On February 14, 2018, the U.S. District Court for the Southern District of New York in Manhattan issued a decision dismissing a complaint brought under Section 36(b) of the Investment Company Act of 1940, as amended, that alleged that an investment adviser had violated its fiduciary duties by charging excessive advisory fees to a mutual fund. The decision is the first since 2011 in which a court has granted a motion to dismiss a Section 36(b) complaint alleging excessive mutual fund fees. More than 20 other mutual fund excessive fee complaints have been filed since the Supreme Court decided Jones v. Harris, 559 U.S. 335 (2010), and almost all have proceeded to discovery rather than being dismissed at the pleadings stage.
Section 36(b) lawsuits are governed by the so-called Gartenberg factors that were adopted by the Supreme Court in Jones v. Harris. Liability under Section 36(b) turns on whether the fee the adviser charged “is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.” The specific factors a court should consider in evaluating whether a fee meets this standard include the nature and quality of the services provided to the fund and its shareholders; the profitability to the adviser from managing the fund; the extent to which the adviser realized economies of scale as fund assets grew and whether the adviser shares these economies of scale with the fund; any fall-out financial benefits that accrued to the adviser because of its relationship with the fund; comparative fee structures; and the independence, expertise, care and conscientiousness of the fund’s board of directors in evaluating the adviser’s compensation.
In reaching its decision, the Manhattan federal court addressed a number of issues arising under the Gartenberg factors in a way favorable for fund advisers and fund boards. The decision concluded that the complaint — which included 102 pages of allegations plus another 84 pages of exhibits — failed to allege facts sufficient to plausibly support an inference that the adviser's fee was so disproportionately large relative to the services rendered that it fell outside the range of what could be negotiated at arm's length. In other words, the court concluded that despite the complaint’s length, its allegations were insufficient as a matter of law to show a violation of Section 36(b).
The complaint focused primarily on fee comparisons. The gist of the complaint was that the adviser charged the fund at issue (1) more than the adviser charged another mutual fund that shared the same investment objective and (2) more than the adviser charged to serve as subadviser of a third mutual fund, again with a similar investment objective. The court rejected these comparisons: “[M]erely because one or two mutual funds pay lower investment advisory fees than what the Fund pays does not suggest that the fee rate [the adviser] charges the Fund is necessarily outside the ‘range of what would have been negotiated at arm’s length’…. A contrary ruling would open the floodgates to Section 36(b) claims any time a shareholder could identify a mutual fund that pays a lower investment advisory fee than the fund he or she chooses to invest in.”
The complaint also alleged that the fund was the most expensive mutual fund among those that Bloomberg Finance categorized as “U.S. equity large-cap blend” funds with assets over $1 billion. The court rejected this comparison as inapt because “the complaint fails to identify how, if at all, the investment advisory services [the adviser] provides the Fund are similar to those provided to the Bloomberg Funds by their respective investment advisers.” The court went on to state that “charging a fee that is above the industry average does not violate Section 36(b)” and that alleging that “among its ‘peers,’ the Fund pays the highest investment advisory fee rate … is not the test for determining liability under Section 36(b).”
The court also rejected allegations about other Gartenberg factors as insufficient to show a violation of Section 36(b). The court rejected the complaint’s allegations that breakpoints are required to share economies of scale. Instead, the court held that, because the fund’s advisory fee had been reduced several years earlier and because some of the current fees were waived under an expense cap, “to the extent economies of scale have been achieved,” there was “some sharing of economies of scale with the Fund and its investors.” With respect to the nature and quality of the services, the court held that the complaint’s allegations — that the fund had only “middling” performance — were insufficient as a matter of law. The court noted that allegations of underperformance do not suffice by themselves to state a claim under Section 36(b), and that the complaint did not even allege underperformance, but rather that the fund’s performance was average. The court rejected the complaint’s profitability allegations — that because the fund’s fees were allegedly high, the adviser must have earned high profits — as speculative without credible allegations about the adviser’s costs. The court concluded that some of the fall-out benefit allegations — that the adviser could provide similar services to other clients using the same strategy it provided the fund — could “support an inference, albeit a weak one, that [the adviser] enjoys a fall-out benefit” but that this was not enough to show that the challenged fee was excessive.
Finally, the court rejected the complaint’s allegations about care and conscientiousness of the fund’s board in approving the fees. The court noted that the plaintiff had no independent knowledge of the circumstances under which the board approved the fees, and held that the complaint’s allegations that the board failed “to engage in a good-faith process designed to guard against taking excessive investment advisory fees” and that the board’s “approval was based on inaccurate and/or incomplete information” were conclusory and therefore not entitled to any weight. The court then noted that the remainder of the plaintiffs’ board allegations “do not address the Board’s process … but instead focus on the merits of the Board’s conclusions.” But “absent some evidence of a deficient approval process or that information was affirmatively misrepresented or withheld from the Board, these allegations are inadequate and do not suggest a basis for this Court to reject the Board’s considered findings as to [the adviser’s] fees.” The court added that “Section 36(b) does not provide relief where more arduous bargaining could have resulted in lower fees. … Rather, it provides relief only where the fees charged are shown to be outside the range of what arm’s length bargaining could produce.”
Goodwin represented the defendant investment adviser in the action.
View the court’s decision.
