The U.S. mutual fund industry is poised to see significant developments in the ongoing wave of Section 36(b) “excessive fee” litigation. Days apart in August, the Seventh Circuit Court of Appeals affirmed the grant of summary judgment in Jones v. Harris Associates, L.P.,1 while a New Jersey federal court denied defendants’ motion for summary judgment in the first of the “manager of managers” cases to reach that stage, Sivolella v. AXA Equitable Insurance Co.2 Together with the recent uptick in the number of cases being brought to challenge fees charged by mutual fund advisers, this area of law merits careful attention by investment advisers, mutual fund boards, and their counsel.
Section 36(b) of the Investment Company Act of 1940 imposes a fiduciary duty on the investment adviser of a mutual fund with respect to the fees charged to the fund, and creates a narrow private right of action permitting shareholders to challenge the fees paid in the one year preceding the filing of the complaint.
While the statute itself does not detail the analysis that a court should undergo when determining whether fees are legally excessive, the Second Circuit in the seminal Gartenberg case3 held that fees should only be considered excessive if “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.” The Second Circuit identified six factors to be considered in determining whether the advisory fees paid by a mutual fund met this standard. These factors, often referred to as the “Gartenberg factors,” are: (i) the nature and quality of the services provided to the fund and its shareholders; (ii) the profitability of the fund to the adviser; (iii) the extent to which the adviser realizes economies of scale as the fund grows in size; (iv) the fee structure of comparable funds; (v) the independence, expertise, care, and conscientiousness of the fund’s board of trustees in evaluating the adviser’s compensation; and (vi) any collateral benefits that accrue to the adviser because of its relationship with the fund. Following Gartenberg, the great majority of courts considering section 36(b) claims have adopted the Second Circuit’s analysis.
The Jones v. Harris Case
In Jones v. Harris Associates, L.P., initially filed in 2004, the plaintiffs alleged that the fees paid by the Oakmark Fund, the Oakmark Equity and Income Fund, and the Oakmark Global Fund (collectively, Oakmark Funds) to their adviser Harris Associates L.P. (Harris) were legally excessive in violation of section 36(b). The district court granted summary judgment to Harris in 2007, applying Gartenberg and holding that, for purposes of section 36(b), “[w]hat matters is whether there is a fundamental disconnect between what the Funds paid and what the services were worth; on this score Plaintiffs have not set forth an issue of fact that, if resolved in their favor, could lead to a finding that Harris had breached its [section] 36(b) duty.”4 Following this ruling, the plaintiffs appealed to the Seventh Circuit.
The Seventh Circuit’s 2008 Opinion (“Jones I”)
On appeal, the Seventh Circuit affirmed the district court’s judgment, using a different rationale. Despite the widespread adoption of the Gartenberg analysis, the Seventh Circuit Court of Appeals in Jones5 took a different route – adopting a market-based standard for judging whether an investment advisory fee is excessive. Thus, the Seventh Circuit held, if the investment advisory fees were honestly negotiated and agreed to by a fund’s board of trustees, those fees could not be excessive so as to constitute a breach of fiduciary duty under section 36(b). Supporting the Seventh Circuit’s conclusion was its contention that market forces – not judicial regulation – should govern the propriety of mutual fund fees, and its expectation that if fees were too high, investors would “vote with their feet” by withdrawing their investments from the fund.
The Supreme Court’s Opinion
The Seventh Circuit’s decision, which created a split among the courts of appeal, was appealed to the Supreme Court. In 2010, the Supreme Court issued an opinion reversing the Seventh Circuit. The Supreme Court found the Seventh Circuit’s exclusive reliance on free market regulation inappropriate, and adopted the Second Circuit’s approach in Gartenberg as the appropriate analysis to apply to determine whether a fee was excessive in violation of section 36(b). Accordingly, the Supreme Court found that to establish a violation of section 36(b), a plaintiff must establish that “the fee is outside the range that arm’s-length bargaining would produce.”
The Court further found that in determining whether the fee was negotiated at arm’s length, “a measure of deference to a board’s judgment [in approving an investment advisory agreement] may be appropriate in some instances,” but that “the appropriate measure of deference varies depending on the circumstances.” The Court concluded by emphasizing that “the standard for fiduciary breach under [section] 36(b) does not call for judicial second-guessing of informed board decisions,” and remanded the case to the Seventh Circuit for the Seventh Circuit’s consideration under the standard set forth by the Supreme Court.
