(Article from Registered Funds Alert, September 2016)
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On August 25, 2016, Judge Sheridan of the U.S. District Court for the District of New Jersey rendered his decision in Sivolella v. AXA Equitable Life Insurance Company, finding that the plaintiffs failed to meet their burden in demonstrating a breach of fiduciary duty under Section 36(b) of the Investment Company Act of 1940 (“1940 Act”). The AXA case was the first Section 36(b) case to advance to trial since the Supreme Court’s 2010 unanimous decision in Jones v. Harris Associates L.P. that upheld the Second Circuit’s well-established Gartenberg precedent.
The Plaintiffs alleged the adviser (“FMG,” an affiliate of AXA) charged excessive advisory fees and administrative fees with respect to 12 funds. The plaintiffs’ case focused on three arguments:
- FMG breached its fiduciary duty to the funds by charging fees that were disproportionate to the advisory and administrative services provided by FMG, as FMG delegated most of its duties to subadvisers and subadministrators that charged a lower fee;
- The funds’ board breached its fiduciary duty by approving the disproportionate fees; and
- FMG manipulated the materials provided to the board in connection with the annual contract renewal process under Section 15(c) of the 1940 Act by providing misleading and unreliable information.
In order to prove a violation of Section 36(b) under the Gartenberg/Jones precedent, a plaintiff must show that the fee charged by the adviser 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.” There are six factors that a court generally considers in evaluating a Section 36(b) claim with respect to each fund:
(i) The nature and quality of the services provided by the adviser to the fund and its shareholders;
(ii) The profitability of a fund to the adviser;
(iii) “Fall-out” benefits realized by the adviser due to its relationship with the fund;
(iv) The economies of scale achieved by the fund as it grows in size and whether the adviser shares such savings with shareholders;
(v) Comparison of a fund’s fee structure to similar funds; and
(vi) The independence and conscientiousness of the fund’s board.
Plaintiffs need not prove that all of these factors weigh in their favor to prevail on a Section 36(b) claim. Additionally, the Supreme Court in Jones cautioned courts from placing too much weight on comparisons of a fund’s fees to similar funds, as there is no guarantee that such fees represent fees negotiated at arm’s length.
Section 36(b) claims are inherently tied to the board’s annual contract renewal process pursuant to Section 15(c) of the 1940 Act. Generally speaking, Section 15(c) requires a fund’s board to consider the renewal of an advisory agreement on an annual basis and imposes a duty on the board to request, and the adviser to provide, all information that may be reasonably necessary for the board to evaluate the agreement. Under Gartenberg and Jones, the decision of a fund’s board, particularly its independent trustees, is given considerable weight by a court unless a plaintiff can show that the board’s process was deficient or the adviser withheld important information from the board.
In finding for AXA with respect to each of the factors enumerated above, Judge Sheridan’s decision heavily discounted the testimony of the plaintiffs’ expert witnesses, citing errors, inconsistencies, lack of relevant experience, poor preparation and even “sarcastic demeanor” as reasons why little weight was given to their testimony.[1] In contrast, Judge Sheridan appears to have relied heavily on the testimony of the board’s lead independent trustee and quoted him at length throughout the opinion.[2]
This Alert does not provide an in-depth review of Judge Sheridan’s findings with respect to each Gartenberg factor, instead focusing on key takeaways for advisers and boards to consider in assessing the adequacy of their annual Section 15(c) process.
Services Provided by the Adviser in a Multi-Manager Structure
A number of recent Section 36(b) claims have targeted advisers to multi-manager funds that delegate responsibilities to subadvisers, as FMG does, arguing essentially that the adviser is being paid without providing meaningful services. This line of argument relates most closely to the factor that focuses on the nature and quality of the services provided by the adviser. Judge Sheridan devoted a significant portion of his opinion to this topic (over 40 pages). In the AXA case, the plaintiffs argued that the plain text of the advisory and administrative agreements, when compared to the language of the subadvisory and subadministrative agreements, showed that FMG was delegating each and every one of its responsibilities.
