On February 28, 2017, the U.S. District Court for the District of New Jersey issued its opinion in Kasilag v. Hartford Investment Financial Services, LLC, the second Section 36(b) "excessive fee" case to proceed to trial following the Supreme Court's 2010 decision in Jones v. Harris Associates L.P. The lawsuit was brought by shareholders of six mutual funds advised by defendants Hartford Investment Financial Services, LLC and Hartford Funds Management Company, LLP (collectively, Hartford). The plaintiffs alleged that the advisory fees retained by Hartford, after delegating "virtually all of the actual investment management services and activities" to an unaffiliated sub-adviser, were excessive in relation to the "woefully minimal" services performed by Hartford. Judge Rene Marie Bumb determined that the plaintiffs failed to meet their burden to demonstrate that the defendants charged excessive fees in breach of their fiduciary duty under Section 36(b) of the 1940 Act and ruled in favor of the defendants. In so doing, the court rejected the plaintiffs' "retained fee theory," which sought to limit the court's consideration of the services provided to the funds to those performed directly by the defendants, separate and apart from the services performed by the sub-adviser. Under this theory, the plaintiffs also contended that the fees paid to the sub-adviser should be disregarded (rather than treated as an expense of Hartford) in calculating Hartford's profitability.
Section 36(b) imposes a fiduciary duty on investment advisers with respect to the compensation they receive for providing advisory services to mutual funds and provides fund shareholders with an express private right of action to enforce this duty against advisers and their affiliates that receive compensation from funds. In such cases, the burden of proof rests on the plaintiffs to show, by a preponderance of the evidence, that the advisory fee is excessive, i.e., that the fee is "so disproportionate that it does not bear a reasonable relationship to the service the defendant rendered and could not have been negotiated at arm's-length."
To determine whether an advisory fee is excessive, courts consider the fee in light of the factors set forth in the 1982 decision of the U.S. Court of Appeals for the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc., which was cited with approval by the Supreme Court in Jones v. Harris. These factors are:
- the nature and quality of the services provided by the adviser to the mutual fund;
- the profitability to the adviser of managing the fund;
- "fall-out" benefits;
- 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;
- comparative fee structures with similar funds; and
- the independence and conscientiousness of the independent board members.
The court noted that this is a nonexclusive list of factors and that courts are to consider "all relevant circumstances." The court further stated that Section 36(b) "does not call for judicial second-guessing of informed board decisions" and that courts are to give considerable, but not conclusive, weight to a decision to approve a particular advisory agreement made by independent board members in consideration of the foregoing factors. However, even if a fee is negotiated by a board in possession of all relevant information, the fee may still be excessive if it 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 the Hartford case, the independence and conscientiousness of the independent board members were not in dispute at the trial stage. In addition, despite the court's holding in its earlier denial of the defendants' motion for summary judgment that the issues of fall-out benefits and economies of scale were among the Gartenberg factors that remained in "genuine dispute," the plaintiffs did not address or present evidence regarding those factors at trial. The trial thus focused on questions regarding: (1) the nature of the services provided by Hartford; (2) the quality of the services provided by Hartford, as measured by fund performance; (3) the profitability of the funds, including the methodology of calculating fund profitability; and (4) a consideration of comparative fee structures. A few observations concerning the court's consideration of these factors are as follows:
Nature of services provided. Noting that the advisory agreements expressly contemplated the possibility of Hartford's hiring a sub-adviser, the court determined to consider all services provided under the advisory agreements in exchange for the advisory fee, "regardless whether Defendants performed them or hired others to fulfill their obligations." The court stated that the plaintiffs did not offer evidence showing that the sub-adviser's services were suspect or inadequate. The court also noted the testimony offered by the defendants concerning the services directly provided by Hartford under the advisory agreement, including Hartford's obligation to select and oversee sub-advisers, as well as the entrepreneurial, reputational and legal and regulatory risks borne by Hartford in advising the funds.
Quality of Services Provided. A key consideration regarding the assessment of fund performance in the Hartford case was determining the appropriate metrics. The defendants offered two analyses, one comparing fund performance to Lipper peer groups and another comparing fund performance to the performance of funds in peer groups selected by an expert witness. Based on these metrics, the court found that one fund had strong performance, four funds had generally average performance and another fund (with performance ranging between the 77th and 71st percentiles in its Lipper peer group) had below-average performance. While the plaintiffs attempted to impeach the Lipper comparison on grounds that Hartford had conversations with Lipper that influenced the selection of peer groups for certain funds and that Lipper data may include inaccuracies, the court determined that Lipper's data should not be discounted based on these arguments, noting in particular that Lipper did not simply rubber-stamp the defendants' proposed peer group changes, and found the Lipper data to be reliable. The plaintiffs argued that a proper comparison of fund performance should be a comparison to relevant benchmark indices. However, the court noted that the plaintiffs "presented little evidence that the failure to hit a benchmark is a strong indication of poor performance," noting that benchmark performance numbers do not include fees, and, "[a]s such, in going against a benchmark, a mutual fund begins in the hole."
Profitability and Methodology. As noted above, the plaintiffs in the Hartford case argued for the use of a "retained fee" theory to calculate fund profitability--a methodology that essentially excludes sub-advisory fees from both the numerator and denominator of the profitability calculation and can result in extremely high profit margins. The court rejected this theory, noting that plaintiffs presented no supporting accounting authority for this methodology. Rather, the court cited testimony from both plaintiff and defendant witnesses that generally accepted accounting principles would treat sub-advisory fees as an expense of the adviser. Additionally, the court noted that Section 36(b) has never required a "cost-plus" method of setting profits and, consistent with its inclusion of the services provided by the sub-adviser in assessing the nature of services provided, the court determined to consider profitability inclusive of the sub-adviser's fees.
The court also reviewed the profitability numbers as calculated by Hartford, under which annual adviser profitability with respect to the funds in question ranged as high as 80.3%. The court determined that the plaintiffs failed to meet their burden to establish that the funds were so profitable that their fees could not have been the result of an arm's-length negotiation, noting the testimony of the plaintiffs' expert witness to the effect that profits were "a little high, but could have resulted from an arm's length bargain."
Comparative Fees. Noting the importance of considering fees charged to other funds in determining whether an advisory fee is excessive, the court determined that the evidence presented weighed against a determination that the fees charged by Hartford were excessive. In this regard, the court noted that no fund's fee fell within the bottom tenth percentile of the Lipper peer group or the peer group assembled by the defendants' expert. In addition, while the court was sympathetic to the plaintiffs' argument that certain peer funds' fees may not have been negotiated at arm's length, the court stated that the plaintiffs' arguments did not undermine the generally median fee levels of the funds when compared to those of peers.
The opinion in the Hartford case was issued approximately six months after the opinion following the trial in Sivolella v. AXA Equitable Life Insurance Company, another Section 36(b) case decided in the U.S. District Court for the District of New Jersey, in which the plaintiffs' claim also related to a "manager of managers" model (wherein an adviser relies on sub-advisers to provide investment management services). As in the Hartford case, the court in AXA determined that the plaintiffs had failed to meet their burden to demonstrate that the defendants breached their fiduciary duty in violation of Section 36(b).
The litigation was filed in the U.S. District Court for the District of New Jersey under the name Kasilag et al. v. Hartford Investment Financial Services, LLC et al., Case No. 11-cv-01083.