitute a breach of fiduciary duty." 115 Cong.Rec. 13693 (1969) (emphasis added). In the House, Representative Moss stated that the duty was "a legal obligation to so administer and so charge the fund so that (the adviser) does not commit an excess against the fund." 116 Cong.Rec. 33281 (1970) (emphasis added).
While Congress rejected any attempt to rest the inquiry on what was "reasonable," it did not indicate that the common law standard of "corporate waste," which had previously been available to challenge advisory fees, was to be disregarded as an element of the Court's inquiry.
The Senate committee explicitly "decided (only) that the standard of "corporate waste' (was) unduly restrictive." Senate Report, at 5, U.S. Code Cong. & Admin. News 1970, p. 4901. Section 36(b) was an attempt to strengthen, not erode, that standard. See Tannenbaum v. Zeller, 552 F.2d 402, 416 n.20 (2d Cir. 1977), cert. denied 434 U.S. 934, 98 S. Ct. 421, 54 L. Ed. 2d 293 (1977); Herzog v. Russell, 483 F. Supp. 1346, 1349 n.1 (E.D.N.Y.1979).
Specific purposes to be served under Section 36(b) were stated in the legislative history and these may be summarized as follows. These purposes serve as the only congressional guide to the principles of the judicial review of compensation obtained by a fiduciary of a money market fund.
The Intention of the Legislation
(a) That the investment adviser is entitled to make a profit.
(a) That a cost-plus type of contract is required.
(b) That general concepts of rate regulation as applies to public utilities are to be introduced.
(c) That the standard of "corporate waste" is to be applied.
(d) That management fees should be tested on whether they are "reasonable".
(e) That a congressional finding has been made that the present industry level or that the fee of any particular adviser is too high.
(f) That the Court is authorized to substitute its business judgment for that of the directors.
(g) That the responsibility for management is to be shifted from directors to the judiciary.
(h) That economies of scale are necessarily applicable at every stage of growth of the Fund.
3. The test of fairness is to be made by the Court, in part:
(a) By reference to industry practice.
(b) By reference to industry level of management fees.
4. The Court shall determine whether
(c) The attention of directors was fixed on their responsibilities.
(d) The directors requested and obtained information reasonably necessary to evaluate the terms of the management contract.
(e) The directors having the primary responsibility for looking after the best interests of the Fund's shareholders, have evaluated such information accordingly.
The net intent of the legislation to the extent it was expressed would seem to leave it to the federal courts to interpret compliance with "fiduciary duty" in the common law tradition (in this case "federal common law", really federal equity jurisprudence). Thus viewed, Section 36(b) represents a political compromise of a highly emotional nature which eschews rate regulation for personal services but nonetheless caps compensation at market acceptability accompanied by good faith and fair disclosure of that range.
An examination of the case authorities also fails to illumine precisely the path to be followed by the Court in weighing the compensation of the investment adviser of a money market fund under fiduciary standards. Only general concepts have been articulated. The standard of fiduciary duty under Section 36(b) "is concerned solely with fairness and equity." In re Gartenberg, 636 F.2d 16, 17 (2d Cir. 1980), cert. denied, -- - U.S. -- , 101 S. Ct. 1979, 68 L. Ed. 2d 298 (1981). "The essence of the (fiduciary) test is whether or not under all the circumstances the transaction carries the earmarks of an arm's length bargain." Pepper v. Litton, 308 U.S. 295, 306-07, 60 S. Ct. 238, 245-46, 84 L. Ed. 281 (1939).
The conduct of the investment adviser must be governed by the "duty of uncompromising fidelity" and "undivided loyalty" to the Fund's shareholders that is imposed by Section 36(b). Galfand v. Chestnutt, 545 F.2d 807, 809, 811 (2d Cir. 1976). For example, the investment adviser because he is a fiduciary, may not sell his office for personal gain. Rosenfeld v. Black, 445 F.2d 1337, 1342 (2d Cir. 1971), cert. dismissed 409 U.S. 802, 93 S. Ct. 24, 34 L. Ed. 2d 62 (1972). When "endeavoring to influence the selection of a successor," a fiduciary must act "with an eye single to the best interests of the beneficiaries." Id. Moreover, it is well settled that the investment adviser owes a duty of full disclosure to the trustees and shareholders of the Fund. Galfand, 545 F.2d at 811. See Tannenbaum v. Zeller, 552 F.2d 402, 417 (2d Cir.), cert. denied, 434 U.S. 934, 98 S. Ct. 421, 54 L. Ed. 2d 293 (1977) (Sec. 36(a)); Fogel v. Chestnutt, 533 F.2d 731, 750 (2d Cir. 1975), cert. denied, 429 U.S. 824, 97 S. Ct. 77, 50 L. Ed. 2d 86 (1976); Moses v. Burgin, 445 F.2d 369 (1st Cir. 1971), cert. denied, 404 U.S. 994, 92 S. Ct. 532, 30 L. Ed. 2d 547 (1971). And even when full disclosure has been made, the courts must "subject the transaction to rigorous scrutiny for fairness." Galfand, 545 F.2d at 811-12; Krasner v. Dreyfus Corp., 90 F.R.D. 665 (S.D.N.Y.1981).
The Fairness of the Advisory Fee
In determining whether MLAM has breached its fiduciary duty, this Court must primarily examine what the Fund paid and what it received. The Court must consider the "nature, quality and extent" of the services to the Fund in relation to the fee paid by the Fund. Note, Mutual Fund Advisory Fees-Too Much for Too Little? 48 Fordham L.Rev. 530, 545 (1980). Accord, Krasner v. Dreyfus Corp., 500 F. Supp. 36 (S.D.N.Y.1980). Congress intended
that the court look to all facts in connection with the determination and receipt of such compensation, including all services rendered to the fund or its shareholders and all compensation and payments received, in order to reach a decision as to whether the adviser has properly acted as a fiduciary in relation to such compensation. Senate Report, at 15, House Report, at 37, U.S. Code Cong. & Admin. News 1970, p. 4910.
The legislation permits the Court to give such weight as it may allow to the approval of the investment advisory agreement by the ...