Section 36(b) imposes a fiduciary duty on a mutual fund’s investment adviser with respect to the fees the fund pays the adviser and provides shareholders with the right to bring an action against the adviser if the fees are excessive. Under the Supreme Court’s decision in Jones v. Harris, 559 U.S. 335 (2010), fees are excessive if they are so disproportionately large that they bear no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining. The Supreme Court directed courts to look to certain factors – called the Gartenberg factors after a leading case from the U.S. Court of Appeals for the Second Circuit – to evaluate whether the fees are excessive. These factors include the nature and quality of services provided, profitability to the adviser, any “fall-out” financial benefits to the adviser, the adviser’s costs and whether it shared any economies of scale with the fund, and comparisons of fees paid by similar funds. Courts also take into account the independence and conscientiousness of the fund board in evaluating the fees.
The decision was not close. On every contested issue the court addressed, the court concluded that the plaintiffs had not met their burden of proof. It found that the plaintiffs did not prove that any of the Gartenberg factors suggested the fees were excessive. Because the decision focuses on factual determinations and witness credibility rather than issues of law, an appellate court is likely to be quite deferential in reviewing the trial court’s decision if plaintiffs appeal.
- A focus on the facts rather than legal issues. The decision focuses on the facts, and many of the factual findings are based on witness credibility. The court gave little weight to any of the plaintiffs’ witnesses. It found all but one of the plaintiffs’ expert witnesses to not be credible, and found that the single credible expert had insufficient expertise to be persuasive. In contrast, the court found all of the adviser’s fact witnesses and expert witnesses to be credible. The court also found that the fund board’s lead independent trustee was credible, and that his testimony was “consistent, thorough, and accurate.” In contrast, the court avoided addressing disputed issues of law. For example, although the court wrestled during closing arguments with what impact the board’s process and approval should have on the plaintiffs’ standard of proof, the court assumed for purposes of its decision that the plaintiffs had to meet a preponderance of the evidence standard, which is the standard most easily met by the plaintiffs. The court found, however, that plaintiffs had not met this standard.
- Any appeal will be reviewed under a deferential standard. The court’s focus on facts and credibility rather than disputed legal issues means that the decision is unlikely to be reversed on appeal. Appellate courts review a trial court’s legal conclusions on a “de novo” basis, which means the appellate court examines those conclusions without giving any deference to the trial court’s analysis or determination. In contrast, appellate courts review factual findings under a “clearly erroneous standard,” meaning that they generally defer to the trial court and will not disturb those findings unless the appellate court finds clear error. In particular, appellate courts defer to trial courts on issues of witness credibility because it is the trial court that has the opportunity to observe the witnesses in person. Because its decision in this case turns on factual findings and not legal conclusions, the trial court has made it likely that the appellate court will review the decision under a deferential standard.
- Gartenberg factors. The court held that the plaintiffs did not have to prove any particular number of Gartenberg factors to prevail, but instead that the court would need to accord each factor appropriate weight. Having reached that conclusion, the court found that the plaintiffs had not met their burden of proving any of the Gartenberg factors.
- No damages. Finally, the court concluded that to prevail in a lawsuit under Section 36(b), a shareholder would need to show “actual damages” to the fund. The court held that the plaintiffs had failed to meet their burden of proving damages.
a. Quality of services. The gravamen of the plaintiffs’ case was that the adviser delegated responsibility for most services to investment subadvisers but kept a substantial part of the advisory fee for itself. The plaintiffs’ primary argument on quality of the services was that a comparison of the provisions of the advisory agreement and subadvisory agreements demonstrated that virtually all advisory services were delegated to the subadviser. The court acknowledged that the contractual language was the same, but found that the adviser had shown through evidence at trial that the adviser provided many services that were not delegated to the subadvisers. These services included among others supervision of the subadvisers, portfolio construction, setting benchmarks, setting investment strategy, asset allocation for funds with multiple subadvisers, valuation of hard-to-value securities, compliance and legal services, and board governance services. The court also found that the adviser bore various risks for which it was entitled to be compensated. In the face of this evidence, the court therefore rejected the plaintiffs’ argument “that the contract language itself controls” as “elevating ‘form over substance.’” The court likewise rejected the plaintiffs’ argument that services were deficient because fund performance was poor. To the contrary, the court found, “the vast majority of the Funds performed at or above expectations.”
b. Profitability. The court found the plaintiffs had not shown that profitability was unreasonable. The court concluded that the adviser’s profitability reports to the board employed proper accounting methodologies. The plaintiffs had challenged the profitability methodology because it treated subadvisory fees as expenses to the adviser rather than as contra-revenue. The court concluded the expense treatment fell “within ordinary accounting principles.” The court further found the adviser’s cost allocation methodologies to be “consistent with accounting principles.”
c. Economies of scale. The court found that plaintiffs had not met their burden of showing that the adviser had failed to share economies of scale with the funds. The court found that, in addition to employing breakpoints in the advisory fee schedules, the adviser shared economies of scale by employing “cost-saving methodologies ... to pass on savings to investors.”
d. Fall-out benefits. Similarly, the court found that plaintiffs had not met their burden of proving either (i) the existence of fall-out benefits or (ii) that the board had failed to consider the fees that, according to plaintiffs, constituted fall-out benefits.
e. Fee comparisons. The court also found that the plaintiffs had failed to meet their burden with respect to fee comparisons. The court found that the fund board received accurate information on fee comparisons with other funds from reliable sources and had determined that the funds’ fees fell within that range.
f. Board independence and conscientiousness. Echoing a concern it had expressed during the trial, the court noted its discomfort with the fact that the fund board had an interested chair – that is, a chair affiliated with the adviser. But the court found, based on the lead independent trustee’s testimony, that the board structure (e.g., use of a lead independent trustee, a supermajority of independent trustees, board committees, and active engagement by independent legal counsel) adequately addressed “any potential conflict posed by” having an interested chair. The court had also expressed a concern during trial about the lack of “diversity” on the board. By “diversity,” the court was referring to having trustees whose experience was not exclusively “from Wall Street,” but rather were former regulators or otherwise had a background that made them particularly well-suited to look out for shareholders’ interests. The court ultimately found that the board was “impartial, diverse, and independent.”