In a decision issued on December 28, 2009, the U.S. District Court for the Central District of California (the “Court”), determined 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. The decision generally tracked the statement of intended decision (the “Statement”) issued by the Court in September, which explained the Court’s factual findings and legal conclusions with respect to the case, and directed the defendants’ to submit proposed findings of fact and conclusions of law before the Court rendered its final decision. For a detailed discussion of the Statement and the Court’s factual findings contained therein, see the September 29, 2009 Alert.
In its final decision, while acknowledging that the Seventh and Eight Circuits have recently adopted alternative tests for determining whether a violation of Section 36(b) has occurred, the Court 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 F.2d 923 (2d Cir. 1982) (“Gartenberg”). (For more information on the 2008 Section 36(b) decision rejecting Gartenberg that was handed down by the Seventh Circuit and is currently under review by the Supreme Court, see the March 10, 2009 Alert. For a discussion of the 2009 Eighth Circuit decision, which articulated yet another Section 36(b) standard, see the April 14, 2009 Alert.) The Court observed that Gartenberg establishes a very high hurdle for the plaintiff shareholders to prove a breach of fiduciary duty under Section 36(b). 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; any fall-out benefits accruing to the defendants from their relationship with the funds; and the conduct and expertise of, and level of information possessed by, the funds’ directors in approving the fees. The Court’s opinion includes extensive findings of fact, which, among other things, set forth detailed schedules of the 12b-1 fees, advisory fees and transfer agency/administrative fees paid by the subject mutual funds, and a description of the contract approval process.
Independence and Conscientiousness of the Independent Directors. The Court rejected the plaintiffs’ arguments that the funds’ independent directors 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 paid to the funds’ investment adviser and distributor, respectively. The Court concluded that the defendants presented substantial evidence at trial to support their claim that the independent directors’ independence and the contract approval process satisfied the standard set forth in Gartenberg; however, the Court rejected a proposed finding of fact that “the independent directors were well-informed on all material issues, and exercised their business judgment in a manner that they reasonably determined was in the best interests of the fund shareholders.” Although the record contained “sufficient evidence to establish that the directors met their obligations under the Gartenberg standard,” in the Court’s view, the independent directors did not diligently inquire into some issues of importance, and failed to recognize the consequences of some information presented to them. In this regard, the Court questioned (a) the independent directors’ acceptance without further inquiry of statements that the compensation paid to the defendant adviser and distributor’s employees was necessary to meet competition in the marketplace, and (b) the independent directors’ consideration of the fact that the increase in the adviser’s assets under management during the period in question was largely due to the appreciation of existing assets, not additional amounts invested as result of distribution efforts paid for with the funds’ 12b-1 fees. The Court also believed that the independent directors did not receive sufficient information regarding the profit margins for administrative services provided to the funds. The Court, nevertheless, determined that its questions regarding the conscientiousness of the funds’ independent directors were not sufficient to rebut “the substantial evidence that the overall conduct of the directors met the Gartenberg standard,” and concluded based on the entirety of the record that “the Unaffiliated Directors carefully and diligently exercised their responsibility in approving the fees at issue.”
Nature and Quality of Services. The plaintiffs claimed that (a) 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 and (b) the adviser breached Section 36(b) because it (i) 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 and (ii) essentially admitted it had been charging excessive fees for administrative services provided to the funds when the adviser instituted a cap on those fees during the period covered by the suit . Ultimately, the Court concluded 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 the arguments and evidence presented at trial failed to implicate the nature and quality of the services provided by the defendants.
Profitability of the Funds. The Court concluded that the defendants’ profitability during the relevant time period did not weigh in favor of finding a violation of Section 36(b) since defendants’ profit margins were within the range permitted by other courts under Section 36(b).
Economies of Scale. The Court found that the plaintiffs could not successfully argue that the defendants had not equitably shared economies of scale with the funds because the plaintiffs failed to prove that economies of scale existed for the funds. In this regard, the Court noted that the only evidence offered by the plaintiffs to prove that economics of scale existed was the testimony of plaintiffs’ own expert witness which was flawed and insufficient to establish the existence of economies of scale. Specifically, the Court noted that the plaintiffs’ expert failed to adequately analyze whether the per unit operating cost of the funds decreased as the size of the funds increased.
Comparative Fee Structures. The Court observed that, although relevant, a comparison of the expense ratios of the funds at issue to those of other funds was “of minimal probative value” in the context of a Section 36(b) inquiry due to the difficulty of a fund changing advisors, citing Gartenberg. The Court, nonetheless, went on to conclude that the evidence showing that the funds’ fee structure was lower than the industry average supports a finding that the defendants’ fees were not disproportionate to the services rendered.
Fall-Out Benefits. The Court found that there was no evidence establishing any fall-out benefits to the defendants from their relationships with the funds, whose management and servicing constitute the defendants’ sole enterprise. The Court also observed that since all revenue received by the defendants would be reflected in the financial statements provided to the independent directors in connection with contract approvals, “any potential fall-out benefits would have been considered by the Board as part of their review of those financial statements.”