The US District Court for the Southern District of New York (the “Court”) dismissed a lawsuit filed by mutual fund shareholders against the funds’ affiliated investment advisers and distributor. Plaintiffs alleged defendants breached their fiduciary duty to shareholders under the Investment Company Act of 1940, as amended (the “1940 Act”), by charging excessive fees. The federal district court characterized the lawsuit as an attempt to reconfigure allegations contained in prior complaints, after noting that substantially the same counsel for plaintiffs had represented shareholders in two previous analogous cases in which defendants had similarly prevailed. In re Scudder Mut. Funds Fee Litig., No. 04 Civ. 1921 (DAB), 2007 WL 2325862 (S.D.N.Y. Aug. 14, 2007), and In re Evergreen Mut. Funds Fee Litig., 240 F.R.D. 115 (S.D.N.Y. Feb. 5, 2007). The Court’s decision came on a motion under Rule 12(b)(6) of the Federal Rules of Civil Procedure by the defendant advisers and distributor that the suit be dismissed on the grounds that the plaintiffs’ allegations in the complaint failed to state any claim on which the Court could grant relief.
The Shareholders’ Allegations. Plaintiffs alleged defendants breached their fiduciary duty under Section 36(b) of the 1940 Act by charging fees which were disproportionate and not reasonably related to the services for which the fees were charged. The claims related to investment advisory, Rule 12b-1, transfer agency, and administrative fees. Section 36(b) provides that an investment adviser has a fiduciary duty to shareholders with respect to the receipt of compensation for services by the adviser and its affiliates. Among other things, plaintiffs alleged that (a) defendants failed to reduce fees in line with the economies of scale created by the funds’ growth, (b) the funds’ poor performance as compared to that of other mutual funds revealed shareholders did not receive superior investment advice in exchange for higher fees paid, and (c) defendants used the higher fees to offset revenue-sharing payments (payments made to broker‑dealers selling the funds in order to receive preferential treatment in one or more aspects of the broker‑dealers’ selling programs).
The Court’s Gartenberg Analysis. In granting defendants’ motion to dismiss, the Court applied the Gartenberg factors as interpreted by the Federal Court of Appeals for the Second Circuit in a 2006 decision affirming a district court’s dismissal of an attempted Section 36(b) suit under Rule 12(b)(6) for failure to state a claim. Amron v. Morgan Stanley Investment Advisors, Inc. 464 F.3d 338 (2d Cir. 2006) (“Amron”). (The Gartenberg factors used by the courts in deciding Section 36(b) suits were identified by the Second Circuit in a 1982 decision as the appropriate considerations for determining whether a Section 36(b) violation has occurred, i.e., whether a 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.” Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923, 928 (2d Cir. 1982), cert. denied, 461 U.S. 906 (1983).) The Court examined the facts alleged by the plaintiffs with respect to each Gartenberg factor under the pleading requirements enunciated in Amron and found plaintiffs’ complaint did not meet the requisite standard for any factor.
Nature and Quality of the Services Provided - Although plaintiffs claimed that the performance of the funds was below that of others in the industry, the Court noted performance is but one measure of services provided, and plaintiffs failed to allege any deficiencies with respect to other services provided to fund shareholders, including, for example, telephone assistance or transaction-related services. In finding that the plaintiffs had failed to satisfy this factor, the Court cited Amron’s holding that facts simply alleging underperformance without more were insufficient to satisfy the first Gartenberg factor.
Profitability of the Mutual Fund to the Adviser-Manager - Plaintiffs alleged the funds were extremely profitable to defendants, citing the net income shown in the defendants’ parent’s financial statements for its asset management business. Plaintiffs made further broad allegations regarding profitability in the mutual fund industry in general. The Court observed that it was not clear what portion of the parent’s profits were attributable to the fees that were the subject of the complaint. In finding that the plaintiffs had not met their burden of pleading on the second Gartenberg factor, the Court cited Amron’s holding that allegations regarding high fees were irrelevant to the issue of profitability without facts regarding fund operating costs. The Court also stated that the complaint’s industry-wide commentary regarding profitability was akin to the kind of non-specific allegations the Amron court had found insufficient to withstand a motion to dismiss.
“Fall-Out” Benefits to the Adviser. - The Court determined plaintiffs’ allegations regarding “fall-out” benefits received by the defendants from directed brokerage, soft dollar payments and transfer agency fees essentially focused on the propriety of those fees as opposed to their amount, as to which the plaintiffs made no allegations. The Court characterized the test under Section 36(b) as basically an economic one where the improper use of fees is not excessive per se. The Court went on to hold that the plaintiffs had not met their burden of pleading under this Gartenberg factor, because absent any information as to the size of fees used to generate “fall-out” benefits, mere allegations of impropriety did not satisfy this factor.
Economies of Scale – On this factor as well as on the profitability factor, the Court focused on plaintiffs’ failure to allege any facts relating to the costs of operating the funds. The Court held that allegations of the size of the funds and their rates of growth were insufficient to satisfy this factor as were plaintiffs’ general allegations regarding theoretical economies of scale. The Court stated that Amron had made clear that in order to allege facts sufficient to satisfy this factor, a plaintiff must include facts relating to the costs of performing fund transactions or facts regarding the relationship between such costs and the number of transactions performed.
Comparative Fee Structures - In assessing plaintiffs’ allegations that the funds’ expense ratios were higher than those of other funds with similar objectives, the Court cited Amron’s position that whether a mutual fund has a higher fee than another fails to raise sufficient suspicion under this factor and the fact that similar allegations by the plaintiffs in Amron were found inadequate.
Independence and Conscientiousness of the Trustees - Plaintiffs claimed the directors suffered from a lack of experience and likely were not able to devote the time necessary to oversee the number of funds in their charge. The Court characterized these allegations as conclusory and insufficient as a matter of law. Citing Amron, the Court also concluded that the plaintiffs’ allegations failed to overcome the 1940 Act’s “express presumption that ‘mutual fund trustees and natural persons who do not own 25% of [a fund’s] voting securities are disinterested.’” (It is worth noting that an “interested person” analysis under the 1940 Act definition of that term is substantially broader than this statement in the Court’s opinion and its predicate in Amron would suggest; in particular, any such analysis would address issues such as a trustee’s ownership or other interests in, or relationships with the adviser, the distributor or their parent companies.)
On the basis of the foregoing, the Court dismissed the plaintiffs’ complaint with prejudice.