On August 25, 2016, in a closely watched case, a New Jersey federal court ruled in favor of a mutual fund adviser that allegedly received excessive fees because it delegated certain investment management and administrative services to sub-advisers and sub-administrators. As with all other trials concerning claims for violations of Section 36(b) of the Investment Company Act of 1940 (the Act), the court ruled that the plaintiffs failed to meet their burden of proof. This ruling is significant because there are many similar lawsuits involving the use of sub-advisers pending around the country.
Following a 25-day bench trial, the district court in Sivolella v. AXA Equitable Life Ins. Co. No. 3:11-cv-04194-PGS-DEA (D.N.J. Aug. 25, 2016), issued a 146-page decision, which dismissed the case and entered judgment in favor of the defendants, AXA Equitable Insurance Company (AXA) and AXA Equitable Funds Management Group (FMG), the investment adviser and administrative service provider to the subject mutual funds.
In particular, the court held that the plaintiffs failed to present evidence demonstrating that the fees received by the defendants were so disproportionately large that they bore no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining. In so holding, the court ruled that none of the so-called Gartenberg factors, described below, weighed in the plaintiffs’ favor.
The following are some highlights of the court’s ruling:
Witness Credibility: Central to the court’s ruling was its assessment of the credibility of the parties’ witnesses. In particular, the court found that the plaintiffs’ experts lacked credibility because their testimony was internally inconsistent, evasive, failed to consider evidence in the record or demonstrated an unprofessional demeanor. The court also found that the reports of plaintiffs’ experts contained significant errors. In contrast, the court found that the testimony of the defendants’ experts and witnesses, particularly the lead independent trustee, was reliable and credible. The court also noted that most of the plaintiffs were absent or did not testify during trial, while members of AXA’s senior leadership were present each day of the trial.
Analysis of Gartenberg Factors: The court also addressed the following issues with respect to each of the Gartenberg factors, finding that the plaintiffs failed to demonstrate that any of the factors weighed in their favor:
- Independence and Conscientiousness of the Board: The court held that the evidence showed that the board is sufficiently independent and diverse, and that it was conscientious in its review of FMG’s fees. Specifically, the court focused on the several board meetings held each year, the function of the numerous board committees, the extensive training for new board members, the involvement of the board’s independent outside counsel and the robust 15(c) process that occurs each year. The court observed that the Chairman of the Board is an interested trustee but concluded that this did not present a material conflict or other issue in light of the significant role of the lead independent trustee and the board’s view that the independent trustees essentially run the board.
- Advisory Agreement Review Process: The court addressed in detail the board’s annual process for reviewing the management and administrative agreements and found that the board’s process was “robust.” The independent trustees engaged in a year-long contract review process. After the board voted to extend the contracts, the lead independent trustee began the next year’s review process by calling each of the trustees to identify issues to be reviewed over the coming year.
- Nature and Quality of FMG’s Services: The plaintiffs argued that, based on the plain language of the contracts, the defendants delegated most of the services. However, the court looked beyond the plain language of the contracts, finding that the evidence showed that FMG retained many of the services that appear to be delegated to sub-advisers and sub-administrators, and that FMG also provided extensive services to the funds beyond what is stated in the contracts. The court took issue with the plaintiffs’ failure to introduce evidence of the fees that the defendants ultimately retain, concluding that, without this information, the court could not find that FMG’s fees were excessive.
- FMG’s Profitability: The plaintiffs contended that, for purposes of computing profitability, the defendants should not treat sub-adviser costs as direct expenses. The court rejected the plaintiffs’ theory, based on expert testimony. The court also found FMG’s allocation of costs based on revenue as the cost driver was appropriate based on the credible testimony of the defendants’ experts.
- Economies of Scale: The court was particularly persuaded by the testimony of the defendants’ experts on this factor, who explained what economies of scale are, how to measure them properly and why the plaintiffs’ experts were wrong. The court found that the board receives extensive information regarding economies of scale, including concerning the funds’ breakpoints. The board also analyzes information about the effective fee levels of the funds. The court also discussed that, in addition to breakpoints, FMG used other cost-saving methodologies to pass savings to investors, including: (i) product cap reimbursements; (ii) expense limitation agreements; (iii) pricing to scale (i.e., setting advisory fees at a fund’s inception at a level that assumes the fund is already at scale); and (iv) directed brokerage.
- Fall-Out Benefits: The court rejected the plaintiffs’ claims that product wrapper fees and the general account spread constitute fall-out benefits. The court otherwise found that the board received sufficient information regarding other potential fall-out benefits.
- Comparative Fees: The court found that the board compared the fees of each fund at issue against reliable sources—specifically data from Lipper and Strategic Insight—and determined that they are reasonable in the industry based on that data. The court did note that the Lipper data has limitations, in particular that it compares index or hybrid funds to active funds but found that the board was aware of these limitations and requested a breakout of index funds alone for comparison.
Fund Performance: The court further analyzed fund performance separately from the Gartenberg factors and found that, notwithstanding the plaintiffs’ contention that certain funds performed poorly, the evidence showed that the funds generally performed at or above expectations. In analyzing performance, the court emphasized that, while underperformance of funds may be considered, courts are cautious about attaching too much significance to a fund’s financial performance, and allegations of underperformance alone are insufficient to prove that fees are excessive.
Damages Analysis: The court did not need to assess the issue of damages, but it nonetheless found that the plaintiffs failed to prove that they suffered any actual damages. The court also rejected the plaintiffs’ claim that full disgorgement of fees was appropriate, explaining that the proper measure of damages is the difference between what was charged and what would have been a reasonable fee for the services provided. In other words, full disgorgement of fees could be appropriate only in the event the adviser truly delegated all services.
Changes by the Board Resulting From the Lawsuit: The court also observed that, as a result of this lawsuit, the defendants implemented a number of positive changes. In particular, the court focused on the board’s elimination of lavish expenses (e.g., dinners totaling several thousands of dollars), and the way in which materials delivered to the board were improved. With respect to the board materials, the court noted that the materials had evolved significantly over a three-year period to move from a straightforward list of Gartenberg factors to a presentation that indexed the materials to each of the factors.
Although no plaintiff has ever successfully proven its claims under Section 36(b), actions brought under the Act typically take significant time and resources to defend. The AXA decision provides guidance to fund directors with concrete examples of inquiries into both specific board processes (such as review of profitability and economies of scale) and the manner in which boards resolve issues involving conflicts with management.