On March 30, 2020, 10 years to the day after the Supreme Court issued its decision in Jones v. Harris, 559 U.S. 335 (2010), the U.S. Court of Appeals for the Sixth Circuit issued the first published federal appellate decision addressing the factors for deciding claims under Section 36(b) of the Investment Company Act of 1940 in a post-Jones world. In its new decision, the Sixth Circuit addressed and squarely rejected the “subadvisory fee comparison” theory of liability espoused in Section 36(b) complaints filed against more than a half-dozen different mutual fund investment advisers.
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, 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.
Most Section 36(b) complaints filed since Jones have been premised on one of two related theories of liability. Under the “subadvisory fee comparison” theory addressed by the Sixth Circuit, a plaintiff compares the fee an adviser charges a proprietary mutual fund to the lower fee charged for allegedly similar services when the adviser acts as a subadviser to an otherwise unaffiliated fund. Under a “manager-of-managers” theory, a plaintiff contends that the adviser delegated responsibility for most services to subadvisers but kept a substantial part of the advisory fee for itself. Until the Sixth Circuit’s opinion, no published appellate decision had addressed either theory of liability.
The Sixth Circuit’s opinion reviewed a district court’s earlier decision in favor of the adviser. After discovery but before trial, the district court had granted summary judgment to the adviser, holding that there were no material facts in dispute and that under the undisputed facts, plaintiffs could not show a violation of Section 36(b). The plaintiffs appealed. Because the district court ruled on summary judgment, rather than after trial, the standard of review on appeal was “de novo,” meaning that on review the appellate court gave no deference to the district court's ruling. In contrast, after a trial on the merits, an appellate court will not disturb a district court's factual findings unless they are “clearly erroneous.”
In its decision, the Sixth Circuit held that two Gartenberg factors - comparative fee structures and nature and quality of the services - can be particularly important, but that standing alone those factors are not dispositive. The court noted that the adviser had put forth unrebutted evidence that the adviser charged fees that were in line with those of comparable funds while providing above-average performance. In so holding, the Sixth Circuit largely agreed with the Seventh Circuit's decision after remand from the Supreme Court in Jones v. Harris on the importance of these factors.
With respect to comparative fee structures, the Sixth Circuit held that comparisons to other similar funds based on Lipper data were relevant, while comparison to subadvisory fees were not. The court pointed to language in the Supreme Court's Jones decision that courts should avoid “inapt comparisons,” and that Section 36(b) “does not necessarily ensure fee parity between mutual funds and institutional clients” like the sponsors of subadvised funds. The Sixth Circuit also focused on language in Jones “that comparisons with fees charged to other clients will not 'doom any fund to trial.'“ Rather, “[t]rial is appropriate '[o]nly where plaintiffs have shown a large disparity in fees that cannot be explained by the different services in addition to other evidence that the fee is outside the arm's-length range.'“
The Sixth Circuit pointed out that the adviser had provided evidence that its responsibilities, and the associated risks, were different as adviser to the funds compared to when acting as a subadviser. “Relying on the Supreme Court's instruction that '[i]f the services rendered are sufficiently different that a comparison is not probative, then courts must reject such a comparison,'“ the court ruled that “the comparison between” the adviser’s affiliated funds and the subadvised funds “is inapt.”
The fund shareholders bringing the lawsuit attacked the adviser's reliance on Lipper data for fee comparisons, arguing that “the fees charged to the Lipper comparators may not have been negotiated at arm's length,” and so “may not actually be comparable.” The court rejected that argument and held that Lipper “is an independent provider of data that is widely accepted in the field as a tool to compare fees and performance in the mutual fund industry.”
The court then turned to a different Gartenberg factor, economies of scale. The plaintiffs did not dispute that the adviser had shared some economies of scale - through fee waivers - but argued that the adviser had not shared them sufficiently. The court rejected this argument, holding that some sharing was sufficient in the absence of evidence that a board could not have agreed to such sharing after good faith negotiation. The court also noted that breakpoints were not the only means of sharing economies of scale.
Finally, the court addressed and rejected the plaintiffs' attack on the board's care and conscientiousness. It held that “although JPMIM may not have presented to the Board all the information” the plaintiffs “wanted, the Board still engaged in a thoughtful review process that considered substantial information from” the adviser “as well as information from independent third parties.”
As a published opinion, the new decision is binding precedent in the Sixth Circuit and may be cited as persuasive (but not binding) authority in courts outside the Sixth Circuit. A copy of the decision is available here.