Jones v. Harris Associates (08-586), Graham County Soil and Water Conservation District v. United States ex rel. Wilson (08-304) and Berghuis v. Smith (08-1402)

March 31, 2010 Supreme Court Update

Greetings, Court fans!

The Court issued decisions in three cases yesterday: Jones v. Harris Associates (08-586), in which the Court defined the standard for determining when a mutual fund adviser has violated the Investment Company Act of 1940 by charging excessive fees, Graham County Soil and Water Conservation District v. United States ex rel. Wilson (08-304), on whether prior disclosure of potential fraud in state and local governmental reports precludes individuals from pursuing qui tam actions under the False Claims Act, and Berghuis v. Smith (08-1402), addressing the Sixth Amendment right to be tried by a jury composed of a fair cross section of the community. Let's get right to it.

The Investment Company Act of 1940 subjects mutual fund investment advisers to a "fiduciary duty with respect to the receipt of compensation for services." In a slew of lawsuits in recent years, mutual fund investors have alleged that their fund's adviser – which typically created the fund, selected its directors, managed its investments, and provided other services – charged excessive fees. In Jones v. Harris Associates, the Court unanimously held that the standard for determining whether an adviser has breached its fiduciary duty is whether the fees are "within the range of what would have been negotiated at arm's length in light of all the surrounding circumstances." This so-called Gartenberg standard was first developed by the Second Circuit over 25 years ago, and has been adopted by numerous other courts and formalized in SEC regulations. When Harris Associates reached the Seventh Circuit, however, Judge Easterbrook rejected that standard in favor of one that was less friendly to investors. In Judge Easterbrook's view, fiduciaries should only be obligated to make full disclosure, and the amount a fiduciary receives should be subject to scrutiny only if it is so unusual as to give rise to an inference that the fiduciary did not make full disclosure, or that the mutual fund directors abdicated their responsibilities. Judge Easterbrook believed this standard was more consistent with the competitive nature of the modern mutual fund market, where investors who were dissatisfied with their fund's fees could easily take their money elsewhere. The Seventh Circuit denied rehearing en banc, but Judge Posner dissented, arguing that Judge Easterbrook's opinion was "an economic analysis that is ripe for reexamination" – setting up the latest round of Easterbrook v. Posner before the Supreme Court.

Justice Alito, writing for the Court, acknowledged that the Gartenberg standard lacked "sharp analytical clarity," but upheld it as the best embodiment of the principles of the fiduciary duty provision of the Investment Company Act. (Chalk up a win for Posner.) In applying the Gartenberg standard, courts should consider the fees that an adviser charges its independent non-mutual fund clients, giving such comparisons more or less weight depending on the similarity of the services provided, while being "wary of inapt comparisons." Courts should not rely too heavily on comparisons with fees charged by other advisers to their mutual funds, however, because those fees might not be the product of arm's length negotiations. (The "everyone else is doing it" defense appears to be losing strength even beyond the realm of executive compensation.) Finally, if it appears that a fund's disinterested directors approved a fee arrangement after being presented with and considering all the relevant factors, a court should give their decision considerable weight, even if the court might have evaluated the factors differently. Justice Thomas wrote a separate concurring opinion to emphasize that while the original Gartenberg decision could be read to authorize judicial "fairness" review of fees, he agreed with the Court's interpretation that Garternberg requires deference to the informed conclusions of disinterested directors.

Next comes what was once a highly contested and much-anticipated decision on qui tam relators under the False Claims Act (FCA), which has now been largely rendered moot by amendments to the FCA in the (highly contested and much-anticipated, by some) health care legislation recently passed by Congress. The question presented in Graham County Soil and Water Conservation District v. United States ex rel. Wilson was whether the FCA bars qui tam actions when the alleged fraud has been disclosed in reports by state and local, as opposed to federal, agencies. The FCA bars qui tam actions "based upon the public disclosure of allegations or transactions in a [1] criminal, civil, or administrative hearing, [2] in a congressional, administrative, or Government Accounting Office [(GAO)] report, hearing, audit, or investigation, or [3] from the news media, unless the action is brought by the Attorney General or the person bringing the action is an original source of the information." Here, Wilson raised concerns about possible fraud when she was employed by the Conservation District, but did not file a qui tam action until after state and local agencies had investigated and generated reports. The Seventh Circuit held that Wilson could go forward because, given that the term "administrative" was placed between the undeniably federal terms "congressional" and "GAO," the bar must apply only to federal administrative reports and investigations.

Justice Stevens, writing for a 7-2 majority, was not persuaded by what he called the Seventh Circuit's "Sandwich Theory," or the SG's arguments as amicus for Wilson. In the Court's view, there is nothing inherently federal about the term "administrative," and the list in which it appears is too short and too disjunctive to apply the maxim of statutory interpretation that "a word may be known by the company it keeps." The Court observed that the report and investigation category [2] at issue was itself sandwiched between category [1] judicial or administrative hearings, which courts had interpreted to include state proceedings, and category [3] news media, which all parties agreed was not limited to the federal government. The Court found nothing in the legislative history to suggest that Congress intended to limit the bar to federal reports and investigations, and was not persuaded by Wilson's and amici's policy arguments that many state and local investigations may never come to the DOJ's attention. The Court noted that, even where such reports exist, the FCA allows a qui tam suit by an "original source" of the information; whether Wilson qualifies as an original source is an open issue to be decided on remand. Justice Scalia wrote separately to concur in the judgment and to concur in all parts of the opinion except the part that considered legislative history.

