Introduction The U.S. Court of Appeals for the Ninth Circuit recently affirmed the dismissal of an amended complaint asserted by a shareholder of the Davis New York Venture Fund (the “Fund”) under section 36(b) of the Investment Company Act of 1940 against the Fund’s investment adviser, Davis Selected Advisers, and distributor, Davis Distributors. Turner v. Davis Selected Advisers, LP, No. 13-15742 (9th Cir. Sept. 29, 2015).
The lawsuit, originally filed in the U.S. District Court for the District of Arizona, alleged that defendants breached their fiduciary duties to the Fund by charging excessive advisory and 12b-1 fees. The District Court dismissed the Amended Complaint with prejudice and denied plaintiff’s efforts to obtain leave to file a second amended complaint. The Ninth Circuit affirmed.
Summary At the outset, the Ninth Circuit noted that in evaluating an investment adviser’s fiduciary duty under section 36(b), a court takes into account both procedure and substance. With respect to procedure, the level of deference a court affords a mutual fund’s board of directors’ decision to approve a certain fee depends on the “robustness” of the board’s process for reviewing that contract. As for substance, courts apply the so-called “Gartenberg factors” affirmed by the U.S. Supreme Court in Jones v. Harris Assocs., L.P., 559 U.S. 335 (2010), to determine 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.”
With respect to advisory fees, the Ninth Circuit concluded that plaintiff’s comparison of the fees charged to the Fund—an actively managed fund with a large cap focus—to the fees charged to the S&P 500 Total Index Return Fund—an index fund—were entirely inapt. The Ninth Circuit found plaintiff’s comparisons to fees charged by other mutual funds, absent allegations about the services provided to or strategy followed by those funds, to be similarly inappropriate. And the court found plaintiff’s allegations concerning economies of scale to be conclusory and insufficient to save the Amended Complaint from dismissal.
Turning to 12b-1 fees, the court found plaintiff’s allegations similarly deficient. First, plaintiff alleged that the service fee is used in part to grow the fund, such that the resulting increase in the advisory and TA fees constituted fall-out benefits. The court concluded that advisory and TA fees would always increase as a result of fees used to grow the assets in the fund and, in any event, calling it a fall-out benefit “says nothing about whether the service fee here fails to resemble what would be the product of arm’s-length bargaining.” Next, the court rejected plaintiff’s contention that it was improper to charge a 12b-1 fee for services the distributor was required to provide by law or regulatory requirement: “A legal obligation to perform certain services, however, is not an obligation to perform those services for free.” Next, the court found insufficient plaintiff’s comparison of the 12b-1 fees charged to the Fund, to the fees charged to other funds, absent some explanation of what 12b-1 services were provided to the other funds. Finally, plaintiff found no traction arguing that the 12b-1 fees were improperly used for post-sale shareholder services (as opposed to activity primarily intended to result in the sale of shares). The court held that “a claim challenging the use, as opposed to the size, of a fee is not cognizable under § 36(b).” The court also concluded in any event that plaintiff did not have standing to challenge the 12b-1 fees because he held Class A shares, which were not assessed 12b-1 fees and, therefore, he had not suffered any injury.
Conclusion The decision highlights both the substantial hurdles that plaintiffs face in stating a claim under section 36(b), as well as the importance of a thorough section 15(c) process. Fund directors should always engage in a vigorous review process when approving the fees to be charged to shareholders. As long as the process was not deficient, and the board had available to it “data necessary to determine whether” the fees were appropriate, courts will typically afford fitting deference to the board’s fee decisions.
Here is a copy of the Ninth Circuit’s Decision.