Alert October 02, 2012

Variable Annuity Holder Allowed to Assert Section 36(b) Excessive Fee Claims Against Investment Adviser of Underlying Mutual Funds

In an action brought by an investor in a variable annuity asserting excessive fee claims in violation of Section 36(b) of the Investment Company Act of 1940 (“ICA”) against the investment adviser to the variable annuity’s underlying mutual funds, a New Jersey federal court recently denied defendants’ motion to dismiss those claims for lack of standing.  Section 36(b) imposes a fiduciary duty on the recipients of compensation for services provided to mutual funds, and allows a “security holder” in a mutual fund or the SEC to bring an action on behalf of the fund for alleged breaches of that duty.  The court rejected defendants’ argument that the plaintiff was not a “security holder” within the meaning of Section 36(b).

Excessive Fee Claim.  To effect the plaintiff’s variable annuity investment, the insurance company placed the plaintiff’s premiums into a separate account owned by the insurance company.  Plaintiff then selected certain mutual funds as investment options, in which separate account assets proportionate to the plaintiff’s holding were invested.  The overall value of plaintiff’s units in the separate account fluctuated according to the value of the underlying securities.  Plaintiff alleged that the advisory fees paid by those mutual funds were excessive because the adviser’s role was generally limited to providing supervisory input, and that the adviser contracted with sub-advisers to perform all of the investment management services for the funds.

Variable Annuity Investor as “Security Holder” of Underlying Fund.  Defendants argued that the term “security holder,” which is not defined in the ICA, refers to the legal or record owner of a security – here, the separate account – while plaintiff argued that it refers to the equitable or beneficial owner of a security.  The court noted the underlying purpose of the ICA and Section 36(b) to create protections for mutual fund holders and concluded that it made little sense to limit “holders” to entities such as the separate account or trust that lack any economic interest or stake in the transaction because they did not pay the allegedly excessive compensation.  Rather, the court stated, “Plaintiff and similarly situated investors are responsible for and paid all of the challenged fees.  Plaintiff and other investors bear the full risk of poor investment performance.  Plaintiff and other investors have the right to instruct [defendant] how to vote their shares.  Assets held in a separate account are immune from claims of [defendant’s] creditors, while being vulnerable to claims of the investors’ creditors.  And when Plaintiff decides to withdraw her investment in the [defendant’s] Funds, she, not [defendant], pays the taxes on that investment.”  The court said that this was different from a fund-of-funds situation where the investors did not enjoy the incidents of ownership in the underlying funds such as voting or receiving dividends.

Unjust Enrichment Claim Dismissed.  The court dismissed plaintiff’s claim for unjust enrichment asserted under the federal common law.  Noting that federal common law claims are warranted only where they are necessary to fill in interstices of the ICA, the court held that because plaintiff had already asserted an excessive fee claim under Section 36(b), the plaintiff’s unjust enrichment claim was not necessary to fill in the interstices of the ICA, and thus should be dismissed.

Sivolella v. AXA Equitable Life Insurance Co., No. 11-cv-4194 (D.N.J. Sept. 21, 2012).