A recent ruling by the U.S. Court of Appeals for the Second Circuit greatly missed the mark, and could be concerning for investors relying on the Investment Company Act to keep mutual fund advisors honest. The case involved the J.P. Morgan U.S. Large Cap Core Plus Fund — an active mutual fund with $6.5 billion in assets that has trailed its index over virtually every time period, according to Morningstar. In the lawsuit, investors claimed that J.P. Morgan’s management fee (the fee charged by J.P. Morgan in exchange for managing the fund’s investment portfolio) was excessive under Section 36(b) of the Investment Company Act, which imposes a fiduciary duty on mutual fund advisors with respect to fees.
Investors argued that J.P. Morgan charged the fund a management fee of 80 basis points (recently lowered to 70 basis points), but charged significantly lower fees to similar products, including a different J.P. Morgan mutual fund that charged roughly half the fee at issue. Investors also pointed to Bloomberg data on U.S. equity large-cap blend funds, which likewise suggested that the fee was excessive.
The Court rejected the investors’ comparison to the similar J.P. Morgan mutual fund because that fund held fewer securities and did not take short positions. But investors should question how the Court could have assessed, at this preliminary stage of litigation, whether those differences were actually material to the management of the funds, and whether any such differences could justify a 2x difference in management fees.
The Court also rejected the investors’ comparison to the fees charged by an unaffiliated mutual fund managed by a different investment advisor, which had hired J.P. Morgan to manage the fund’s investment portfolio (i.e. to serve as a subadvisor). That fund charged 12 basis points less than the J.P. Morgan fund at issue. In the court’s view, 12 basis points was a “relatively marginal difference” in fees. But in a fund with $6.5 billion in assets, that fee difference results in a loss to investors of millions of dollars per year, which quickly compounds to tens and even hundreds of millions of dollars over time.
Finally, the Court rejected the Bloomberg data cited by investors because it included index funds in addition to active funds. But the Court did not explain why a comparison to index funds is inappropriate under these circumstances. Indeed, given that the fund had rarely if ever beaten or even matched its index, the advisor arguably provided services even less valuable to investors than those provided by an index fund.
The Court also ruled against the investors on a handful of other factors relevant to fees, even though discovery in the case had yet to begin. The Court noted that the investors’ complaint “does not reference profit margins” or “relative profitability of funds,” but such data is not publicly available for any mutual fund in the country. The investors would have certainly discovered such data if the lawsuit had been permitted to proceed, given that mutual fund boards are required to consider an advisor’s profitability every year when approving the advisor’s fees.
The Court also acknowledged that J.P. Morgan had likely experienced increased profits as a result of the fund’s “explosive growth,” and that it had not “fully shared” those profits with investors.” Nonetheless, the Court still held that the investors had failed to sufficiently allege that the advisor’s the fee was excessive.
In a concurring opinion, one justice on the three-justice panel noted that the decision seems to create an “impossible” burden for investors challenging an excessive management fee under the Investment Company Act, which was designed to regulate fees in “situations like this one, where J.P. Morgan is both the adviser and the creator, sponsor, and promoter of the mutual fund.” Nonetheless, he joined the panel’s decision dismissing the investors’ claims.
The Second Circuit’s decision is contrary to the weight of authority nationwide, which has almost uniformly held that investors have sufficiently alleged excessive fees under materially identical circumstances. Fortunately for investors, the decision is a non-precedential Summary Order, and therefore will likely have limited effect on future cases brought under the Investment Company Act.
The case is Pirundini v. J.P. Morgan Investment Management, Inc., No. 18-733 (2d Cir. 2019).