In 2010, the Supreme Court, in Jones v. Harris Associates, L.P., 559 U.S. 335 (2010), issued a significant decision concerning Section 36(b) of the Investment Company Act of 1940, which imposes a fiduciary duty on mutual fund advisers with respect to the fees they receive from the funds they manage. So what happened next in the world of Section 36(b) litigation?
In Jones, the Court approved the so-called “Gartenberg standard” (first articulated by the Second Circuit in 1982), holding that liability exists only where the adviser “charge[s] a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arms’ length bargaining.” The Supreme Court held that all relevant factors matter when analyzing this standard, including the independence and conscientiousness of the fund’s board of directors, the nature and quality of the services provided by the adviser, the adviser’s profitability, any ancillary monetary benefits received by the adviser in connection with operating the fund (“fall-out” benefits), whether the adviser shared economies of scale with shareholders, and the comparative fee structures of other similar funds. However, the Court also made clear that “the standard for fiduciary breach under [Section] 36(b) does not call for judicial second-guessing of informed board decisions”; rather, the Court stated that if “disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently.”
While the Court’s decision in Jones was much anticipated in light of its potential to discourage current and future litigation under Section 36(b), the decision was ultimately a mixed blessing for both sides: the Court adopted the prevailing standard − which set a high bar for recovery − but rejected an even higher standard that relied less on factual circumstances.
This article addresses a few notable developments: (1) the ensuing wave of Section 36(b) litigation has focused on a primary advisor’s delegation of management services to subadvisors; (2) while most cases have survived motions to dismiss, plaintiffs have received several unfavorable pre-trial decisions; (3) plaintiffs lost the first trial in the current wave of litigation; and (4) a handful of cases have settled, including two after the recent trial ruling in favor of the adviser.
The New Wave Of Section 36(b) Litigation
In the wake of Jones, some early lower court decisions suggested that Jones might reduce the number of new Section 36(b) filings. For example, before Jones was decided, the Eighth Circuit in Gallus v. Ameriprise, 561 F.3d 816 (8th Cir. 2009), vacated a summary judgment decision in favor of the adviser, in part, because of contentions that the adviser had “purposefully omitted” facts about fees charged to institutional clients in its communications with the board. However, after Jones, the Eighth Circuit changed course, affirming dismissal of the case. See 675 F.3d 1173 (8th Cir. 2012).
Yet the ensuing wave of Section 36(b) litigation in the years following have cut hard against that prospect. Since the Supreme Court’s decision in 2010, at least twenty-six Section 36(b) cases have been filed in thirteen jurisdictions, including six filed in 2016.
Nonetheless, Jones has at least caused plaintiffs to refine their excessive fee theory. In particular, Jones made clear that “inapt comparisons” of fees charged to different types of clients served by an adviser (which may require different kinds of services from the adviser) are insufficient. The decision instructs courts to focus on the “similarities and differences between the services that the clients in question may require.” In the Jones case itself, the Supreme Court noted “significant differences between the services provided by an investment adviser to a mutual fund and those it provides to a pension fund,” which could justify different fees charged to each fund.
Post-Jones, plaintiffs have seized on a comparison that they hope to be less “inapt”: the fees charged by a primary adviser compared to the lower fees charged by a subadviser for purportedly the same services. Recent cases have portrayed subadvisory fees as legitimate compensation for the investment management services rendered, while arguing that any additional fees paid to primary advisers are unjustified and therefore excessive. For example:
- In Zehrer v. Harbor Capital Advisors, Inc, No. 1:14-cv-00789 (N.D. Ill.), the plaintiffs allege that the adviser’s fee was excessive because the adviser delegated “substantially all” asset management responsibilities to a variety of third-party money managers, but kept most of the advisory fees paid by the mutual funds at issue. According to the plaintiffs, the portion of the fees retained by the adviser was “more than 80%” greater than the fees paid by the adviser to the subadvisers.