Justice Sotomayor's dissent, which Justice Breyer joined, was virtually a mirror image of the Court's opinion. The dissenters found that the term "administrative," sandwiched between "congressional" and "GAO" must refer to federal agencies; were not persuaded by the majority's broader sandwich theory, given that the judicial and administrative hearings category was not before the Court, and, arguably, should also be limited to federal proceedings; saw much in the legislative history to support a less restrictive bar; and would give greater deference to the DOJ's concerns that allegations in state and local reports might never come to its attention without the aid of qui tam relators. While the dissenters and Wilson may have lost this case, their position has ultimately been adopted in amendments to the False Claims Act, passed as part of the health care bill. Those amendments make clear that the bar operates only where disclosures have been made in a "Federal criminal, civil, or administrative hearing in which the Government or its agent is a party" or a "congressional, GAO, or other Federal report, hearing, audit, or investigation."

Finally, in Berghuis v. Smith, the Court addressed the scope of the Sixth Amendment right to be tried by an impartial jury, which the Court has long interpreted as requiring trial by a jury composed of a "fair cross section of the community." In order to establish a prima facie case of violation of the fair cross section right, a defendant must establish that (1) a distinct group (2) is not represented in the jury pool in numbers that are fair and reasonable in relation to the number of such persons in the community and (3) this underrepresentation is a result of systemic exclusion. In the seminal case adopting this test, Duren v. Missouri (1979), plaintiff established that women (a distinct group), represented 54% of the jury-eligible population, but accounted for only 14.5% of the jury pool (obvious underrepresentation), and that this was caused by a Missouri law allowing all women to opt out of jury service (systemic exclusion). In Smith's case, the jury pool consisted of 60-100 people, of which at most 3 were black; the jury actually selected was all white. Smith claimed that the lack of black jurors was caused by Kent County's juror selection system, which first allotted jurors to the county's 12 district courts and then, only after the district courts' needs were satisfied, to the single circuit court in the county, which tried felonies. Smith also argued that Kent County's no-questions-asked hardship exemption process and failure to ensure the participation of eligible jurors (via sheriff if necessary) contributed to the disparity. Kent County, which also believed that its district court first allocation system caused minorities to be siphoned out at the district court phase, flipped the allocation order shortly after Smith's conviction. On direct appeal, the Michigan Court of Appeals ordered an evidentiary hearing on Smith's fair cross section claim. The trial court found underrepresentation of blacks in the jury pool based on the fact that blacks were 7.28% of the population and only 6% of the jury pool (an absolute disparity of 1.28% and a comparative disparity of 18%), but found no systemic exclusion. From there, it was a bouncing ball . . . the Court of Appeals reversed, finding in favor of Smith, but the Michigan Supreme Court reversed right back finding no systemic exclusion; the federal district court then denied habeas relief, but the Sixth Circuit reversed, finding unreasonably disparity based on the 18% comparative disparity (which it viewed as the correct measure) and systemic exclusion based on the Kent County juror allotment process. And so, after years of challenges, the ball seemed to be into Smith's court . . . until the Court unanimously reversed.

Led by Justice Ginsburg, the Court first noted that under the Antiterrorism and Effective Death Penalty Act (AEDPA), a state court decision can be overturned on federal habeas review only if it constitutes an unreasonable application of clearly established law. Here, the Court found that the law was not clearly established in Smith's favor and the Michigan Supreme Court's application of that law was reasonable. The Court dodged the question of whether there was fair and reasonable number of black jurors in the Kent County circuit court pool, but not without noting that there was no clearly established precedent holding that courts must apply the comparative disparity test (as the Sixth Circuit held) rather than an absolute disparity or other type of test. (So, if this issue had been dispositive, it would have gone to Michigan under AEDPA's deferential standard of review.) Next, the Court concluded that Smith had failed to established systemic exclusion of blacks from the jury pool. While Kent County may have believed its district court first allotment system resulting in minority siphoning, Smith presented no evidence to show that was in fact the case (such as a comparison of the percentage of blacks in the juror pools in district court versus circuit court). Therefore, the Michigan Supreme Court clearly did not act unreasonably by finding no systemic exclusion. The Court also rejected out of hand Smith's arguments that other aspects of Kent County's process, such as a relaxed hardship exemption standard, constituted systemic exclusion. Even in Duren, the Court noted that individual hardship exemptions would probably pass muster.

Justice Thomas joined the Court's opinion in full, but wrote separately to note that he would be willing to reconsider the fair cross section test entirely as he found it unconnected to the text and history of the Sixth Amendment. (Justice Thomas, ever faithful adherent to stare decision, willing to reconsider long established precedent? This can't have happened since . . . last month.)

The Court released two more decisions this morning, which I will bring you shortly. Until then, thanks as always, for reading!


From the Appellate and Complex Legal Issues Practice Group at Wiggin and Dana
For more information, contact Kim Rinehart or any other member of the Practice Group at 203-498-4400