Heading to Trial
If you place coverage for mutual funds, investment advisors, employers or institutions that are mutual fund fiduciaries, you need to be aware that the plaintiff’s bar is at it again.
The recent excessive-fee cases they’ve brought on behalf of fund shareholders have the potential to expand liability, and thus insurance costs, in multiple ways. These cases are surviving motions to dismiss and are moving to trial. Knowing what this litigation is all about is key to understanding how it could impact the insurance industry and how to mitigate the blow.
Claims of excessive advisory fees brought by mutual fund shareholders are often referred to as “36(b) cases” because they fall under Section 36(b) of the Investment Company Act of 1940, which gives shareholders the right to sue an advisor if they believe the advisor’s compensation level is unfairly high. Historically, there has been a pretty high bar for plaintiffs to overcome the deference given to fund boards of directors and their assessment of fairness in this context. The rule has long been that if a fund’s board approves an advisory fee, challenges to it are not likely to be successful unless the advisor has acted inappropriately in its own financial interest by, for example, providing minimal services while charging high relative fees.
But there has been a recent spate of 20 or so excessive advisory fee lawsuits, beginning with Sivolella v. Axa Equitable Life Insurance Co. in 2011, that have made it to trial or pre-trial. These cases have shown that, while the old rule hasn’t exactly changed, the latch on the door may be weakening, and plaintiffs are finding alternative inroads to recovery. Here are some examples:
Third-Party Subadvisory Cases
While past excessive advisory fee claims generally focused on the fees fund shareholders paid to advisors, Axa and other cases like it turn on arrangements with unaffiliated subadvisors. The plaintiffs in Axa argued that the advisor charged too high an advisory fee given that third-party subadvisors performed most of the fund management and shareholders also paid a subadvisory fee. This theory, that it is patently unfair for advisors running a so-called “manager of managers” business to collect advisory fees on top of subadvisory fees, has survived motions to dismiss (or similar defense maneuvers) in many of the cases in which it has been used around the country.
Affiliated Subadvisory Cases
Another somewhat novel theory involving subadvisory relationships has also had some success in pushing past traditional obstacles to trial. In Goodman v. J.P. Morgan Investment Management, Inc., the plaintiffs argued “a notable disparity” in fees, claiming the fees paid by fund shareholders for J.P. Morgan advisor services were disproportionately large when considering the fees paid by J.P. Morgan subadvisory clients. The Southern District Court of Ohio denied the defendant’s motion to dismiss the case.
These principles have also been used by plaintiffs to survive motions to dismiss involving “funds of funds,” which are mutual funds that invest in shares of other mutual funds, as opposed to investing directly in stocks and bonds. In a 2014 case brought in the Southern District of Iowa, a 401(k) plan made it to trial arguing that an advisor was unfairly getting “something for nothing” by charging both a management fee for the fund of funds and a subadvisory fee for the affiliated underlying funds in which the fund of funds invested.
Twists to Traditional 36(b) Cases Some of the ongoing excessive advisory fee cases seem fairly traditional at a glance but reveal more creative plaintiff strategies underneath. In a 2015 case brought in the Southern District of New York, Chill v. Calamos Advisors LLC, the plaintiff argued that facts showing the advisor’s long reliance on certain funds’ advisory fees for income illustrated a heightened incentive to charge excessive advisory fees. This case, too, survived a motion to dismiss.
Whatever the outcome of these cases at trial, brokerages should keep a sharp eye on this litigation trend. It is playing out across the asset management industry, in various jurisdictions and against a regulatory backdrop in which the Securities and Exchange Commission and the Department of Labor have focused on guidance and rulemaking requiring significant transparency into the fees paid by fund shareholders.
Many questions remain. Will the courts find advisory and subadvisory fee comparisons to be apples to apples or apples to oranges? If an advisor is found to have charged excessive advisory fees, could it have similar exposure on its subadvisory fees? What about its subadvisory clients’ boards or advisors? Will they be liable? Will standard D&O insurance be sufficient in the new era of 36(b) litigation? If boards’ and advisors’ potential liability increases, will they seek greater insurance coverage? Will the insurance industry provide it? Are there fiduciary implications for employers that offer retirement plans but don’t pay attention to excessive fees or contest them? Is there potential broker-dealer liability lurking around the corner? What other issues might loom large?
To the extent that you place insurance for mutual funds, advisors, entities that are fiduciaries or others in the asset management industry, you might start thinking about your clients’ risk mitigation practices—and how they should change—if the potential liabilities associated with excessive advisory fee litigation ultimately balloon, as it currently seems they could. Should advisors revise their management contracts to specify in greater detail the differences between advisory and subadvisory services? Should mutual fund boards add new questions regarding subadvisory arrangements to the standard factors considered in their annual advisory contract approvals? Should they consider disclosure enhancement regarding the advisory contract renewal? Should funds adopt excessive advisory fee risk assessment or compliance oversight programs? Should advisors? If they do, how should the fee benchmark measure be established?
These are just some of the questions the industry faces. Within the year we should start to see how it will all shake out.