- Similarly, a variant on the subadviser theme has appeared in cases where the primary adviser also acted as a subadviser to other third-party funds. For example, in Chill v. Calamos Advisors, LLC, No. 1:15-cv-1014 (S.D.N.Y), the plaintiffs alleged that the fees received from certain third-party funds subadvised by the adviser were “substantially lower” than those received from the retail mutual fund at issue, even though the adviser provided “identical” investment advisory services to the subadvised funds. In other words, unlike the prevalent theory in the new wave of Section 36(b) cases, which alleges that the main adviser is “skimming” by delegating work to subadvisors for a lower fee, this theory asks why the primary adviser charges its own retail funds more for advisory services than it charges third-party advisers for subadvisory services.
Plaintiffs have had some success with the refined theories based on subadvisory fees. Indeed, most of the new cases have survived motions to dismiss. However, other cases have been dismissed pre-trial:
- In Ingenhutt v. State Farm Investment Management Corp., No. 1:15-cv-01303 (C.D. Ill. 2016), the court dismissed a Section 36(b) complaint because it was full of “artfully craft[ed] ‘facts’ that are in reality speculative assertions.” In particular, plaintiffs failed to sufficiently allege that (i) the adviser’s fees were not justified by services provided; (ii) the funds identified by plaintiffs that charged lower fees were sufficiently similar to warrant comparison; and (iii) the increase in fund expenses over the relevant time period was not related to a corresponding increase in costs. Plaintiffs have filed an amended complaint and the court has not ruled on the adviser’s motion to dismiss that complaint.
- In Laborers’ Local 265 Pension Fund v. iShares Trust, 769 F.3d 399 (6th Cir. 2014), the Sixth Circuit affirmed the summary judgment dismissal of a Section 36(b) claim attacking an affiliated securities lending arrangement. The case was dismissed by the district court on the basis that the transactions at issue were subject to an exemptive order by the SEC under Section 17 of the Investment Company Act, depriving plaintiffs of a claim under Section 36(b). The Sixth Circuit affirmed the dismissal, rejecting the plaintiff’s argument that the affiliate’s “lending fee should be aggregated with [the adviser’s] separate investment-advisory fee in order to determine whether [the adviser] violated its fiduciary duty by receiving excessive compensation.”
- In American Chemical & Equipment, Inc. v. Principal Management Corp., No. 4:14-cv-00044 (S.D. Iowa 2016), the complaint also included some allegations relating to a securities lending arrangement. However, the case was dismissed at summary judgment because the plaintiff − an investor in a fund-of-funds − lacked standing to challenge advisory fees paid by the underlying funds at issue (which the plaintiff did not hold). Plaintiffs have filed an appeal.
In addition, plaintiffs have received unfavorable partial summary judgment rulings in two of the earliest cases to reach the trial stage:
- In Kasilag v. Hartford Investment Financial Services, LLC, No. 11-1083 (D.N.J. 2016), the court granted partial summary judgment in favor of the adviser, holding that the board’s consideration of the fees charged by the adviser will be entitled to deference at trial. The court held that the plaintiffs’ criticisms were mere “quibbles” that amounted to “no more than nit-picking the Board’s process” and did “not create a triable issue of fact” with respect to the Board’s process or independence. The court also denied the plaintiffs’ cross-motion for summary judgment on liability, so the case will now proceed to trial on the remaining Gartenberg factors. The parties completed a four-day trial in November 2016 and will present closing arguments in February 2017.
- Similarly, in McClure v. Russell Investment Management Co., No. 1:13-cv-12631 (D. Mass. 2016), the court granted partial summary judgment in favor of the adviser, narrowing the forthcoming trial. Ruling from the bench, the court (Young, J.) stated that the defendants were “right as to the degree of deference. . . to be given to the board,” but that the plaintiff “probably squeak[s] by summary judgment” on three discrete issues: (i) fall-out benefits, (ii) profitability and (iii) the nature and quality of the adviser’s services. A trial is scheduled to be held in March 2017.
The First Trial
In addition to the challenges above, plaintiffs lost the first case tried in the current wave of Section 36(b) litigation. In Sivolella v. AXA Equitable Life Ins. Co., No. 11-cv-4194 (D.N.J. 2016), the plaintiffs claimed that the adviser’s fees were excessive because the adviser delegated virtually all management responsibilities to subadvisers while it kept most of the fees. After a 25-day trial centering around the relevant factors under the Jones standard, the court ruled in favor of the adviser, rejecting the plaintiffs’ theories of liability and damages.
