The U.S. District Court for the District of New Jersey recently issued its post-trial ruling in Kasilag et al. v. Hartford Investment Financial Services, LLC et al. The Hartford ruling is the second post-trial Section 36(b) decision issued following the Supreme Court’s 2010 Jones v. Harris Associates opinion, and in many ways resembles its predecessor – also issued by the District of New Jersey – in the Sivolella et al. v. AXA Equitable Life Insurance Company, et al. case. The Hartford opinion further reinforces the heavy burden plaintiffs face in Section 36(b) cases.
Section 36(b) of the Investment Company Act of 1940 imposes a fiduciary duty on an investment adviser to a mutual fund “with respect to the receipt of compensation for services, or of payments of a material nature” paid by the fund or its shareholders to the adviser or its affiliates. The section gives mutual fund shareholders a private right of action to enforce that duty. The statute assigns a plaintiff the burden of proof, and the case law makes it clear that a breach may be shown only where the fee charged is “so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.” In addition, the section specifically provides that approval by the fund’s board of directors of the compensation or payments “shall be given such consideration by the court as is deemed appropriate under all the circumstances.”
In Jones, the Supreme Court cited with approval the use of several factors set forth in an earlier case decided by the Second Circuit, Gartenberg v. Merrill Lynch Asset Management, Inc., but emphasized the ultimate “arm’s length bargain” standard. The “Gartenberg factors” are: (i) the nature, extent, and quality of the services provided by the adviser to the mutual fund; (ii) the profitability to the adviser of managing the fund; (iii) “fall-out” benefits; (iv) the existence of any economies of scale achieved by the adviser as a result of growth in fund assets under management and whether such savings are shared with fund shareholders; (v) fee structures utilized by other similar funds; and (vi) the expertise of the fund’s independent directors, whether the independent directors are fully informed about all of the facts bearing on the adviser’s service and fee, and the extent of care and conscientiousness with which the independent directors perform their duties with respect to the adviser’s fee. Jones emphasizes that the informed decisions reached by a fund’s independent directors deserve special consideration: “a measure of deference to a board’s judgment may be appropriate in some circumstances” and “the appropriate measure of deference varies depending on the circumstances.” Further, where the independent directors “considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently.”
Plaintiffs across the country have brought a number of Section 36(b) cases attacking the so-called “manager of managers” model, which is used by many in the industry. Under this model, an adviser engages one or more sub-advisers to provide certain advisory services to a fund, while retaining ultimate responsibility for such services, performing others, and bearing attendant regulatory and entrepreneurial risks (among other things). Like the AXA case, Plaintiffs’ challenge to certain Hartford funds’ advisory fees was premised on the claims that the Hartford adviser had delegated substantially all of its responsibilities to sub-advisers and that therefore the portion of the fee it retained was inherently unreasonable. Hartford represents the second such case to reach trial.
The Hartford case was originally filed in 2011 and was first considered by the Court on the merits last year in its summary judgment decision. In that decision, the Court concluded that the evidence Plaintiffs presented had not “genuinely contested the board members’ independence… [and had not] shown the Board was uninformed or the process tainted by important withheld information.” The independent directors’ approval of fees, therefore, was to be given “substantial weight” in the Gartenberg analysis. Nevertheless, the Court proceeded to analyze the other Gartenberg factors – and concluded that triable factual issues with respect to those other five factors precluded a defense victory at that time. Although the Court had anticipated that the trial would not be a “far-flung foray into the annals of accounting procedures or mutual fund administration,” it ultimately covered a broad array of facts, which the Court considered “consistent with the relevant case law’s instruction to consider all relevant circumstances.”
In its post-trial ruling, the Court concluded that Plaintiffs had failed to carry their burden under Section 36(b). The 70-page opinion recites both extensive record evidence on the few Gartenberg factors that the Plaintiffs argued and rejects the legal authority upon which Plaintiffs relied. The crux of Plaintiffs’ case, however, rested on their argument regarding the adviser’s profitability and their related “retained fee theory” – or, as the Court described it, “the argument that one should consider the services performed specifically by Defendants as separate and apart from those performed by the sub-adviser.” This argument hung on expert testimony provided by the same individual who had testified for the AXA plaintiffs on the same theory. As in AXA, the Court found that this testimony was largely unpersuasive and “illustrated several shortcomings” – and, therefore, was given no weight. Consequently, the Court instead relied upon profitability data proffered by the Defendants and their expert; these figures (profit margin by fund, per year, excluding distribution and pre-tax) ranged from 45.6%-80.3%. Consistent with its overall findings, the Court found that “Plaintiffs have failed to meet their burden of establishing that the Funds were so profitable that their fee could not have been negotiated at arm’s-length.”
