On March 18, 2019, the U.S. Court of Appeals for the Second Circuit affirmed the dismissal prior to discovery of a complaint filed under Section 36(b) of the Investment Company Act of 1940. The Second Circuit’s decision is significant for a number of reasons. First, it is the first appellate decision regarding a complaint premised on a “subadvisory fee comparison” theory, which contends that an advisory fee is excessive if it is larger than the fee the adviser charges for providing subadvisory services. Second, it is one of only a few decisions in the last 10 years that affirms dismissal of a Section 36(b) complaint before discovery. Third, the Second Circuit held that in determining whether to dismiss a Section 36(b) complaint, the issue is not whether one or more of the so-called Gartenberg factors weigh in favor of the plaintiff, but rather whether all of the allegations and Gartenberg factors, considered collectively, plausibly suggest that an adviser has violated Section 36(b).
The underlying complaint had alleged that a mutual fund investment adviser charged excessive fees to an affiliated mutual fund because (i) the adviser charged another affiliated mutual fund lower fees, (ii) the adviser charged lower fees for subadvisory services to an otherwise unaffiliated mutual fund, and (iii) the fund paid higher fees than many funds on a list of funds categorized as “large-cap U.S. equity blend” by Bloomberg Financial. Last year, the federal district court in Manhattan had dismissed the complaint prior to discovery.
In its 2010 decision in Jones v. Harris, the U.S. Supreme Court held that to violate Section 36(b), an adviser “must charge a fee that 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 court pointed to a number of factors, known as the Gartenberg factors after an earlier Second Circuit case, that courts often looked to aid the inquiry. As articulated by the Second Circuit, those factors are: “(1) the nature and quality of services provided to fund shareholders; (2) the profitability of the fund to the adviser‐manager; (3) fall‐out benefits; (4) economies of scale; (5) comparative fee structures; and (6) the independence and conscientiousness of the trustees.”
In its new decision, the Second Circuit held that in evaluating whether to dismiss a Section 36(b) complaint, a court must “weigh the Gartenberg factors collectively to determine whether the complaint’s allegations, taken as a whole, plausibly allege that [the] fees were outside the range of what would have been negotiated at arm’s length.” In other words, courts should not focus on whether one factor or another weighed in favor of plaintiffs or the adviser, but rather whether all of the allegations and the factors, taken collectively, plausibly suggested a violation of the statute. The court held that although several Gartenberg factors weakly weighed in favor of the plaintiff, collectively they did not plausibly suggest that the challenged fee fell outside what could have been negotiated at arm’s length.
The court characterized the complaint’s three proffered fee comparisons as “weak.” First, the affiliated mutual fund that paid lower fees held fewer portfolio positions and, unlike the fund at issue, did not take short positions. Second, the court distinguished the subadvisory fees paid by the unaffiliated fund’s investment adviser because, as the Supreme Court had cautioned in Jones v. Harris, courts must “be mindful that the [Investment Company] Act does not necessarily ensure fee parity between mutual funds and institutional clients.” In light of “this warning and the relatively marginal difference in net fees,” the court declined to give the “comparison much weight.” And third, the court rejected the comparison to the list of funds – those categorized as “U.S. equity large-cap blend funds” by Bloomberg Financial – as inapt, “particularly given” the list’s “inclusion of index funds.”
The court rejected the complaint’s allegations regarding nature and quality of the services the adviser provided to the fund and regarding profitability. The complaint characterized the fund’s performance as “essentially middling,” which the court characterized as “neither here nor there” and not weighing in favor of a violation of the statute. The court also held that the complaint’s profitability allegations were not “sufficient to draw any meaningful inference as to actual profitability.”
On the other hand, the court held that the complaint’s allegations regarding fall-out benefits, economies of scale, and the independence and conscientiousness of the fund board provided limited support for the plaintiff’s claim of a breach of Section 36(b). In contrast to several other courts that have concluded otherwise, the court held that the complaint’s allegations about the adviser’s ability to operate a “clone” fund similar to the fund at issue and to provide additional services to the fund as administrator supported “at least a ‘weak’ inference of” fall-out benefits. The court held that the fund’s growth in assets from $69 million in 2006 to approximately $10 billion in 2016 supported an inference that the adviser benefited from economies of scale that were not fully shared with shareholders, but that the inference was “tempered” because, during the same period, the adviser both added an additional portfolio manager and decreased the fee it charged the fund. The court held that the complaint’s allegations about the board’s independence and compensation were generally insufficient as a matter of law, but that the complaint’s allegations that the board received inadequate information about profitability supported an inference in the plaintiff’s favor.
The court concluded, however, that notwithstanding that the complaint made a showing under three of the six Gartenberg factors, it did “not state a plausible claim for relief.” Rather, “in light of the surrounding circumstances, … the existence of fall-out benefits, some unshared economies of scale, and an ill-informed Board do not support an inference 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.”
U.S. District Judge Edward Korman, who sat by designation on the Second Circuit panel that decided the appeal, concurred with the panel’s decision. He wrote separately, however, to state that he felt that a prior Second Circuit decision, Amron v. Morgan Stanley Investment Advisors, 464 F.3d 338 (2d Cir. 2006), was wrongly decided because it required that the Gartenberg factors be applied at the motion-to-dismiss stage, prior to discovery, rather than after plaintiffs had the opportunity to take discovery from the adviser. According to Judge Korman, plaintiffs in a Section 36(b) case cannot reasonably be expected to know all the relevant facts without discovery, pointing to the complaint’s lack of specific allegations about the adviser’s profitability. Judge Korman opined that the Amron decision bound the panel but “should not be the law.” It should be noted, however, that despite Judge Korman’s concerns, the vast majority of Section 36(b) complaints, including complaints filed in courts within the Second Circuit, have not been dismissed prior to discovery.
The Second Circuit’s decision is designated as a “summary order,” which means that it is not binding precedent, but may be cited as persuasive authority. A copy of the decision is available here.
Michael K. IsenmanPartner
Mark HollandRetired Partner