Within recent weeks, there have been three noteworthy court rulings in pending Section 36(b) cases, with one court granting a motion to dismiss and two different courts fully granting substantive motions for summary judgment.
Section 36(b) of the Investment Company Act of 1940 imposes a fiduciary duty on an investment adviser to a mutual fund “with respect to the receipt of compensation for services, or of payments of a material nature” paid by the fund or its shareholders to the adviser or its affiliates. This section gives mutual fund shareholders a private right of action to enforce that duty. The statute assigns a plaintiff the burden of proof, and the case law makes it clear that a breach may be shown only where the fee 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.” In addition, the section specifically provides that approval by the fund’s board of directors of the compensation or payments “shall be given such consideration by the Court as is deemed appropriate under all the circumstances.”
In Jones v. Harris Associates L.P., the U.S. Supreme Court cited with approval the use of certain non-dispositive factors to assess a Section 36(b) claim that were set forth in an earlier case decided by the Second Circuit, Gartenberg v. Merrill Lynch Asset Management, Inc., but the Supreme Court emphasized the ultimate “arm’s length bargain” standard when assessing this claim. The “Gartenberg factors” are: (i) the nature, extent, and quality of the services provided by the adviser to the mutual fund; (ii) the profitability to the adviser of managing the fund; (iii) “fall-out” benefits; (iv) the existence of any economies of scale achieved by the adviser as a result of growth in fund assets under management, and whether such savings are shared with fund shareholders; (v) fee structures utilized by other similar funds; and (vi) the expertise of the fund’s independent directors, whether the independent directors are fully informed about all of the facts bearing on the adviser’s service and fee, and the extent of care and conscientiousness with which the independent directors perform their duties with respect to the adviser’s fee. Jones emphasizes that the informed decisions reached by a fund’s independent directors deserve special consideration: “a measure of deference to a board’s judgment may be appropriate in some circumstances” and “the appropriate measure of deference varies depending on the circumstances.” Further, where the independent directors “considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently.”
Starting in 2011, a wave of Section 36(b) cases—ultimately totaling more than 20—were filed in federal district courts throughout the country. A number of these cases have now progressed through discovery to the merits stage, with the first trials conducted in 2016 and the pace of summary judgment rulings now increasing. Most recently, there have been three notable rulings: the grant of a motion to dismiss in Pirundini v. J.P. Morgan Investment Mgt. Inc., and full grants of summary judgment in cases against J.P. Morgan Investment Management and Harbor Capital Advisors. The Pirundini motion to dismiss opinion is the only grant of full dismissal for failure to state a claim following the Supreme Court’s Jones decision, and the recent summary judgment rulings are the only two decisions granting summary judgment in full post-Jones.
Pirundini v. J.P. Morgan Investment Management Inc.
On February 14, 2018, the U.S. District Court for the Southern District of New York granted the motion to dismiss filed by defendant adviser J.P. Morgan Investment Management Inc. (JPMIM) in Pirundini v. J.P. Morgan Investment Mgt. Inc., creating a contrast against the number of recent denials of motions to dismiss Section 36(b) claims. In Pirundini, Plaintiff alleged that the fees charged to the J.P. Morgan U.S. Large Cap Core Plus Fund (Fund) were excessive because JPMIM also provided investment advisory services to several other mutual funds and portfolios, including the JPMorgan U.S. Equity Fund (JPM Equity Fund), a mutual fund sponsored by JPMIM and with whom the Fund shared many of the same external service providers, and the Long/Short Large-Cap Portfolio of the PSF Fund (the PSF Fund), a fund sub-advised by JPMIM, which Plaintiff alleged followed comparable investment strategies, for lower fees.
In dismissing Plaintiff’s claim, the Court emphasized that “the standard for breach of fiduciary duty under Section 36(b) neither ‘call[s] for judicial second-guessing of informed board decisions’ concerning fee agreements, nor does it require courts ‘to engage in a precise calculation of fees representative of arm’s-length bargaining.’” The Court highlighted that a complaint need not address all of the Gartenberg factors to survive a motion to dismiss. Nonetheless, the Court analyzed each particular factor in turn, finding the balance weighed in favor of dismissal.
