Five years removed from the credit crisis and “great recession” of 2008, the U.S. fund industry still faces substantial litigation risk, both in terms of ongoing cases that challenge the core of the advisory/sub-advisory model and the potential for new threats. While cases premised on the alleged failure of mutual funds to accurately describe their investment strategies and attendant risks from the credit crisis have subsided, cases challenging advisory fees under Section 36(b) of the Investment Company Act of 1940 (ICA) are on the rise. The plaintiffs’ bar, working alone and on occasion in the wake of the Securities and Exchange Commission (SEC), has invested a great deal of its resources in targeting the mutual fund industry, and appears intent on pursuing cases across the country on a variety of theories.
This article summarizes the current mutual fund litigation landscape, as both a status report on where the fund industry now finds itself in high stakes investor cases, and an assessment of where the civil litigation against the fund industry could be headed in the months and years to come.
Claims Under the 1933 and 1934 Acts Have Proven Difficult for Plaintiffs
In the aftermath of the credit crisis, the plaintiffs’ bar relied on the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act) to launch a number of lawsuits against mutual funds and their advisers. Today, only a few of these lawsuits remain pending. Favorable market conditions, and the United States Supreme Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders1 – which held that the investment adviser to a mutual fund could not be held primarily liable under Section 10(b) of the 1934 Act for statements made in a fund’s prospectus – have at least temporarily stemmed the tide of new Rule 10b-5 lawsuits against investment advisers based on disclosures in fund prospectuses. And, investor lawsuits brought under Section 11 of the 1933 Act relating to inadequate mutual fund disclosures have, for the most part, also faded – due in no small part to the success of the industry in obtaining dismissal of these lawsuits at the motion to dismiss stage, on the basis that the plain language of a fund’s registration statement addressed the risks that plaintiffs cited.2
That this trend of lawsuits has subsided does not suggest that the risk of Rule 10b-5 and Section 11 lawsuits has been eliminated. To the contrary, litigation waves are cyclical and often hinge on market events or SEC regulatory action.3 There is every reason to expect that the plaintiffs’ bar will be looking for new opportunities to pursue claims under these federal securities statutes.
Plaintiffs Strike out with Auction-Rate Preferred Securities Cases
Plaintiffs have been largely unsuccessful in lawsuits filed against closed-end funds in connection with the collapse of the market for auction-rate preferred securities (ARPS) in early 2008. Following the subsequent redemption of ARPS by certain funds, a number of closed-end funds faced dual legal challenges from state and federal regulatory authorities and from shareholders in the form of demand letters or lawsuits. Notwithstanding this litigation offensive, most of the shareholder complaints were dismissed, and those that are still pending face strong motions to dismiss.
As the name suggests, ARPS are long-term variable-rate instruments with their interest rates determined by “Dutch” auctions. ARPS were among the primary instruments used by many closed-end funds to leverage municipal and taxable fixed-income portfolios.4 Closed-end funds issued ARPS with the goal of paying higher dividends on the funds’ common shares.5 Although closed-end funds initially had an extremely high rate of successful auctions for ARPS, by early 2008 the ARPS market felt the impact of the broader subprime and credit crisis, and auctions began to fail (i.e., seller supply exceeded buyer demand).6 As could be expected on the heels of the sudden market collapse, regulatory agencies and private plaintiffs took action against closed-end funds. In 2008 and 2009, many funds reached settlements with federal and state regulators, in which the firms agreed to redeem some of the ARPS that they sold.7
Meanwhile, private plaintiffs brought lawsuits on behalf of either ARPS holders or common shareholders. The ARPS holder lawsuits generally alleged, among other things, that the fund’s adviser had marketed ARPS without disclosing their liquidity risk.8 None of these complaints resulted in any victories for the plaintiffs. Common shareholders also filed a number of lawsuits based on allegations that the redemptions of ARPS at par value constituted breaches of fiduciary duty to the common shareholders and/or constituted a waste of the fund’s assets. And like the ARPS holders’ claims, the common shareholders’ complaints either have been dismissed or are facing a pending motion to dismiss based in substantial part on plaintiffs’ failure to overcome the “business judgment” rule.9
Plaintiffs' Big Push in Section 36(b) Litigation
Shareholders have the express right to sue to enforce a single provision of the ICA – Section 36(b). This section imposes a fiduciary duty on an investment adviser with respect to the compensation it receives from a fund, and provides shareholders the right to sue to recover, for the benefit of the fund, excessive fees paid to the adviser in violation of this duty.10 Under Supreme Court precedent, “to face liability under §36(b), an investment adviser must charge 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.”11 Additionally, courts deciding Section 36(b) cases must give “considerable weight” to the decision of an informed board of directors that approved the adviser’s fee.12 Despite the high legal hurdles to establishing a Section 36(b) claim, plaintiffs’ law firms seeking to exploit this narrowly focused provision have launched an increasing number of attacks on investment advisers in recent years, primarily targeting advisers’ use of sub-advisers.
