Court Credits Robust Board Process and Persuasive Independent Trustee Trial Testimony in Section 36(b) Victory

On August 5, 2019, the U.S. District Court for the Central District of California issued its post-trial ruling in Kennis v. Metropolitan West Asset Mgmt. LLC, holding that the plaintiff had failed to meet his burden to show that defendant-adviser Metropolitan West Asset Management (MetWest) charged excessive advisory fees to the Total Return Bond Fund in violation of Section 36(b) of the Investment Company Act of 1940. 

The Kennis decision is the eighth consecutive decision to conclude that an adviser’s services provided and risks associated with managing a mutual fund, as compared to institutional or sub-advisory accounts, are substantively different. Notably, the decision also once again highlights the continuing importance of an informed Board of Trustees and strong Board process.

Section 36(b) imposes a fiduciary duty on an investment adviser to a mutual fund “with respect to the receipt of compensation,” and gives mutual fund shareholders a private right of action to enforce that duty. The statute expressly assigns to any such plaintiff the burden of proof, and subsequent case law makes 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.”2 Critical to this analysis is the amount of deference that the court must give to the independent trustees’ approval of the advisory agreement at issue, which turns on: “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.”3

In Kennis, the plaintiff alleged that the advisory fee MetWest charged to the Fund was excessive, because MetWest charged a higher fee to advise its Total Return Bond Fund (Fund) than it charged to sub-advise a number of unaffiliated mutual funds to which it provided allegedly similar services. The plaintiff also pointed to the allegedly high profitability of the adviser, and further claimed that MetWest failed to share economies of scale adequately, because the Fund’s fee schedule lacked adequate breakpoints as assets under management grew. The plaintiff also attacked the care and conscientiousness of the Fund’s Independent Trustees, claiming that the Independent Trustees failed to request or receive adequate information concerning the nature of the services that MetWest provided to the Fund as compared to the funds it sub-advised, and because it failed to negotiate a reduction in the Fund’s advisory fee.

Following a two-week bench trial, the court ruled that the plaintiff’s attempts to compare the Fund to sub-advised funds were inapt given the “substantially different” and greater services and risks MetWest faces when managing the Fund. The court also squarely rejected the plaintiff’s attacks on the board process, holding that the Board’s approval of the Fund’s fee was entitled to “substantial deference” because, among other reasons, the Independent Trustees requested and received sufficient information concerning each of the factors pertinent to their review of the advisory agreement, and that they had satisfied their responsibility to ensure the advisory fee was fair and reasonable.

The Kennis court’s ruling is noteworthy for its recognition of the importance of the role of the Independent Trustees and the fulsomeness of the Section 15(c) process by which they reviewed and approved the advisory fees. The court repeatedly credited testimony from the Fund’s Independent Trustees concerning the robustness of the Section 15(c) process, including detailed requests for information concerning the factors relevant to the review of the advisory agreement, as well as their lengthy review, discussion and follow-up requests based on the information provided.

Indeed, in rejecting the plaintiff’s attempts to compare the services and risks associated with managing the Fund to that of MetWest’s sub-advised funds, the court relied on the trial testimony of the Board Chairman that the Independent Trustees “were familiar with what a sub-adviser’s role is versus an adviser’s role in the mutual fund context; and that the Board and MetWest had conversations throughout the year regarding that topic.”4 The court concluded that the Independent Trustees’ judgment “that the [sub-advisory] ‘product’ was so different” could reasonably and correctly have been made based on the information that the Board did receive and review.5 Similarly, the court credited the Independent Trustees’ testimony regarding the Board’s thorough review of information regarding economies of scale and profits.

Given the robustness of the Board’s 15(c) process, the court ultimately concluded that the Board’s decisions were owed substantial deference, and that the plaintiff failed to demonstrate that the comparative fees, economies of scale, or profitability factors weighed in his favor, and thereby failed to prove that MetWest charged a fee “that 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.”6

Dechert LLP served as counsel to the Independent Trustees of the Fund. All factual statements above are from public sources.

Footnotes

1) Dkt. 508, No. 2:15-cv-08162-GW-FFM (C.D. Cal.).
2) Jones v. Harris Associates, L.P., 559 U.S. 335, 346 (2009).
3) Jones, 559 U.S. at 349, 351.
4) Slip Op. at 36.
5) Id. at 37.
6) Id. at 58-59.