On February 28, 2017, a New Jersey federal court ruled in favor of a mutual fund adviser alleged to have received excessive fees because it delegated certain services to sub-advisers. In Kasilag v. Hartford Investment Financial Services, LLC, No. 1:11-cv-01083-RMB-KMW (D.N.J. Feb. 28, 2017), the district court ruled that the plaintiffs failed to meet their burden of proof under Section 36(b) of the Investment Company Act of 1940. This ruling is significant as there are many similar lawsuits pending around the United States involving the use of sub-advisers, and it is the second trial victory in the last six months for mutual fund advisers under Section 36(b).
Following a four-day bench trial, the court issued a 70-page decision, which dismissed the case and entered judgment in favor of the defendants. Prior to trial, the court ruled in favor of the defendants at the summary judgment stage on the issue of independence and conscientiousness of the board. Thus, the trial centered on the remaining so-called Gartenberg factors, described below. The court ultimately balanced those factors in favor of the defendants, ruling that the plaintiffs failed to present evidence demonstrating that the fees the defendants received 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.
Kasilag v. Hartford follows the recent (and also significant) ruling in Sivolella v. AXA Equitable Life Ins. Co. No. 3:11-cv-04194-PGS-DEA (D.N.J. Aug. 25, 2016), where the district court similarly ruled in favor of the mutual fund adviser following a lengthy trial. (The Sidley Update on Sivolella v. AXA is linked here.) Thus, it remains the case that no plaintiff has ever successfully proven its claims under Section 36(b), and the rulings in Kasilag v. Hartford and Sivolella v. AXA provide important guidance to advisers and fund directors.
The following are some highlights of the court’s ruling in Kasilag v. Hartford:
Nature of the Adviser’s Services: The plaintiffs argued that the defendants provided minimal services in exchange for the fees they received and that the services defendants delegated to the sub-advisers should be excluded from consideration under Section 36(b). The court rejected the plaintiffs’ theory, finding that the services of the sub-adviser are relevant to its analysis of the nature of the adviser’s services. The court was also unpersuaded by the plaintiffs’ contention that less than one full-time employee was devoted to each at-issue fund. Further, the court ruled that plaintiffs failed to prove that the nature of all services provided to the fund (whether performed by the adviser or delegated by the adviser to a sub-adviser) indicate that the fees were excessive. The court found this to be particularly true in light of the risks borne by the defendants in their provision of services to the funds, including entrepreneurial risk, reputational risk and legal/regulatory risk.
Quality of the Adviser’s Services (Performance of the Funds): The court considered the performance of the funds as indicative of the quality of services provided by the adviser. The court found that five out of six of the funds at issue performed strongly. Regarding the sixth fund, the court found that its generally weak performance tipped “very mildly” in the plaintiffs’ favor. The court also rejected the plaintiffs’ argument that the funds’ failure to exceed their benchmarks necessarily meant that the funds performed poorly, finding instead that benchmarks are just one metric for evaluating performance.
Profitability: The plaintiffs contended that, for the purposes of computing profitability, the defendants should not treat sub-adviser costs as a direct expense and should instead exclude them entirely from the profitability calculation. The court rejected the plaintiffs’ theory, relying heavily on GAAP principles that treat sub-advisory fees as an expense. The court also criticized the plaintiffs for failing to present any evidence to support their position that sub-advisory fees should be excluded from the profitability analysis. In so ruling, the court noted that the adviser “retained” upwards of 75 percent of the overall management fee and paid the remaining smaller portion to sub-advisers.
Comparative Fee Structures: The defendants presented evidence of two methodologies by which to analyze comparative fee structures: Lipper peer groups and the peer groups selected by their expert, each of which demonstrated that the at-issue funds had “generally median fee levels” as compared to peer funds. In contrast, the plaintiffs failed to present any evidence of comparative fee structures at trial, instead emphasizing the unimportance of this factor. The court disagreed with the plaintiffs, finding that comparative fee structures should be considered and that this factor weighed in favor of defendants. Notably, in response to the plaintiffs’ suggestion that Jones v. Harris Associates L.P., 559 U.S. 335 (2010), prohibits comparisons to other funds, the court held that, “[c]ontrary to Plaintiffs’ position, however, ‘not relying too heavily’ on comparisons does not mean ‘not relying at all.’” Further, “[w]ariness of inapt comparisons and an instruction not to rely too heavily upon fee comparisons does not equal an outright bar to the consideration of comparative fee analyses under Jones.” The court also declined to consider evidence related to total expense ratios, but noted it was “inclined to disagree with Plaintiffs” on the issue of whether it would be appropriate to consider such evidence; instead, the court focused on comparative management fees.
Economies of Scale: The plaintiffs conceded that they did not address economies of scale at trial, and the court accordingly held that the plaintiffs failed to meet their burden of proof on this factor. In so holding, the court noted the plaintiffs’ complaint that one of the funds at issue (with assets under management exceeding $11 billion) should have had “breakpoints” above $1 billion.
Fall-Out Benefits: The plaintiffs did not present any argument with respect to fall-out benefits. The court accordingly held that the plaintiffs failed to meet their burden of proof on this factor.