The decision was heavily influenced by the court’s findings with respect to the fund’s board of directors, which the court determined was truly independent of the advisor and consisted of individuals with sufficiently diverse professional backgrounds and expertise. The court credited the board’s process as “careful and conscientious,” and noted that the independent directors had received information from multiple outside experts and consultants in addition to the information provided by the adviser. The court credited, in particular, evidence that the board had engaged with the adviser throughout the relevant period to develop and improve board materials regarding the fees received and services provided by the adviser and subadvisers.
As to the plaintiffs’ excessive fee theory, the court rejected their primary argument that the adviser’s management fee was excessive because it delegated nearly all of its responsibilities to subadvisors but retained a significant fee. Although the plaintiffs were “essentially correct” that the advisory agreements facially seemed to show that the adviser delegated its contractual obligations to the subadvisers, the court credited the adviser’s oversight responsibilities, as well as some services retained under contract, such as preparing proxy statements and periodic reports. Moreover, the court declined to elevate “form over substance” by limiting its review to the contract language. Indeed, the testimony and evidence demonstrated that the adviser provided a “number of services” separate and in addition to those provided by the subadvisers which were not expressly described in the agreements. For example, the court noted the adviser’s role in developing and implementing the funds’ investment strategies, hiring the subadvisers, providing risk management services, operating a shareholder call center, developing investment guidelines and benchmarks, continuously evaluating fund performance, and restructuring or merging the funds (which the adviser had done five times during the relevant period). The court also credited business risks assumed by the adviser which were not shared by the funds or the subadvisers.
The court likewise rejected the plaintiffs’ allegations with respect to the other relevant factors. For example, the court rejected arguments that: (i) the adviser’s methodology for allocating expenses and classification of certain expenses was improper because the board had considered both issues, as had two independent accounting firms; (ii) the adviser failed to share economies of scale with investors, in part, because the board had frequently discussed that topic and had successfully obtained additional fee breakpoints, as well as savings through cost caps, expense reimbursements, and directed brokerage agreements; and (iii) the adviser had received fall-out benefits in the form of brokerage fees received by an affiliated entity because the benefits had been disclosed to the board and properly considered during the annual advisory contract renewal process. The court also rejected criticisms of the adviser’s comparative fee materials prepared by Lipper because the plaintiffs’ expert admitted that Lipper was an “independent and authoritative source for data,” and the board had already considered and addressed the criticisms at issue.
Notably, the court discounted much of the testimony from plaintiffs’ experts because of perceived flaws in their methodologies, unprofessional demeanor, conflicting testimony, and “cursory” review of the record.
There appear to have been three settlements in the current wave of litigation. One case involving Fiduciary Management Co. was settled in January 2016, and another case involving SEI Investments Management Corp. was settled in December 2016. In addition, Harris Associates — the very adviser vindicated by Jones — settled a Section 36(b) case in December 2016. After the Supreme Court remanded Jones to the Seventh Circuit for further consideration, it remained pending for more than five years. In the fall of 2015, the Seventh Circuit issued an opinion apologizing for the delay (which it said was an oversight), and affirming the district court’s order granting summary judgment in favor of the adviser. However, less than a year later, a different plaintiff with different counsel filed a new Section 36(b) case with allegations regarding two of the three funds at issue in the original Jones case. Although the case was settled shortly after it was filed, it demonstrates the persistent risk of Section 36(b) litigation.
While these settlements have little predictive value with respect to the other pending cases, it is notable that the latter two settlements came on the heels of unfavorable rulings in Hartford, Russell and AXA, 2017 will likely tell whether a settlement trend is emerging or whether settlements will continue to be isolated occurrences.
As the wave of Section 36(b) litigation works its way through the courts, the industry continues to weather the storm: while new cases have been filed, plaintiffs have yet to win one on the merits, and have received a string of unfavorable decisions, including a ruling in favor of the adviser in the first case to be tried. Although the financial and reputational threats of Section 36(b) litigation continue to be significant, even after Jones, the forthcoming year will likely tell whether this current wave of litigation will be successful.