As to the comparative fees Gartenberg factor, Plaintiff compared the fee rates JPMIM charged to the Fund to two different metrics: (1) the fee rates paid by JPMIM’s other mutual fund clients; and (2) the fee rates paid by mutual funds not advised by JPMIM but whose size, character and investment strategy Plaintiff alleged to be comparable. With respect to Plaintiff’s first metric, the Court found the comparison of the fee rate JPMIM charged to the Fund with that charged to the JPM Equity Fund appropriate, as Plaintiff had “adequately alleged that the services [JPMIM] provides to both funds are sufficiently similar for their fee rates to be compared.” The Court held that even though the two funds had different strategies, the fact that they were both managed by the same three employees supported the allegation that the services provided were similar. As to Plaintiff’s second metric, however, the Court held that the complaint failed to “identify how, if at all, the investment advisory services [JPMIM] provides the Fund are similar to those provided to other funds by their respective investment advisers.” Ultimately, the Court found that the comparative fee factor weighed in Defendant’s favor because Plaintiff’s contention that JPMIM charged the Fund a higher fee rate than it charged to the JPM Equity Fund and PSF Fund did not suggest that the fee rate was “necessarily outside the range of what would have been negotiated at arm’s-length.” As the Court cautioned, such a ruling “would open the floodgates” to Section 36(b) claims any time a shareholder could identify a mutual fund that pays a lower fee than the fund in which she chooses to invest.
In addressing the nature and quality of services factor, the Court rejected Plaintiff’s attempt to characterize the nature and quality of services as poor, finding the sole reliance on the Fund’s investment performance insufficient under Second Circuit case law. Further, Plaintiff failed to even allege that the Fund underperformed its peers.
With respect to economies of scale, the Court rejected Plaintiff’s argument that the adviser realized economies of scale, because Plaintiff alleged no facts concerning whether the per-unit costs of performing transactions for the Fund decreased as assets under management grew, as required under controlling precedent. Further, Plaintiff failed to adequately allege that the benefits of the purported economies of scale were not being shared with investors. In fact, Plaintiff’s own assertion that fee waivers were in place for 2015 as the Fund’s assets grew indicated some sharing of economies of scale.
As to Plaintiff’s profitability claim, the Court observed that “Plaintiff claims the Fund must be profitable for [Defendant] because the fees [JPMIM] charges the Fund are high.” In rejecting Plaintiff’s profitability allegation, the Court emphasized that the factual assertions underlying Plaintiff’s claim were insufficient, and more importantly, none suggested that the Fund was particularly profitable.
With respect to fall-out benefits, the Court credited, to a small extent, Plaintiff’s argument that as a result of the services it provided to the Fund, JPMIM was able to provide the PSF Fund almost identical services that it provided to the Fund at no extra cost and with significant profits. However, the Court rejected Plaintiff’s other argument—that as a result of serving as the Fund’s investment adviser, JPMIM and its affiliates were engaged to provide numerous other services to the Fund pursuant to separate contracts for substantial pay—concluding that this could not qualify as a fall-out benefit. As the Court explained, it was just as likely that JPMIM and its affiliates would have been retained to perform these separate services even if JPMIM did not provide investment advisory services to the Fund, and in fact, their retention for other services was far more likely attributable to the Fund having been established by JPMIM than by the fact that JPMIM provided investment advisory services to the Fund.
As to the care and conscientiousness of the independent trustees of the Fund’s Board, Plaintiff conceded that she had no independent knowledge of the circumstances under which the Board evaluated and approved the management agreement and fees. Rather, Plaintiff’s allegations as to this remaining Gartenberg factor relied entirely on the report of the approval process in the Fund’s public SEC filings. The Court rejected Plaintiff’s allegations that the Board had been provided incomplete information and did not engage in a good-faith process, finding that Plaintiff had failed to identify facts supporting the claim that the Board’s approval process was deficient. Because Plaintiff’s allegations focused on the merits of the Board’s conclusions as opposed to the process, there was no basis to conclude that the Board did not exercise care and conscientiousness.
