On August 25, 2016, the US District Court for the District of New Jersey issued its opinion in Sivolella v. AXA Equitable Life Insurance Company following a 25-day, non-jury trial. The lawsuit was brought by holders of variable annuity contracts with AXA Equitable Life Insurance Company (AXA) who had allocated assets to twelve mutual funds in EQ Advisors Trust (the Trust) managed by AXA Equitable Funds Management Group, LLC (FMG). Plaintiffs had alleged that FMG charged exorbitant fees for investment management and administrative duties while delegating substantially all of those same duties to sub-advisers and sub-administrators for nominal fees. In a lengthy analysis of testimony and evidence, Judge Peter G. Sheridan concluded that plaintiffs failed to meet their burden (1) to demonstrate that defendants breached their fiduciary duty in violation of section 36(b) of the 1940 Act, and (2) to have shown any actual damages. In an order accompanying the opinion, the case was dismissed with prejudice.
Section 36(b) imposes a fiduciary duty on mutual fund investment advisers with respect to the receipt of compensation for services and provides shareholders with an express private right of action against advisers and affiliates receiving compensation from funds to enforce this fiduciary duty. The burden of proof rests with plaintiffs to show that the adviser's 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," the standard that was embraced by the US Supreme Court in its 2010 decision in Jones v. Harris Associates L.P.
Notably, the AXA case is the first 36(b) lawsuit to proceed to trial since the Jones decision and the first to trial on a socalled "manager of managers" theory of liability, relating to circumstances in which an adviser relies on sub-advisers to provide investment management services. In cases brought on this theory, plaintiffs generally assert that sub-advisers perform most or all of the services, but receive only a "fraction" of the fee paid to the delegating adviser/manager.
A few observations about the AXA decision are as follows:
Analysis of Services Provided Beyond Contractual Terms: The crux of plaintiffs' claim was that the fees paid to FMG were unjustified by the services FMG provided to the funds since FMG delegated virtually all of its duties to sub-advisers and sub-administrators and retained a disproportionate amount of the total fees paid by the funds. In evaluating this claim, the court noted that plaintiffs' were "essentially correct" that the services described in the advisory agreements were largely the same as those described in the subadvisory agreements and thus, "may suggest that the sub-advisers perform a majority of the investment management services on behalf of FMG." However, Judge Sheridan rejected plaintiffs' contention that the "plain language of the agreements controls" in determining the extent and scope of services provided. Instead, he adopted defendants' view that to rely solely on the contractual terms "elevates form over substance" and "overlooks crucial evidence demonstrating that FMG retained a substantial amount of work for the Funds." On this issue, the opinion concluded that an analysis must consider the totality of services provided, "whether enumerated in a contract or undertaken in a manner to carry out the contractual duties." Based on "voluminous testimony of credible witnesses," the court found that FMG performed "significant administrative and investment management duties," including "a number of services beyond those expressly outlined in the agreements."
Assessments of Witness Credibility and Interests of the Parties: Witness credibility had a "significant impact" on the case's outcome. Indeed, Judge Sheridan devoted a significant portion of the opinion to "credibility assessments" of the witnesses appearing at trial, including expert witnesses, and the court's determinations relating to the "appropriate weight to accord their testimony." For instance, the court found that Steven M. Joenk, the President and CEO of FMG and Chairman of the Board of Trustees of the Trust (the Board), "is motivated to ensure that FMG receives higher fees because he serves as the CEO, rather than to protect the interest of investors." The court suggests that "[t]his calls into question whether [Joenk] made accurate statements and presentations to the Board regarding the Gartenberg factors" and assigns a "potential bias" to Joenk's testimony. In addition, the court gave certain plaintiffs' expert witness testimony "little weight" due to inconsistent statements, lack of sufficient preparation and, in one case, an expert's "sarcastic demeanor" and "unprofessional" comments. In contrast, the court found that the lead independent trustee and defense witness, Gary S. Schpero, gave "generally consistent, thorough, and accurate" testimony. Judge Sheridan also reached conclusions about plaintiffs and defendants based solely on attendance at the trial. Noting, in this regard, that only one of the seven plaintiffs testified at or attended the trial, the court concludes that "this lack of attendance demonstrates that Plaintiffs had little interest in the trial or its impact upon them." In contrast, the court notes that Joenk attended nearly all 25 days of the trial, stating that "this juxtaposition between the parties' respective attendance demonstrates that Plaintiffs may not have had a significant issue at stake."