The court found that the administrative contract language clearly indicated that FMG retained significant obligations. With respect to the advisory agreements, however, Judge Sheridan found that the contractual language on its face seemed to indicate a complete delegation of FMG’s advisory responsibilities. In finding for AXA on this point nonetheless, the court relied on evidence showing that FMG retained many significant responsibilities not specified in the various advisory contracts, and found that AXA, an affiliate of FMG, provided significant services to the funds, the costs of which were borne by FMG. The overall services provided to the funds by FMG and AXA included:
- Supervision and management of subadvisers, including diligence and monitoring of performance;
- Construction and restructuring of portfolios;
- Setting benchmarks;
- Structural changes to funds (such as changing a fund’s strategy or objective, terminating a subadviser or merging a fund);
- Formulating and implementing investment strategies for each fund (or sleeves of a fund);
- Asset allocation and rebalancing;
- Fair valuation for hard-to-value securities;
- Legal and compliance services;
- Preparing and managing board materials and meetings;
- Disaster recovery services; and
- Call centers to handle shareholder inquiries.
In light of this discussion in Judge Sheridan’s opinion, it may be wise for advisers to compare the duties outlined in their advisory and subadvisory agreements (or other agreements). To the extent that this comparison shows an apparent delegation of all duties, an adviser should ensure that its Section 15(c) materials discuss any duties provided by an adviser that are not explicitly discussed in the applicable agreements. Additionally, advisers should consider public disclosure, including in shareholder reports, of the types of services provided to the funds they advise.
The Board
In the AXA case, the court evaluated whether having an interested chair of the board undermined the board’s independence and ability to fulfill its duties. The funds’ lead independent trustee testified that he and the other independent trustees were, in reality, responsible for setting the agenda for board meetings, while the interested chair then carried out that agenda in running board meetings. While the court questioned whether an interested chair could realistically look out for the best interests of fund shareholders while simultaneously serving as CEO of the adviser, the fact that the board had a supermajority of independent trustees who demonstrated that they carry out their duties in a conscientious manner appears to have mitigated Judge Sheridan’s concerns. The fact that the board meeting agenda was decided with input from the independent trustees also appears to have been an important factor in the court’s decision. For other fund complexes, if the board has an interested chair but no lead independent trustee, it may be time to consider adopting that practice.[3]
Notably, Judge Sheridan also made a point of including a separate section in his opinion discussing how the filing of the lawsuit seems to have been the catalyst for several improvements to the board’s practices and the Section 15(c) materials it receives in connection with annual contract renewals. For example, the opinion notes that the lawsuit appears to have resulted in a more critical review of board expenses, such as dinners associated with board meetings, and Judge Sheridan included a footnote recommending that the board adopt a policy regarding board expenses to ensure transparency regarding board-related costs. Additionally, the Judge stated that, since the commencement of the lawsuit, the board had begun receiving information in connection with the annual Section 15(c) process regarding the portion of the advisory fee that FMG retained after paying the subadviser,[4] and that the Section 15(c) materials were supplemented with an index of materials that tied each document to the relevant Gartenberg factor(s). While adoption of similar policies and practices cannot insulate a board from a Section 36(b) claim, they could prove to be helpful in the event a fund complex is sued.
The Plaintiffs in the AXA case have indicated that they intend to appeal the decision. We will continue to monitor this and other pending Section 36(b) cases (of which several are still pending, on similar and different fact patterns), and will address any notable developments in future Alerts.
[1] Notably, each of the plaintiffs’ experts in the AXA case have been retained as experts by plaintiffs in a separate Section 36(b) case, pending in the same court (but before a different judge), against Hartford Investment Financial Services, LLC. The attorneys for both AXA and the plaintiffs also represent the parties in the Hartford case.
[2] We note that the lead independent trustee, Gary Schpero, is a retired partner of Simpson Thacher who previously led our investment management practice.
[3] Judge Sheridan’s opinion also implies that the appointment of Mr. Schpero as lead independent trustee was a result of the lawsuit, but this point fails to consider that he assumed that mantle from another trustee upon his retirement from the board.
[4] We note, however, that the record seems to reflect that this information was considered by the board prior to the commencement of the lawsuit.