Sub-adviser fees have garnered the attention of plaintiff lawyers bringing excessive fee claims against mutual fund advisers -- not because they are alleged to be excessive but because they allegedly demonstrate that the investment management fees retained by the adviser are excessive. According to the Investment Company Institute, as of April 2009, nearly 40 percent of mutual funds had at least one sub-adviser. For its services, a subadviser is typically paid a portion of the investment management fee charged by the fund's "principal" investment adviser. Although no court has ever found an adviser's fee to be excessive, a number of complaints have been settled. The latest excessive fee cases are noteworthy for their focus on advisers who hire sub-advisers and the alleged significance of sub-advisory arrangements in determining whether the fees retained by the adviser are excessive.
Under Section 36(b) of the Investment Company Act of 1940, mutual fund advisers are deemed to have a fiduciary duty with respect to the receipt of compensation for services by their funds. The long-standing judicial test of whether a fee is "excessive" -- and thereby a breach of the adviser's fiduciary duty -- is whether the fee "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 determining whether a fee is excessive, courts generally must consider all pertinent factors. Traditionally, courts have considered the following factors:
- the nature, extent, and quality of the adviser's services
- the investment performance of the fund and the adviser
- the costs incurred and profits realized by the adviser and its affiliates
- the extent to which economies of scale are realized and shared with investors
- comparisons of the services provided and fees charged by the same and other advisers to other mutual funds or other types of clients
- any ancillary benefits the adviser and its affiliates may derive such as soft dollars
- the diligence of the fund board in approving the investment advisory contract
These factors and the related judicial test are sometimes referred to as the Gartenberg standard, so named after the 1982 Second Circuit case that first established the judicial test for evaluating excessive fee claims. This has not deterred plaintiffs from bringing cases to test new theories. For example, plaintiffs have brought cases challenging advisory fees on the basis that the "disinterested" directors of unitary fund boards lacked independence when they approved the funds' advisory contracts because of the aggregate amount of compensation they received from the funds they oversaw. More recent cases have challenged advisory fees on the basis that the adviser charged far less to pension funds or other institutional clients for similar services, while other cases have challenged advisory fees by questioning the adviser's veracity and good faith in negotiating with the fund board during annual contract renewals. In 2010, the U.S. Supreme Court approved the Gartenberg standard in its decision in Jones v. Harris Associates, which considered, among other things, the relevancy of fees charged by mutual fund advisers to other clients.
This brings us to the latest round of excessive fee cases. The most recent case, Sivolella v. AXA Equitable Life Insurance Company and AXA Equitable Funds Management Group, LLC. , was filed in July in the United States District Court of the District of New Jersey. The lawsuit was brought derivatively by a single shareholder on behalf of eight sub-advised AXA funds seeking recovery under Section 36(b) of the Investment Company Act for alleged excessive fees paid to the adviser for investment management services. To our knowledge, this is the first lawsuit involving insurance product funds that focuses on subadvisory arrangements.
The crux of the plaintiff's allegations is that the sub-adviser provides all or nearly all the investment management services for a fraction of the investment management fee, while the adviser provides little or no investment management services yet keeps for itself the bulk of the investment management fee. The plaintiff further alleges that because the sub-adviser provides all or nearly all the services, its fee is representative of what the investment management fee should be as the result of arm's-length bargaining, and that, accordingly, the portion of the fee retained by the adviser is unreasonable and excessive.
The complaint itself, however, is structured around the traditional Gartenberg factors. For example, the plaintiff alleges that the nature and quality of the investment management services performed (as well as the costs and profitability of providing such services) did not justify the management fees charged to the AXA funds, in light of the fact that the adviser had delegated virtually all of its duties to sub-advisers at a fraction of the fees collected from the funds and performed little, if any services, to the funds. To illustrate the point, the complaint includes a table that shows the advisers retained between roughly 71% and 94% of the entire advisory fee on the AXA funds, while the sub-advisers kept the remaining portion. The plaintiff claims that these markups were disproportionate to the services actually rendered by the adviser and resulted in exorbitant profits to the adviser, thereby constituting a breach of the adviser's fiduciary duty to the AXA funds.