Statutory Inconsistencies and the Parties at Issue: In the introductory portion of the opinion, the court reviewed the statutory cause of action under section 36(b) of the 1940 Act, including its legislative history. In this connection, the opinion notes that an action for breach of fiduciary duty under section 36(b) may not be brought against any person other than the recipient of compensation for services, "i.e. the defendant must be either an investment adviser or an affiliated person to the investment adviser." However, in summarizing the elements necessary for proving a breach of fiduciary duty under section 36(b), the opinion states that the defendants must be "investment advisers or a board of trustees" (emphasis added). Moreover, although the Board was not named as a defendant in the case, at several points the opinion refers to the plaintiffs' allegation that the "Board breached its fiduciary duty in approving the fees" for investment management and administrative services and stated that "at issue in this case is whether the Board breached its fiduciary duty in approving [the agreements]."
Risk Assumption as a Justification for Fees: The court found that the adviser's fee was justified, in part, by FMG's enterprise risk, which is described as relating to "litigation and reputational risks, operational and business risks, and the risk that FMG and the Funds may have to pay the sub-advisers in the event of legal action." In reaching this conclusion, the court was persuaded by defendants' testimony that FMG's risk is not eliminated by contractual provisions limiting its liability and providing for indemnification in certain circumstances. In this regard, the opinion cites the lead independent trustee's testimony that, "notwithstanding the contract language [which provided for a gross negligence standard of care], both the Board and regulators would ultimately hold FMG liable for any issues that impact the Funds or investors." FMG was not required to quantify its enterprise risk in citing such risk to justify a portion of the fees paid.
Profitability Findings: Plaintiffs contended that FMG's methodology used to determine profitability was improper. In particular, plaintiffs challenged FMG's (1) accounting treatment of sub-advisory and subadministration expenses, which plaintiffs' argued should have been excluded from profitability calculations and (2) use of revenue to allocate expenses in calculating profitability. In finding that classifying sub-adviser and sub-administrator fees as expenses is "within ordinary accounting principles," the court cited each party's expert witness and, noting that plaintiffs' witness gave "muddled" and "inconsistent" testimony, was persuaded by the "more credible" testimony of defendants' expert witness. Similarly, the court cited the weight of witness testimony in finding that FMG's use of the cost allocation method based on revenue is consistent with accounting principles. In this connection, the court noted that two audit firms, Ernst & Young and PricewaterhouseCoopers, were "involved in creating FMG's methodology for allocating expenses based on revenue" and that plaintiffs' expert witness neither opined on an alternative methodology that FMG should have employed nor provided any documentation suggesting that the auditors thought cost allocation based on revenue was unreasonable.
Importance of Board's Composition and Process, Including Sources of Information: Judge Sheridan rejected plaintiffs' claims that the Board lacked impartiality, diversity, care and conscientiousness. Despite the "Wall Street leanings" of the Board and the supposed lack of a trustee with significant regulatory experience, the court was convinced, largely from Schpero's testimony, that the Board was sufficiently diverse and was assisted by independent counsel with regulatory experience. In finding that the Board was conscientious and "robustly reviewed" the adviser's compensation, Judge Sheridan credited the trustees' attendance at and frequency of meetings, their involvement in preparing and requesting materials for the contract review process and reliance on multiple outside consultants and experts, including Lipper, Morningstar, Strategic Insight and independent legal counsel to the independent trustees.
Consequential Benefits of Litigation: Interestingly, the opinion includes a section titled "Benefits of the Lawsuit," wherein Judge Sheridan, citing Jones, states that since "all pertinent facts must be weighed," it is relevant to note the "positive change[s]" to the Board's process supposedly attributable to the filing of the plaintiffs' lawsuit. Thus, although plaintiffs failed to meet their burden to demonstrate a breach of fiduciary duty, the opinion reviews several "Board improvements, including changes to the Board composition and Board presentations" which "did not occur until after [the] suit was filed." For instance, Judge Sheridan maintains that "it is clear to the Court that Plaintiffs' lawsuit resulted in a more scrupulous and rigorous examination of Board expenses," a "significant benefit to investors that only occurred because of this lawsuit."
Next Steps The lawyers for the plaintiffs have indicated that they intend to appeal the decision to the US Court of Appeals for the Third Circuit. Towards that end, on September 20, 2016, plaintiffs filed a motion to amend the trial opinion and to amend or make new findings of fact and/or conclusions of law.