The Seventh Circuit’s 2015 Opinion (“Jones II”)
Following a lengthy delay, on August 6, 2015, the Seventh Circuit issued a nonprecedential decision affirming the district court’s grant of summary judgment and applying the standard enunciated by the Supreme Court.6 The Seventh Circuit observed that “the Supreme Court’s approach does not allow a court to assess the fairness or reasonableness of advisers’ fees; the goal is to identify the outer bounds of arm’s length bargaining and not engage in rate regulation.” As a result, the Seventh Circuit determined that “the Supreme Court’s standard is less favorable to plaintiffs than the one the district court used – yet plaintiffs lost even under the district court’s approach.” In particular, the Seventh Circuit found dispositive the facts that the fees charged by Harris were comparable to those charged by advisers for comparable funds, and that the fees “could not be called disproportionate in relation to the value of Harris’s work,” because the Oakmark Funds’ performance was better than the average for comparable funds.
Elaborating on these factors, the court observed that the fees “produced by bargaining at other mutual-fund complexes” established the “bargaining range,” and that because the fees paid by the Oakmark Funds were within this range – coupled with the fact that such funds performed as well as, if not better than, comparable funds – the fees were not so large that they could not have been the result of arm’s length bargaining. The court proceeded to reject the plaintiffs’ contention that the fees charged to the Oakmark Funds should be compared not to other mutual funds, but to non-mutual fund clients of Harris. The court found that such a comparison was not appropriate, because the plaintiffs had failed to present evidence tending to show that Harris provided non-mutual fund clients with the same type of services provided to the Oakmark Funds or incurred the same costs. Thus, the Seventh Circuit held that Harris was entitled to summary judgment on plaintiffs’ section 36(b) claim.
The Seventh Circuit’s Jones II decision marks the likely end of the Jones saga, which lasted over ten years and touched every level of the federal courts. Consistent with the Supreme Court’s ruling, the Jones IIdecision emphasizes that no one factor is dispositive – rather, a court must determine whether, taking all the facts into account, a fee is so disproportionately large that it could not have resulted from arm’s length bargaining. If this standard cannot be met on the facts of a particular case, summary judgment is warranted.
Summary Judgment Denied in Sivolella v. AXA Equitable Insurance Co.
Also in August, the first of the recent wave of “manager of managers” cases reached the summary judgment stage. In Sivolella, the plaintiffs allege that the advisory and administrative fees paid by 12 funds advised by AXA (Sivolella Funds) are legally excessive because the adviser delegates substantially all its duties to one or more sub-advisers, yet nonetheless charges a fee on top of the fees paid to the sub-advisers.
Oral argument was held on the Motion for Summary Judgment filed by Defendants AXA Equitable Life Insurance Company (AXA) and AXA Equitable Funds Management Group LLC (FMG) in the U.S. District Court for the District of New Jersey on August 5, 2015. Shortly after the argument, in a ruling from the bench, the district court denied the motion – finding issues of material fact as to nearly all of theGartenberg factors.
Argument by Defendants
In their argument, the defendants focused on the high hurdle a plaintiff faces to bring a viable claim under Section 36(b), and the deference accorded to a fully-informed board of trustees. The defendants argued that the plaintiffs’ attempt to differentiate Sivolellaon the basis that sub-advisers were used to manage and advise the funds should be disregarded, since the use of third parties to assist with some services provided to a mutual fund is a commonly-accepted practice. The defendants pointed out that even the very early 36(b) cases (including Gartenberg) involved allegations that third parties perform the majority of the work in managing a mutual fund, yet the adviser defendants had prevailed nonetheless.
The defendants emphasized that a disproportionality standard must be used in determining whether the advisory fee is excessive, and that the Gartenberg factors inform whether the fee is disproportionately large. In particular, the defendants stated that the law is clear that the business judgment of a fully informed board of trustees is subject to commensurate deference, and if the board process has no defect, it is extremely difficult to show that the fee is disproportionate. The defendants emphasized that while there may be a few quibbles about the process utilized by the Sivolella Funds’ Board of Trustees (Board), a number of facts (such as the independence of the great majority of trustees) are not in dispute. The defendants argued that the Board was given a substantial amount of material (including information as to each of the Gartenberg factors), and while it is always possible for a plaintiff to identify some additional piece of material that it can allege should have been given to the board, the pertinent standard is whether the board was given sufficient information to render it fully informed with respect to the management agreement.