Based on its finding that Plaintiff’s allegations failed to support a reasonable inference that the fees charged to the Fund 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, the Court held Plaintiff had failed to state a claim for relief under Section 36(b) of the Investment Company Act of 1940.
Plaintiff has appealed this ruling to the Second Circuit Court of Appeals.
Goodman v. J.P. Morgan Investment Management, Inc.
On March 9, 2018, the U.S. District Court for the Southern District of Ohio granted a motion for summary judgment in Goodman v. J.P. Morgan Investment Management, Inc. In this case, Plaintiffs alleged that the fees JPMIM charged to advise seven mutual funds were excessive under Section 36(b) because they were greater than the fees JPMIM charged to sub-advise other funds utilizing the same strategy. Plaintiffs brought a similar claim against the administrator to the mutual funds, alleging that the administrative fees charged were excessive because they were greater than fees charged by other administrators, and that the administrative services provided duplicated services provided by other vendors.
In ruling on Defendants’ motion for summary judgment, the Court first addressed the comparative fees aspect of the Gartenberg analysis. With regard to Plaintiffs’ advisory fee claim, the Court ultimately rejected the argument that Plaintiffs’ comparison to the fees JPMIM charged to sub-advise other funds established that the fees charged to advise the mutual funds at issue were excessive, finding that “even assuming arguendo that some of the services provided as adviser and as subadviser are ‘substantially’ the same, Defendants have presented uncontroverted evidence that the risk undertaken and scale of services are different.” The Court noted that even Plaintiffs’ expert “acknowledged that [JPMIM] assumed ‘a variety of different risks’ in its two roles as adviser and subadviser.” As to Plaintiffs’ administrative fee claim, the Court noted that Plaintiffs’ expert himself admitted that a fund should not always necessarily hire the administrator that charges the lowest fee, because different administrators can provide varying qualities of services. The Court observed that, “[t]he differences in the comparison evidence are material and, even when viewing the evidence in the light most favorable to Plaintiffs, the evidence is insufficient to raise any issue of material fact as to this Gartenberg factor.”
As to the economies of scale Gartenberg factor, Plaintiffs argued that the adviser had realized economies of scale, but that the Funds’ advisory fee schedules did not include breakpoints and the fees charged to the funds had not changed at all or had changed very little. In rejecting Plaintiffs’ contention, the Court noted that fee waivers were in place for the Funds. The Court further observed that whether the advisory fees “could have been set at a lower level is not the issue. The issue is whether the board could have agreed to the [fees] being set at those levels after engaging in good faith negotiations.” The Court found that “there is simply no indication that the Board could not have agreed to the level of fee waivers [in place for the Funds] after engaging in good faith negotiations.”
With regard to Plaintiffs’ “fees and performance” allegations, the Court noted that Plaintiffs did not allege that the funds performed poorly, but only that the at-issue funds were “too profitable for their fee contracts to be the product of arm’s length negotiations.” In response, Defendants pointed to: (i) fee waivers implemented by the adviser and the administrator; and (ii) comparisons to the fees paid by other peer funds as identified by respected independent third party Lipper and disclosed to the independent trustees of the Funds’ Boards (Independent Trustees). Defendants argued that the fees paid by the funds were in line with the fees paid by peer funds, and that the funds delivered strong performance. Although Plaintiffs attempted to challenge the comparability of the peer funds identified by Lipper, the Court found that “Plaintiffs have provided no evidence to support their contention that the comparators used by the Lipper reports are not relevant.” In contrast, “Defendants have presented undisputed evidence that, among mutual funds, the Funds’ fees fall within the range of those comparators [identified by Lipper], and are not ‘disproportionately large.’” Further, “the Funds’ performance is generally favorable, and certainly within a ‘range of acceptable results.’”
