The U.S. District Court for the Central District of California dismissed a suit brought by a mutual fund shareholder against the fund’s investment adviser and an affiliate of the adviser that served as the fund’s distributor over 12b-1 fees paid by the fund to the distributor. (12b-1 fees are paid under a plan approved by a mutual fund’s independent directors pursuant to Rule 12b-1 under the Investment Company Act of 1940, as amended (the “1940 Act”), and are the sole means by which a mutual fund may pay for distribution and sales activities.) The suit was brought under Section 36(b) of the 1940 Act, which in broad terms allows a fund shareholder to sue the fund’s adviser for breach of fiduciary duty with respect to the receipt of compensation, the compensation in this case being 12b-1 fees alleged to have been paid indirectly to the adviser through its affiliate, the distributor. The plaintiff’s allegations focused on non-compliance with Rule 12b-1’s requirements: (a) the plaintiff alleged that the portion of the 12b-1 fees used for post-sales activities was per se unlawful because post-sales services cannot be “primarily intended to result in the sale of shares issued by [the fund]” as required by the Rule and (b) the plaintiff alleged that the remainder of the fund's 12b-1 fees were unlawful because they failed to meet the statutory requirement that “there is a reasonable likelihood that the [12b-1 fees] will benefit the company  and its shareholders.”
In making these allegations, the plaintiff argued that the multi-factor analysis for suits under Section 36(b) established by the US Court of Appeals for the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc ., 694 F2d 923 (2d Cir. 1982) (“Gartenberg”) was not applicable because if the fees were improper, they were necessarily excessive and disproportionate. The court noted that under Gartenberg, courts analyze the following factors in seeking to determine whether “the fee 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”: (i) the nature and quality of the services provided by the adviser; (ii) the profitability of the fund to the adviser-manager; (iii) “fall-out” benefits to the adviser from its relationship with the fund; (iv) any economies of scale achieved by the fund and whether those economies are passed on to fund shareholders; (v) the fund’s fee structure relative to those of other similar funds; and (vi) the independence and conscientiousness of a fund’s independent directors.
The court rejected the plaintiff’s argument regarding Gartenberg and applying that standard, found that the complaint failed to allege sufficient facts regarding the disproportionality of the fees charged relative to the services provided to the fund to survive the motion to dismiss. The court added that an allegation that fees were used for an improper purpose would not by itself state a claim under Section 36(b). The court also rejected the plaintiff's allegation regarding the per se impermissibility of 12b-1 fees for post-sales services. The court dismissed the plaintiff’s Section 36(b) claim with leave to amend, making clear that an amended complaint would need to address the Gartenberg standard.The court also dismissed the plaintiff’s claim under Section 48(a) of the 1940 Act against the adviser alleging that the adviser had caused the distributor to violate its fiduciary duty under 36(b). (Section 48(a) generally prohibits any party from doing indirectly what the 1940 Act does not permit that party to do directly.) In dismissing this claim, the court cited a number of recent cases holding that plaintiff’s Section 48(a) does not create a private right of action. The court dismissed the Section 48(a) claim with prejudice.