On July 24, 2017, the U.S. Court of Appeals for the Eighth Circuit affirmed a district court ruling that a shareholder of a fund of funds lacks standing under Section 36(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), to challenge investment advisory fees paid by the underlying funds.

The plaintiff, a 401(k) plan on behalf of its participants, originally sued the investment adviser of six target-date funds in which it invested. The target-date funds are structured as “fund of funds” and invest in other mutual funds (“underlying” or “acquired” funds) managed by the same investment adviser. The plaintiff alleged that the investment adviser breached its fiduciary duty under Section 36(b) of the 1940 Act and sought to recover “unfair and excessive fees.” Each target-date fund charged an advisory fee of 0.03% of total net assets. The acquired fund fees and expenses (“AFFE”) for each target-date fund ranged from 0.59% to 0.75% of the fund’s total net assets. The plaintiff did not challenge the target-date funds’ advisory fees, but only the AFFE.

Section 36(b) of the 1940 Act limits shareholder suits to breaches of fiduciary duty regarding compensation of payments paid by a mutual fund or its shareholders. The plaintiff argued that it had standing to challenge the underlying funds’ fees to the extent that they were paid indirectly by the target-date funds. The court rejected this argument.

Here, the acquired fund fees at issue were paid by the underlying funds, which are separate investment companies, not by the [target-date funds] in which [plaintiff] was a shareholder. As with any enterprise, adviser fees and other costs reflected in the AFFE reduced the net asset value of the underlying fund paying the fees, which in turn reduced the value of the [target-date funds’] shareholdings in the underlying fund. But the mere reduction of an asset’s value does not mean that the reduction was paid by the asset’s investors. To take an example from the corporate world, an increase in a subsidiary’s operating expenses adversely affects the value of the parent corporation’s investment, but the increased expense is not paid by the parent corporation or its shareholders.

The plaintiff also argued, among other things, that the district court’s ruling “would allow excessive fees to be buried at the underlying fund level and render the fees immune from any challenge under Section 36(b) where most or all of the underlying funds are held by the funds of funds.” The court noted that, in this case, unaffiliated investors hold varying percentages of the outstanding shares of the underlying funds. The court said that the independent directors of each fund would still have responsibility to rigorously review management fees, and the SEC would have authority to bring Section 36(b) actions.

Our Take

Section 36(b) provides a private right of action solely to “a security holder of [a] registered investment company on behalf of such company, against [its] investment adviser,” and it limits such claims to those regarding compensation or payments of a material nature that are paid by the registered investment company or its shareholders. The standard is clear: standing to bring a Section 36(b) case is limited to shareholders of a particular fund. This decision represents an appropriate plain meaning interpretation of Section 36(b) of the 1940 Act.

We note that all registered funds must disclose AFFE in their prospectus. These fees are viewed as an expense to be considered by shareholders of a fund in assessing the costs of investing in a particular fund, including its investment management strategy. They are not a fee giving rise to direct potential liability under Section 36(b) of the 1940 Act. To the extent any Section 36(b) cause of action exists with respect to an underlying fund, it belongs solely to the shareholders of that fund.