In closing, the defendants urged the district court to consider whether, even giving plaintiffs the benefit of the doubt, it would be possible to find at trial that the fees charged were so disproportionately large that they could not be the result of an arm’s length bargain. The defendants submitted that no issue of material fact existed with respect to the key issues relating to the Gartenberg analysis, and that there was no need for a lengthy trial on the few disputes of fact that might exist.
Argument by Plaintiffs
Plaintiffs asserted that there was a dispute of material fact as to every one of the Gartenberg factors.
Beginning with the nature and quality of services provided, the plaintiffs argued that the evidence showed that substantially all advisory services were delegated to the sub-adviser, and day-to-day administration of the fund was delegated to a sub-administrator. Various other services provided were allegedly either only provided for a discrete period in time or insufficient to justify the amount of fees charged. With regard to the quality of services, the plaintiffs asserted that performance is the most important indicia of the quality of services, and nine of the twelve funds performed worse than their fund comparison groups.
Regarding profits realized by the adviser, the plaintiffs stated that although the existence of profits is undisputed, the profit margin is disputed. Furthermore, the plaintiffs’ expert asserted that FMG’s practice of charging the Sivolella Funds for “AXA allocated costs” was improper and was in compensation for allegedly duplicative services, creating yet another issue of material fact. The plaintiffs’ expert also disputed the validity of the fee comparisons considered by the Board, and asserted that the appropriate comparison should be between fees and costs. Notably, the plaintiffs did not present argument on economies of scale.
Moving to fall-out benefits, the plaintiffs asserted that various benefits enjoyed by AXA resulted from AXA’s relationship with the Sivolella Funds. Regarding Board process, the plaintiffs pointed out that their expert had found the Board’s process to be “abysmal.” The plaintiffs asserted the Board was not fully informed because it had not been given information valuing the fall-out benefits accruing to the adviser. The plaintiffs also alleged that the Board was not aware of various other agreements that AXA and FMG had to delegate the services provided to the Sivolella Funds. The plaintiffs argued that, as a result, an issue of fact existed as to whether the Board was fully informed.
The District Court’s Decision
Very shortly after the conclusion of oral argument, the District Court read from the bench an opinion that appeared to have been previously composed. The District Court began by providing an overview of the law governing claims under section 36(b), including the decisions in Gartenberg and Jones. The District Court stated that it found issues of material fact with regard to each area of the Gartenberg analysis.
With regard to the nature and quality of services, the court indicated that the plaintiffs had alleged that FMG provided de minimis services to the Sivolella Funds, whereas the defendants had argued that FMG provided substantial services. The court stated that this disagreement regarding whether services were de minimis, or were as argued by FMG, created a “substantial issue of fact.”
The court similarly found that because it must consider and evaluate the expert testimony submitted by both parties regarding performance and comparative fee methodology, denial of summary judgment was required.
With regard to economies of scale, the court recognized that the cost of providing services to a mutual fund does not grow in proportion to the size of the fund, such that fees must be reduced as assets under management increase. The plaintiffs submitted that the defendants had failed to pass along economies of scale; the defendants alleged that the plaintiffs had failed to prove the existence of economies of scale, and that section 36(b) does not require an adviser to pass on all the benefits of economies of scale. The court found this dispute to present a “clear question of material fact” that could not be determined at the summary judgment stage. The dispute over the existence and valuation of fall-out benefits was similarly found to create an issue of fact.
Finally, the court found that an issue of material fact existed as to whether the Board was fully informed and had been provided with sufficient materials to warrant judicial deference to the Board’s decision to approve the advisory agreement. The plaintiffs had alleged that the Board was not provided with material information, including: the amount of fall-out benefits; the proper way to allocate expenses; the fact that the fees paid to the sub-adviser were paid directly by the Sivolella Funds; and various other agreements delegating services provided to such funds.
In light of the number of disputes of material fact, the District Court found that the case was “certainly not subject to summary judgment” and denied the motion.
Plaintiffs show no sign of slowing their increasingly aggressive assault on the mutual fund advisory model. In light of the outcomes in both the Jones II and Sivolella cases, continued attention should be paid to this evolving field.