Finally, with regard to the independence and conscientiousness of the funds’ Independent Trustees, Plaintiffs argued that “minimal, if any deference” was due to the Independent Trustees’ approval of the funds’ fees because Defendants allegedly failed to provide sufficient information to permit the Independent Trustees to be fully informed about the fees charged to the funds. The Court held that “Plaintiffs have pointed to no irregularities or deficiencies in the Board’s conduct, nor do they allege that the Board completely failed to consider the fees of subadvisory and subadministrative contracts.” Further, “Plaintiffs ‘must demonstrate that the flaws they find in what transpired would have made a legally significant difference.’” Plaintiffs’ evidence, in contrast, “establishes at most that others paid different amounts for fewer services,” but “does not allow a reasonable inference that the amounts paid to the Funds were outside of the range that could be expected to result from arm’s length bargaining.” As a result, the Court found that Defendants were entitled to summary judgment on Plaintiffs’ advisory and administrative fee claims.
Plaintiffs have appealed this ruling to the Sixth Circuit Court of Appeals.
Zehrer v. Harbor Capital Advisors, Inc.
On March 13, 2018, the United States District Court for the Northern District of Illinois granted the adviser’s motion for summary judgment in Zehrer v. Harbor Capital Advisors, Inc. That case challenged the advisory fees paid by two funds advised by Harbor Capital Advisors, Inc. (Harbor Capital) as excessive based on the argument that the fees were too high because Harbor Capital delegated a majority of its duties to sub-advisers, which received part of the fee paid by the funds, and thus the portion of the fee retained by Harbor Capital was excessive.
The Court began its analysis by determining the amount of deference that should be given to the approval of the funds’ advisory agreement by the independent trustees of the funds’ Board. The Court rejected Plaintiffs’ allegations that no deference should be granted to the Board’s decision-making process because: (1) the Board did not “actively negotiate the lowest possible fee;” (2) the Board did not request additional information or retain third parties to analyze the profitability materials it received; and (3) the Board had “conflicts of interest.”
The Court first addressed Plaintiffs’ claim that the Board was “passive” because it failed to negotiate fee reductions or additional breakpoints. The Court found that “Plaintiffs point to no admissible evidence in the record to support an argument that circumstances supported an adjustment of the fee or the addition of breakpoints,” noting that “[e]ven if the Board might have driven a harder bargain, the legal standard does not require that.” Nor did the Court credit Plaintiffs’ argument that a recent period of underperformance meant that the services provided by the adviser were inadequate such that the adviser should be replaced.
The Court next considered Plaintiffs’ argument that the sub-advisory fees paid by the funds should be treated as “contra-revenue,” or subtracted entirely from the profitability calculation, rather than being treated as an expense of the adviser. The Court noted that the Board in fact received profitability calculated in two ways, one treating sub-advisory fees as an expense of the adviser, and one excluding sub-advisory fees as Plaintiffs had endorsed. The Court ultimately held that “Plaintiffs may disagree with the Board’s evaluation of the information, but that disagreement does not raise a triable issue of fact regarding the Board’s diligence where it is undisputed that plaintiffs’ preferred method was considered and rejected.”
The Court also rejected Plaintiffs’ claim that conflicts of interest compromised the Board’s ability to serve a watchdog function on behalf of the funds. The Court noted that there was no dispute that the Board satisfied the Investment Company Act of 1940’s requirement that at least 40 percent of the Board not be “interested persons” as that term is defined in the Act. Instead, Plaintiffs argued that the Board had a “cozy relationship” with the adviser and was unwilling to push back. The Court found that “Plaintiffs point to no evidence in the record from which a reasonable trier of fact could conclude that any trustee’s private interests were in conflict with their duty to the Funds’ shareholders.”
