U.S. District Judge Peter G. Sheridan ruled that the plaintiffs failed to prove that an adviser breached its fiduciary duty to fund shareholders by charging advisory and administrative fees that were excessive despite the argument that significant services were provided by sub-advisers and sub-administrators. This case (Sivolella et al v. AXA Equitable Life Insurance Co et al, U.S. District Court, District of New Jersey, No. 11-04194) was the first case of this kind to go to trial since the U.S. Supreme Court decided Jones v. Harris Associates in 2010.
Plaintiffs were investors in 12 mutual funds in the EQ Advisors complex through a variable annuity issued by AXA Equitable. These funds were operated using a “manager of managers” structure, in which the adviser and its affiliates retained sub-advisers to carry out portfolio management, and bank affiliates provided sub-administration support under agreements that described the sub-contracted services similarly to those called for by the primary agreements. The adviser selected and recommended board-approved sub-advisers, and the adviser and administrator remained responsible for control, oversight and reporting functions.
Section 36(b) imposes upon the adviser to a fund a fiduciary duty “with respect to the receipt of compensation,” and provides shareholders with a private right of action for damages. To recover, under the Gartenberg standards confirmed by the Supreme Court in the Jones case, plaintiffs must show that 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.”
Plaintiffs claimed that AXA’s management entity “charged investors exorbitant fees for mutual fund investment and administrative duties, and then delegated those same duties to sub-advisers and sub-administrators for nominal fees.” After a 25-day trial, the district court found that plaintiffs had failed to prove that AXA’s fees were excessive. Most of the judge’s 159-page opinion constituted findings of fact regarding specific evidence and testimony, and, while it serves as an example of careful judicial scrutiny, the opinion does not establish new or refined legal principles in the interpretation of Section 36(b). Some takeaways were:
- The Burden of Proof. The judge’s opinion underscores that the burden of proof is on the plaintiff to demonstrate that the fee is unreasonable, and not on the defendant to demonstrate that the fee is reasonable. The court found that the plaintiff failed to meet its burden of showing that the fees were unreasonable.
- Credibility. The opinion made findings about the credibility of the key witnesses, including plaintiff and defense experts. The judge discounted the testimony of several of plaintiffs’ expert witnesses due to lack of preparation, inconsistency, bias and attitude. By contrast, the defense witnesses were found to be credible, particularly the one fund trustee who testified, who was the lead independent trustee and a former Simpson Thacher investment management partner.
- The Board Process. The district court acknowledged the rigor of the board’s review, which proved sufficient to obviate any additional judicial scrutiny of the 15(c) determinations under Jones. The opinion described details of the board’s independence and performance, noting that it engaged in a year-round process to evaluate and approve the funds’ advisory and administrative fees and authorized its independent counsel to prepare a 15(c) memorandum seeking documentation to assist the board in reviewing and identifying funds with fee, performance or compliance issues or significant growth.
A summary of the court’s analysis of the Gartenberg factors follows:
- Services Rendered. While the plaintiffs had asked the court to rely on the virtual identity of the services described in advisory and sub-advisory contracts, Judge Sheridan held that it was appropriate to review the totality of the services actually rendered and set forth a catalogue of services provided by the primary adviser that may not have been specified by contract. Such services included organizational, regulatory and board governance services and involve the incurrence of entrepreneurial risk.
- Quality of Services. The district court found that investment performance was not a Gartenberg factor. The opinion concludes, citing a 2nd Circuit case from 2006, that “allegations of underperformance alone are insufficient to prove that an investment adviser’s fees are excessive.” That statement may be one of the two most significant legal findings in the AXA case.
- Profitability. Plaintiffs argued that the amount paid to sub-service providers should not be treated as an expense of the adviser in calculating the adviser’s profitability. The court instead relied on the defense expert’s statements that such treatment was consistent with ordinary accounting principles.
- Economies of Scale. Judge Sheridan identified a variety of methods by which economies were shared with fund shareholders, including breakpoints, product cap reimbursements, expense limitation agreements, pricing to scale and use of directed brokerage. Plaintiffs did not prove that the funds failed the test that economies be shared.
- Fall-out Benefits. Plaintiffs had argued that profits relating to placement of these funds within an insurance wrapper required explicit consideration as to whether profits on the insurance side are “fall-out,” i.e., profits accruing to the adviser “as a result of its work on behalf of the mutual fund.” Instead the judge adopted a “but for” test, as urged by AXA, under which a fall-out benefit is one the adviser would not have earned were it not for the advisory relationship. The judge concluded that wrapper fees and certain other fees were not “fall-out” benefits, excusing AXA from not having specifically considered them.
- Comparative Fees. While plaintiffs alleged that Lipper data used by the trustees was flawed, the court ruled that Lipper was sufficiently independent and that its information could be relied upon despite recognized limitations. The defense position was that Lipper showed the funds’ fees to be approximately at the median.
Having examined and dismissed the sufficiency of the plaintiffs’ proof, Judge Sheridan turned to damages. The court noted that although it “need not reach damages,” having concluded that the defendants were not liable, “the requirement to show ‘actual damages’ is an element plaintiffs have not proven, and by itself, this prevents any recovery by plaintiffs.” The court examined four “damage models” quantifying damages owed. In looking at one model, which called for “complete disgorgement of FMG's entire fee”, the court observed that “[a]ctual damages would be the difference between the fee paid and a fee that would have been ‘fair’,” i.e., that could have been negotiated at arms’ length. In the disgorgement model, the “fair” fee put forward by the plaintiffs is zero, and the court found that “there is nothing in the record to demonstrate that FMG performed no duties, and therefore would not be entitled to any fee.” Of the other three damage models, one was disregarded by the court because it compared the AXA fees to a peer company only offering index funds (whereas AXA offers active, “pactive” and index funds) and the other two were found to be not credible.
The plaintiffs’ lawyers have already announced that they intend to appeal. The plaintiffs’ lawyers are counsel of record in over 20 other cases pending in federal district court against various complexes, all based on similar theories.