March 14, 2018

Rejecting Subadvisory Fee Comparison, Federal District Court Enters Summary Judgment for Investment Adviser and Administrator in Mutual Fund Excessive Fee Lawsuit

On March 9, 2018, the U.S. District Court for the Southern District of Ohio entered summary judgment for defendants in an action brought under Section 36(b) of the Investment Company Act of 1940. The plaintiffs in the action had alleged that an investment adviser and an affiliated fund administrator had violated their fiduciary duties by charging excessive advisory and administration fees to seven affiliated mutual funds. In reaching its decision, the court addressed a number of issues arising out of the Supreme Court’s 2010 decision in Jones v. Harris and under the Gartenberg factors in ways favorable for fund advisers, fund administrators and fund boards. 

The plaintiffs argued that the advisory fees the investment adviser charged its affiliated mutual funds  were excessive because the adviser provided substantially the same services for lower fees to serve as a subadviser to third-party mutual funds. The plaintiffs also argued that the administration fees were excessive because other mutual fund administrators provided allegedly similar administration services to other mutual funds for lower fees. The court rejected these theories and terminated the litigation, which had been scheduled for trial in June.

Of the over 20 mutual fund excessive fee lawsuits filed since the Supreme Court decided Jones v. Harris, the ruling is only the second time a court has ended the litigation by granting summary judgment and the first time a court has done so on the merits. The decision also represents the most detailed rejection to date of a mutual fund excessive fee lawsuit premised on a comparison to subadvisory fees for allegedly similar services.

Section 36(b) lawsuits are governed by the so-called Gartenberg factors that were adopted by the Supreme Court in Jones v. Harris. Liability under Section 36(b) turns on whether the fee the adviser charged “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 specific factors a court should consider in evaluating whether a fee meets this standard include the nature and quality of the services provided to the fund and its shareholders; the profitability to the adviser from managing the fund; the extent to which the adviser realized economies of scale as fund assets grew and whether the adviser shares these economies of scale with the fund; any fall-out financial benefits that accrued to the adviser because of its relationship with the fund; comparative fee structures; and the independence, expertise, care, and conscientiousness of the fund’s board of directors in evaluating the adviser’s compensation.

The vast majority of mutual fund excessive fee lawsuits filed since Jones v. Harris have been premised on one of two theories: (1) the “manager of managers” theory in which a plaintiff alleges that an investment adviser has delegated substantially all of its responsibilities to a subadviser and does not provide sufficient services to justify the “spread” between the fee the adviser receives and the amount the adviser pays the subadviser; and (2) the “subadvisory fee comparison theory” in which a plaintiff alleges that an investment adviser provides substantially similar services when acting as an investment adviser to its affiliated funds and as a subadviser to third-party funds but charges less to act as a subadviser. The new decision involves an excessive fee lawsuit brought under the second, subadvisory fee comparison, theory.

In granting summary judgment, the court considered a number of the Gartenberg factors and concluded that the plaintiffs had no evidence that could lead to a determination that fees were “beyond the range of arm’s-length bargaining.”

The court observed that the adviser had put forth unrebutted evidence that “overall the Funds performed better than, and the fees were in line with, other [similar] mutual funds.” The court explained that, although these two factors were not dispositive, they were “telling regarding whether the fees are excessive.” The court went on to find that the plaintiffs had no evidence with respect to other Gartenberg factors that could lead to a determination that the challenged fees were excessive. The court rejected the plaintiffs’ comparison of the advisory fees to subadvisory fees because, according to the court, material differences in the risk undertaken and the scale of services provided made the comparison inapt. The court strongly emphasized the additional risks faced by the adviser in managing its affiliated funds, explaining that the adviser had proffered unrebutted evidence that the adviser faced “different risks in the different roles of adviser or subadviser.” The court also found that unrebutted evidence showed that the adviser provided different compliance and shareholder services when acting as an adviser compared to a subadviser. The court also observed that for a fund with a subadviser, the subadvisory fee is only a portion of the total advisory fee a shareholder pays, further making the comparison inapt. The court also found material differences between the services the administrator provided to the funds and the services provided by other administrators that the plaintiffs contended charged less, making that comparison inapt as well. According to the court, the plaintiffs’ evidence established “at most that others paid different amounts for fewer services.”

Turning to other of the Gartenberg factors, the court held that economies of scale could be shared in ways other than breakpoints, that unrebutted evidence showed that the adviser had agreed to fee waivers, and that there was “no indication that the [funds’] Board could not have agreed to the level of fee waivers after engaging in good faith negotiations.” Finally, the court explained that the plaintiffs “have pointed to no irregularities or deficiencies in the Board’s conduct, nor do they allege that the Board completely failed to consider” the relevant fees and fee comparisons.

Goodwin represented the defendants in the action.