In a statement of intended decision issued on September 16, 2009 at the conclusion of a civil trail in the U.S. District Court for the Central District of California (the “Court”), the Court stated that the plaintiff investors in various mutual funds had failed to satisfy their burden of proof in their excessive fee suit brought under Section 36(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), against the funds’ investment adviser and affiliated distributor regarding various investment management, Rule 12b-1 and other servicing fees paid to the defendants and their affiliates. 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. (A statement of intended decision serves as an explanation of a trial court’s factual findings and legal conclusions with respect to a case. Both the prevailing and losing party have the opportunity to submit findings of fact and conclusions of law before the final decision is rendered.)
Although the Court briefly acknowledged that other circuit courts had adopted alternative tests for determining whether a violation of Section 36(b) has occurred, the Court ultimately chose to analyze the allegations and evidence presented at trial using the multi-factor analysis for suits under Section 36(b) established by the U.S. Court of Appeals for the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F2d 923 (2d Cir. 1982) (“Gartenberg”). (For a discussion of the Eighth Circuit’s decision establishing a different Section 36(b) standard, see the April 14, 2009 Alert. For more information on the Seventh Circuit’s Section 36(b) standard, which will be reviewed by the Supreme Court, see the March 10, 2009 Alert.) In accordance with Gartenberg, the Court analyzed the nature and quality of the services provided to the funds; the defendants’ profitability with respect to the funds, whether and to what extent the defendants realized economies of scale as fund assets increased; the comparability of the funds’ fees to those of other similar funds; and the conduct and expertise of, and level of information possessed by, the funds’ directors in approving the fees.
Nature and Quality of Services. The plaintiffs claimed that the defendants violated Section 36(b) because they charged the funds Rule 12b-1 fees designed to promote growth in fund assets at a time when increasing fund assets were creating problems for fund management and harming fund performance. The Court rejected this claim, and other arguments made by the plaintiffs regarding Rule 12b-1 fees, because they did not address the nature and quality of the services provided in return for the fees charged. The Court similarly dismissed the plaintiffs’ arguments that the adviser breached Section 36(b) because it unreasonably failed to adjust its advisory fee schedule downward sufficiently in response to growth in fund assets and used a portion of its advisory fees to make undisclosed revenue sharing payments to broker-dealers. Ultimately, the Court stated that arguments regarding the propriety of the use of fees and the effect of dramatic asset growth in each area cited by plaintiffs – 12b-1 fees, advisory fees and transfer agency/administrative fees – could not serve as a basis for liability under Section 36(b) because none of these arguments or any evidence presented at trial established that the nature and quality of the actual services provided was lacking.
Profitability of the Funds. The Court stated that the defendants’ profitability during the relevant time period also did not weigh in favor of finding a violation of Section 36(b) since defendants’ profit margins were well within the bounds permitted by other courts under Section 36(b).
Economies of Scale. The Court found that because the plaintiffs failed to prove that economies of scale existed for the funds, their arguments that the adviser did not equitably share economies of scale could not be unsuccessful. In this regard, the Court pointed to the testimony of plaintiffs’ own expert witness who admitted that he was unable to determine whether economies of scale actually existed because of a lack of data.
Comparative Fee Structures. Notably, the Court rejected the defendants’ arguments that the funds could not have experienced the growth they did if defendants were charging excessive fees since investors “vote with their feet” if assessed high fees. The Court pointed to the testimony of a witness for the defendants who had acknowledged that certain costs (e.g., capital gains taxes) can prevent investors who pay excessive fees from switching funds because investors will not change funds if the cost of changing funds exceeds the amount of the excessive fees. Ultimately, the Court concluded that, although relevant, a comparison of the expense ratios of the funds at issue to those of their funds was “of minimal probative value” in the context of a Section 36(b) inquiry, citing Gartenberg.
Independence and Conscientiousness of the Independent Directors. Finally, Plaintiffs argued that the independent directors of the funds were not truly independent, did not perform their duties with sufficient care and lacked sufficient information regarding profit margins on administrative services fees and 12b-1 fees. Despite both being “troubled” by evidence presented at trial which raised legitimate concerns regarding the independence of some of the independent directors and criticizing the independent directors’ testimony that “tracked—at times nearly word for word—the testimony of the [adviser’s] executives who took the stand,” the Court ultimately concluded that the defendants presented substantial evidence at trial to support their claim that the independent directors were sufficiently independent for purposes of satisfying the standard set forth in Gartenberg. Such evidence included the existence of (i) committees composed entirely of independent directors that nominated independent directors and reviewed each board member’s performance annually and (ii) independent legal counsel for the independent directors. The Court also cited the fact that (A) all board committees were made up entirely of independent directors; (B) all board chairpersons were independent directors; (C) each fund was comprised of a supermajority of independent directors; (D) each board meeting included an executive session where the independent directors have an opportunity to meet outside the presence of management and the affiliated directors; and (E) all the independent directors for each fund cluster sat on the contracts committee for that fund cluster. While, in the Court’s view, the independent directors had not received enough information regarding the profit margins for administrative services provided to the funds, the Court noted that this evidence did not establish Section 36(b) liability without evidence of the nature of administrative services rendered by the fund adviser’s affiliate and any third parties subcontracted to provide those services. In re American Funds Fee Litigation, CV 04-05593 GAF (RNBx) (C.D. Cal. Sept. 16, 2009).