The recent wave of Section 36(b) claims is based on some variation of the theory that in a sub-advised fund, or a “manager of managers” structure, the investment adviser’s fees are excessive because the adviser delegates nearly all of its work to a sub-adviser (or sub-advisers), yet retains a significant portion of the fee. This theory was first tested in Curran v. Principal Management Corp., which was filed in late 2009. The plaintiffs in Curran were shareholders of two funds of funds managed by Principal Management Corporation (PMC). In addition to serving as adviser to the funds, PMC was adviser to the underlying funds, and used a sub-adviser to manage both the funds and the underlying funds. The plaintiffs alleged that PMC charged far more in fees than did the sub-advisers it had hired to perform the actual investment advisory activities for the funds.13 Finding that these allegations created a reasonable inference that the advisory fees were excessive, the federal court in Iowa denied the adviser’s motion to dismiss.14 After three more years of litigation, the parties settled on the eve of trial.
Shortly following the denial of PMC’s motion to dismiss, the plaintiffs’ bar filed new cases seeking to improve upon the Curran plaintiffs’ strategy. In Kasilag v. Hartford Financial Investment Services, LLC and Sivolella v. AXA Equitable Life Insurance Co. (both filed by the same law firm), the plaintiffs alleged that the investment adviser’s fees were excessive because it delegated virtually all of its duties to sub-advisers, but retained 63% and 74%, respectively, of the total advisory fees paid by the funds.15 After initially dismissing the plaintiffs’ claims and allowing plaintiffs to amend their complaint, the court in Kasilag found that the amended complaint advanced a plausible Section 36(b) violation.16 In Sivolella, AXA chose to challenge the plaintiffs’ standing but not the merits of the plaintiffs’ allegations.17 AXA’s motion to dismiss was denied and, like Kasilag, the case proceeded to discovery – where both cases still remain.
Seizing upon the success of the Kasilag and Sivolella plaintiffs in avoiding dismissal, other plaintiffs’ firms have filed a number of additional lawsuits in late 2013 and early 2014 in federal courts across the country. In Cox v. ING Investments, LLC, McClure v. Russell Investments Management, Curd v. SEI Investments Management, and Zehrer v. Harbor Capital Advisors, the plaintiffs followed the same basic pattern of the previous lawsuits (even copying word-for-word sections of those complaints).18 However, unlike in Kasilag and Sivolella, which targeted investment advisers that retained more than a majority of total advisory fees, these cases were brought against advisers that retained closer to half – or even less than half – of the total advisory fees. For instance, the adviser in Curd retained only 37% of the advisory fees. Further, rather than focusing almost exclusively on the fee split, these lawsuits also challenge the overall amount of the advisory fee as excessive. In addition, another lawsuit was filed against PMC, with very similar claims as in Curran.19 And as the plaintiffs in AXA obtained information through discovery, they filed an amended complaint, adding a claim that the adviser’s administrative fees were excessive because it delegated nearly all its administrative work to a sub-administrator, yet retained for itself more than 90% of the administrative fees paid by the fund.20
The newest iteration of this Section 36(b) claim based on the use of a sub-adviser appeared in late February 2014, in a complaint filed against BlackRock Investment Management and two of its wholly-owned affiliates. In Clancy v. BlackRock Investments Management, LLC, et al.,21 plaintiffs brought a Section 36(b) claim against BlackRock Investment Management and two affiliated entities that both serve as the investment adviser to the BlackRock Global Allocation Fund, and also serve as sub-adviser (allegedly employing the same global allocation strategy) to three other global allocation funds that are part of separate fund complexes. The core allegation is that BlackRock is effectively doing the same work for the sub-advised funds as it performs for the BlackRock fund, yet it is receiving an advisory fee that is approximately double what it receives for its sub-advisory work.
