Plaintiffs in an excessive-fee case against The Hartford received some discouraging news last week when a judge ruled entirely in favor of the adviser at trial, the latest result in a wave of similar lawsuits.
The court’s ruling follows a string of other rulings favorable to advisers over the past year. During the same period, cases involving Russell Investment, SEI Investments Management Corp., Harris Associates and Prudential Investments have been resolved by undisclosed agreements. Notably, the stipulation of dismissal in the Prudential case stated that the plaintiffs had reviewed the board materials and “concluded that it is appropriate to dismiss the action.”
While it may be too early to conclude that these cases reflect the end of the current wave of Section 36(b) litigation, plaintiffs’ counsel in the remaining cases are likely to adjust their strategies in 2017 to avoid similar fates. This could lead to even more scrutiny of the board’s process for approving advisory fees, and possibly heightened focus on the board’s communications with counsel.
Recent rulings may foreshadow the outcome of the remaining cases, which similarly focus on subadvisory fees.
In the case involving The Hartford, the court found that the plaintiffs had failed to “demonstrate that the fee is so disproportionate that it could not be one that was negotiated at arms’ length.” Previously, the court had determined before trial that the board had properly considered and approved the advisory fees at issue, and discounted the plaintiffs’ criticism of the board’s process as “quibbles.”
In 2016, AXA likewise emerged victorious after a trial, during which investors failed to convince the judge that the firm received an excessive fee. Among other findings, the court determined that the board was “diverse and independent” and had “robustly reviewed” the adviser’s compensation.
In addition, in November 2016, a Massachusetts federal court granted partial summary judgment in favor of Russell Investment Co., stating that defendants were “right as to the degree of deference. . . to be given to the board, as a matter of law.” The case was subsequently dismissed by agreement.
Preparing for More Scrutiny
These rulings are a reminder that a strong, defensible board process will likely confer a significant advantage to defendants in excessive-fee litigation. As a result, plaintiffs will likely redouble their efforts in 2017 to discredit boards’ independence or process.
Plaintiffs will continue to hone in on information that was allegedly kept from the board during the fee-approval process. They may highlight circumstances that supposedly discredit the directors’ diligence in obtaining and reviewing materials, independence from the adviser or access to third-party experts and advisers. Plaintiffs may also focus on changes made to the board’s process or materials after a lawsuit was filed, even though the court in the AXA case found such improvements to be indicative of a strong board process, not a flaw.
Diligent directors should continue to focus on board process and documentation to combat future litigation. This includes actively engaging with advisers about the content and format of the materials they provide to the board. Where appropriate, they should proactively ask advisers to improve the way materials are organized and transmitted, and should request all information necessary to appropriately analyze the basis for the adviser’s fee. Directors might ask for summaries of the key data points to guide their review of voluminous materials. If it would be helpful, directors might also ask for additional contextual information, such as year-over-year analyses or peer-group comparisons.
This kind of dialogue is part of a robust board process, and should be documented. Any improvements to the materials should also be documented. This documentation is likely to be helpful in Section 36(b) litigation — where the board’s process will be closely scrutinized by plaintiffs — because it demonstrates active, independent engagement by an informed board. While some plaintiffs have tried to demonstrate a flaw in the board materials by pointing to subsequent improvements, those efforts have been generally unsuccessful.
Caution With Emails
Plaintiffs may also scrutinize the communications between the board and independent counsel. In November, a court ruled that PIMCO’s independent directors must hand over certain emails exchanged with their counsel, even though traditional privilege rules typically protect attorney-client communications from disclosure.
Plaintiffs in other pending cases may seek to capitalize on this ruling. Directors should continue to communicate with their independent counsel as needed and appropriate. They should also, however, carefully consider whether particular topics are appropriate for a written communication, avoid inflammatory language and otherwise bear in mind that their emails may be subject to outside scrutiny. Directors should exercise equal diligence in written communications with each other. Emails between directors are generally not subject to attorney-client privilege, and are likely to be turned over in an excessive-fee litigation.