Having concluded that “the Board’s decision is due substantial deference,” the Court proceeded to consider whether Plaintiffs had identified any “additional evidence that the fee is outside the range of fees that could be reached through arm’s-length bargaining.” Accordingly, the Court next moved to a discussion of the remaining Gartenberg factors.
With regard to the nature and quality of services Gartenberg factor, Plaintiffs argued that only the advisory services directly provided by Harbor Capital should be considered when determining whether the fees retained by Harbor Capital were excessive, and those provided by sub-advisers should be excluded. The Court rejected this contention, instead agreeing that “the combined services should be considered against the entire advisory fee.” The Court observed that the investment management agreements between Harbor Capital and the Funds “explicitly permit Harbor [Capital] to retain subadvisers,” and that since Harbor Capital secured the services the sub-advisers provided to the Funds, those services should also be taken into account when considering the services Harbor Capital provides.
The Court also credited the adviser’s argument that the performance of the funds, which performed well compared to peer funds, supported Harbor Capital’s position that it had provided high-quality services provided to the funds. In so holding, the Court rejected the plaintiffs’ claim that the Court should limit its consideration of fund performance to the “damages period” beginning a year prior to the filing of the lawsuit through the present. As the Court further observed, “[e]valuation of performance as it relates to the adviser’s compensation will always be a retrospective inquiry,” since investment performance can be neither predicted nor guaranteed.
Turning to the comparative fees factor, the Court found that “plaintiffs do not point to evidence in the record indicating that Harbor Capital’s fees are higher than those of comparable firms.” Although the Court agreed with Plaintiffs that the fees that should be compared were the advisory fees rather than the total expense ratios, the Court held that the comparable fee information provided by independent third-party Lipper to the Independent Trustees was sufficient, and that Plaintiffs could not show that Harbor Capital had “manipulated the Lipper materials” as Plaintiffs claimed.
With respect to the profitability Gartenberg factor, the Court rejected Plaintiffs’ core argument that the fees paid to sub-advisers should be treated on a “pass through” basis such that they were entirely subtracted from the profitability calculation, a treatment that would raise the profit margins reported by Harbor Capital. The Court observed that “plaintiffs do not dispute that the inclusion of the subadviser fees in Harbor Capital’s expenses is consistent with generally accepted accounting practices (GAAP) for financial accounting.” Instead, Plaintiffs argued that mutual fund accounting need not follow GAAP, but that managerial accounting requires the use of Plaintiffs’ “net-profitability’ metric.” As the Court noted, however, “Plaintiffs point to no case law holding that profitability should be reported in the manner they advocate,” and that the “only cases directly on point” rejected Plaintiffs’ argument. Additionally, the Court again observed that the Board received profitability materials containing profit calculations both including and excluding the sub-advisers’ fees. As a result, Plaintiffs’ argument boiled down to “Monday-morning quarterbacking of the Board’s weighing of Harbor Capital’s profitability” that could not “create a triable issue of fact on this factor.”
Finally, the Court addressed Plaintiffs’ economies of scale and fall-out benefit arguments. The adviser pointed to Plaintiffs’ failure to identify “evidence that the total per-unit cost of servicing the Funds declined as the Funds grew in size,” as well as the fact that Harbor Capital had shared any economies of scale it realized through contractual breakpoints and annual fee waivers. Characterizing Plaintiffs’ arguments to the contrary as “highly cursory,” the Court held that Plaintiffs’ economies of scale arguments were insufficient to raise “triable issues of fact.” As to fall-out benefits, Plaintiffs argued that Harbor Capital realized fall-out benefits in the form of distribution and transfer agency fees paid to wholly owned subsidiaries of Harbor Capital. The Court rejected this argument as well, indicating that Plaintiffs had failed to “point to any evidence or make any argument for why these fees, which were known to and approved annually by, the Board, and paid directly by the Funds, militate towards a finding that the advisory fee charged by Harbor [Capital] is excessive.”
As a result, finding that Plaintiffs had failed to identify any genuine issue of material fact as to any Gartenberg factor, the Court found summary judgment appropriate.