Alert January 08, 2013

Federal District Court Allows Mutual Fund Shareholders to Proceed with Section 36(b) Claims Asserting That Investment Adviser’s Fees are Excessive Because the Funds’ Sub-Advisers Allegedly Perform Most of the Funds’ Investment Management Services

A New Jersey federal court recently denied an investment adviser’s motion to dismiss an action brought by a shareholder in six mutual funds, asserting claims for excessive management fees in violation of Section 36(b) of the Investment Company Act of 1940 (“ICA”).  However, the court dismissed without prejudice Plaintiffs’ claims for excessive Rule 12b-1 distribution fees.

Excessive Management Fee Claim.  Plaintiffs claim that the fees charged by the funds’ investment adviser are excessive to the extent that they exceed the fees the adviser paid to the funds’ sub-advisers, on the ground that the sub-advisers allegedly perform most of the investment management services for the funds.  Plaintiffs further allege that adviser’s management fees are excessive as compared to fees charged by the adviser’s competitor, Vanguard, and fees charged by the adviser to its institutional clients.

The court dismissed Plaintiffs’ prior complaint because Plaintiffs’ assertion that the management fees were excessive in comparison to the sub-advisory fees were “conclusory and unsupported,” but allowed Plaintiffs to amend their allegations.  The court noted that Plaintiffs’ amended complaint now includes “eight additional pages and multiple tables” detailing the investment management services provided by the adviser and the sub-advisers to the funds and the overlap between the two, and asserts that the adviser charges the funds anywhere between three to five times the amount the adviser pays its sub-advisers for “substantially the same services.”  Specifically, Plaintiffs now allege that the investment management services provided by the sub-advisers represent “the most expensive and important services required” by the funds’ investment management agreement, and that any additional supervisory functions performed by the adviser were insignificant and were covered by separate service agreements that compensated the adviser.  The court declined to consider the adviser’s argument that it provides the funds with extensive administrative and investment management services that are not delegated to the sub-advisers, concluding that such an argument goes to the merits of the case and is more appropriate for summary judgment. 

The court further held that the amended complaint sufficiently “beefs up” Plaintiffs’ allegations that Vanguard effectively charges management fees that are 50 times less than those charged by the adviser.  While it acknowledged other courts’ conclusions that comparisons to Vanguard – a not-for-profit entity that markets itself as a low-cost mutual fund provider – generally are of little value, the court gave some limited weight to such a comparison in this context because the adviser and Vanguard used the same sub-adviser.  The court also held that Plaintiffs’ comparison of the adviser’s fees charged to one of the funds at issue and the fees it charged to two of its institutional clients were sufficiently detailed to survive a motion to dismiss, but had probative value only as to that one fund. 

Although not addressed in the adviser’s motion to dismiss, the court considered additional allegations relating to the Section 36(b) analysis.  The court found that Plaintiffs adequately pleaded that the adviser failed to share with them any meaningful benefits from the economies of scale enjoyed by the funds because the adviser’s “breakpoints” – the point at which a fee rate decreases when net assets increase – were set too high and spaced too far apart when compared to the breakpoint schedule for fees paid to the sub-adviser.  The court also stated that the allegations created an inference that the board may not have considered important facts in approving the management fees.  Lastly, the court found that the adviser’s profitability in retaining approximately $100 million of the $150 million in management fees for allegedly providing “minimal supervisory services” to the funds weighed in favor of sustaining Plaintiffs’ claims at this early pleadings stage. 

Excessive Rule 12b-1 Distribution Fee Claims.  Plaintiffs alleged that charging Rule 12b-1 distribution fees and front-end sales loads to shareholders who owned Class A fund shares was duplicative and therefore excessive.  The court dismissed this claim without prejudice, noting that the SEC has recognized that charging both fees is customary and that Plaintiffs lacked any other substantive basis for their “sparse and conclusory” claim.  The court also dismissed without prejudice Plaintiffs’ claims concerning the distribution fees charged to Class B shares, holding that Plaintiffs lacked standing to assert those claims because none of them owns Class B shares.

Kasilag v. Hartford Investment Financial Services, LLC, Civil No. 11-1083 (D.N.J. Dec. 17, 2012).