In addition to attacking the adviser’s fee based on its use of a sub-adviser, the plaintiffs in these cases also assert a variety of similar, secondary allegations. All the complaints contain some assertion that the adviser did not adequately share economies of scale with the fund. To support this allegation, plaintiffs point variously to: (1) the fund’s significant growth with no corresponding reduction in advisory fee rates; (2) the lack of breakpoints in the advisory contract, or the lack of “meaningful” breakpoints because the initial breakpoint is set too high, the breakpoints are spaced too far apart, or the fee reductions at each level are too low; and (3) the disparity in the breakpoint schedules of the advisory contract and sub-advisory contract (which, plaintiffs assert was negotiated at arm’s length, unlike the advisory contract). The plaintiffs in these cases also insinuate that the fund board was not conscientious in approving the advisory contracts, usually alleging that the directors could not have focused sufficient attention on this task because they oversee all the funds in a large fund complex, and that the directors are beholden to the adviser due to the compensation they receive for their service on the board.22
The recent wave of complaints makes clear that no investment adviser is immune from this structural attack on advisory fees. Advisers that retain less than half of total fees paid to the adviser and sub-advisers, charge relatively low fees, receive relatively low dollar amounts of fees, use unaffiliated sub-advisers, and/or use multiple sub-advisers for a single fund may all be at risk. Additionally, the twist on this structural attack, as alleged against BlackRock based on its dual role as an adviser and sub-adviser, if followed on by similar lawsuits, could result in challenges to a common industry practice being brought against some of the biggest industry players. Having said that, the industry is defending all of these cases aggressively, and it remains to be seen if any of these plaintiffs will ever be able to prove the allegations they have made, especially when facing the high standard adopted by the Supreme Court in Jones.
Plaintiffs Have Failed Thus Far in Their Attempt to Expand Recent Successes in Section 36(b) Litigation to Securities Lending Fee Arrangements
The plaintiffs’ bar also has recently attempted to use Section 36(b) to challenge the fees received by an adviser and its affiliates in connection with a fund’s securities lending program. In Laborers’ Local 265 Pension Fund v. iShares Trust, fund shareholders – represented by the same law firm that has brought many of the Section 36(b) suits attacking an adviser’s use of sub-advisers – sued the fund’s investment adviser, BlackRock Fund Advisors and its affiliated securities lending agent, alleging that they had received excessive compensation from revenue earned on the funds’ securities lending transactions. In this case, the defendants retained 40% of the revenue and the funds received the remaining 60%.23 The court dismissed the plaintiffs’ claims, finding that the defendants were operating the securities lending program pursuant to an exemptive order from the SEC, which precluded application of Section 36(b).24
Although the case was dismissed, it appears to have spurred a renewed focus on fee splits in securities lending arrangements. Shortly after the iShares decision, the SEC’s Office of Compliance Inspections and Examinations initiated a sweep, scrutinizing investment advisers’ use of securities lending programs and affiliated lending agents.25 We will have to wait and see what this sweep produces.
Outlook for the Future
The fund industry remains an attractive target for plaintiffs’ lawyers, many of whom have invested heavily in claims against the industry. The industry has achieved a good deal of success in defending lawsuits brought under the 1933 and 1934 Acts and those targeting the use of ARPS, and the legal landscape might even change for the better when the Supreme Court rules in the Halliburton and Omnicare cases. Yet, the current wave of Section 36(b) lawsuits is likely to expand in scope as the plaintiffs’ bar continues to look for a return on its litigation investment. And, against this backdrop, adverse market events or significant regulatory developments could lead to even more litigation focus on the mutual fund industry.