In reviewing the remaining Gartenberg factors, the Court generally found that Plaintiffs had failed to provide key evidence to meet their burden:
Nature and Quality of Services: Consistent with Jones and its overall approach to the trial, the Court took an ‘all relevant circumstances’ approach to reviewing the services provided to the funds. This, therefore, meant the Court considered the services provided by the sub-advisers in addition to the services provided by the adviser. Significant for the Court was Plaintiffs’ failure to provide evidence on the services provided by the sub-adviser – further supporting the finding that Plaintiffs failed to carry their burden of proof. The Court also found that both parties’ evidence regarding the funds’ performance “support a finding that the Funds performed roughly in a middle-of-the-road fashion or better.” Notably, the Court agreed with Defendants that certain problems exist in comparing fund performance solely to benchmarks, which do not bear fees and are not offered for sale. The Court further found that while the relative poor performance of one of the funds “tips very mildly in Plaintiffs’ favor,” it did not outweigh the remaining factors, which weighed in favor of the Defendants.
Profitability: In considering this factor, the Court was “guided by the notion that it is not a permissible approach under Section 36(b) to argue that the adviser ‘just plain made too much money.’” The Court rejected the “retained fee” methodology discussed above, as well as Plaintiffs’ argument that sub-advisory fees should be treated as “contra revenue” (i.e., as neither a revenue nor an expense of the adviser) when calculating profitability. The Court stated that Plaintiffs expert’s testimony on this point “was undermined by his own concession that he had no supporting accounting authority for his novel position” and that he had “readily conceded that under the Generally Accepted Accounting Principles…sub-advisory fees are treated as an expense of the adviser….” Recognizing that the court in Schuyt v. Rowe Price Prime Reserve Fund had affirmed a pre-tax profitability of 77.3%, the Court found that Plaintiffs had failed to meet their burden that the funds were so profitable that their fees could not have been negotiated at arm’s length.
Economies of Scale, Comparative Fee Structures, and Fall-Out Benefits: Plaintiffs did not present evidence at trial regarding these issues. This was significant to the Court, which found that these failures weighed against a finding that the fees at issue could not have been negotiated at arm’s length. Notably, while recognizing the admonition in Jones that courts should be wary of giving undue weight to fees charged by other funds, the Court considered the evidence provided by Defendants on comparative fee structures, finding that factor to weigh in favor of finding against Plaintiffs. Specifically, the Court found that “the data from Lipper is reliable,” despite various challenges from Plaintiffs.
Taken collectively, the Court concluded that Plaintiffs had failed to meet their burden. While the Court agreed with Plaintiffs that Gartenberg does not mandate “a checklist,” their failure to present evidence on several topics was necessarily a failure to move closer to meeting their burden. Given that the Court had already found the “independence and conscientiousness of the independent trustees cuts in favor of Defendants’ position[,]” Plaintiffs’ failure to present evidence about several Gartenberg factors undermined their efforts. Moreover, the evidence Plaintiffs did put forward regarding the adviser’s profitability and the nature and quality of the services provided did not rise to the level of satisfying their burden. Consequently, the Court found that “Plaintiffs have not carried their burden of proof” and dismissed the action.
The Hartford decision reinforces many of the takeaways from the AXA opinion, including the fact-intensive nature of the proceedings, the significance of evidence absent from the record, and the importance of presenting credible expert testimony to support one’s claims. In addition, by granting “no weight” to Plaintiffs’ “retained fee theory,” the decision directly rejected the legal authority upon which plaintiffs have premised their numerous “manager of managers” cases. Plaintiffs are expected to appeal this ruling (as they already have done in AXA), so the final word on the “retained fee” theory and the “manager of managers” challenges remains to be written.