The complaint also asserts that because the adviser provides little or no services, any economies-of-scale benefits that the adviser has realized have not been adequately shared with investors. The plaintiff further alleges that the fund board's advisory contract approval process lacked "the requisite integrity, care and good faith" and was, therefore, defective because, among other reasons, the board knew, or should have known, about the disparities between the advisory and sub-advisory fees and related services. Lastly, the complaint draws comparisons against fees charged to certain Vanguard funds for allegedly similar investment management services. The plaintiff contends that the fee comparisons demonstrate that the fees charged to the AXA funds were much higher than what would been charged had the fees been bargained at arms-length. The plaintiff seeks recovery of the alleged improper payments, or alternatively, rescission of the investment management agreements and restitution of all fees paid.
Last year, two other actions were filed in federal courts containing allegations similar to the ones made in the AXA Equitable complaint regarding subadvisory arrangements. One action was filed in the U.S. District Court of the District of Delaware, entitled Southworth, et al. v. Hartford Financial Services, LLC. The other action was filed in the U.S. District Court of the Southern District of Iowa, entitled Curran et al. v. Principal Management Corporation et al. Both were filed as derivative actions seeking recovering under Section 36(b) of the Investment Company Act for alleged excessive advisory and distribution fees. In Curran, the court ruled against a motion to dismiss, thereby allowing excessive fee claims to proceed against the investment adviser to two sub-advised funds of funds. The court dismissed similar claims involving the funds of funds' underlying funds on standing grounds. The case is now pending trial.
On the other hand, in Southworth, the court entered an order on September 13th granting the defendant's motion to dismiss the complaint for failure to state a claim under Section 36(b), though it also gave the plaintiff until November 14th to amend the complaint. While the court did not give an opinion for the dismissal -- at least not yet -- the defendant argued that the facts alleged in the complaint with respect to the investment management fees are based on nothing more than "conclusory assertions" and general criticism of the mutual fund industry's fee structures, and that such sparse allegations are insufficient to make out a plausible claim under the heightened pleading standard set out in the U.S. Supreme Court's decisions in Iqbal1and Twombly2 . With respect to the allegations comparing the investment management fees to the fees paid to the funds' sub-advisers in particular, the defendant argued, among other things, that those comparisons do not plausibly show the adviser's fees to be excessive because they are not supported by specific factual allegations about the services provided by the adviser. Thus, "the Complaint's bare-bones conclusion that the sub-advisers are providing essentially all investment management services for only a fraction of the fee is not based upon sufficient factual allegations to make out a plausible claim."
While the final disposition of the case is still unknown, the ruling to dismiss the excessive fee claims in Southworth is obviously a welcomed result for the mutual fund industry. It also stands in contrast to Curran where the court specifically cited the plaintiff's the-sub-adviser-does-all-the-work allegations in denying the motion to dismiss in that case. In its briefings, the defendant in Southworth distinguished the Curran decision by noting that the court in that case emphasized that the funds paid "four layers" of advisory and subadvisory fees arising from the funds of funds structure at issue, whereas in Southworth there was no allegation that shareholders paid multiple times for overlapping and repetitive services. Notably, the defendant also argued that the Curran decision was wrongly decided, citing no Section 36(b) case law in support of its decision that the factual allegations were sufficient to state a claim.
The Curran decision is problematic to the extent it can be read to suggest that conclusory allegations regarding an adviser's services and the fees in comparison to those of the sub-adviser are sufficient to state a claim under Section 36(b). Fortunately, the court in Southworth appears to have rightly rejected such an approach.
Although the plaintiffs in Curran may now have the advantage of being able to conduct discovery, it is worth noting that they also carry the burden of proof to show that the adviser's fees were, in fact, excessive under the Gartenberg standard. Because fund advisers typically provide extensive administrative and investment management services that the sub-adviser does not provide, we expect that most fund advisers finding themselves in the circumstances of the Curran defendants would be able to readily show the hollowness of the allegation that the adviser's fee is excessive. Indeed, the Southworth defendant emphasized in its briefings the obvious contradiction between the plaintiff's allegations and the extensive administrative and investment management services provided by the defendant as detailed in its investment management agreement with the subject funds.
Thus, while it still remains to be seen whether plaintiffs' latest theory will have any greater success this time around, for nearly 30 years now, the Gartenberg standard has proven -- and continues -- to be a significant barrier for plaintiffs to overcome.