The fund manager was victorious in the first court decision to come from a group of complaints filed over the last several years against manager-of-manager models.
Following a 25-day bench trial, the US District Court for the District of New Jersey recently ruled against a group of plaintiff shareholders who claimed that AXA Equitable Funds Management Group (FMG) “charged exorbitant fees for mutual fund investment and administrative duties, and then delegated those same duties to sub-advisers and sub-administrators for nominal fees.”[1] The court concluded that the plaintiffs had failed to meet their burden in demonstrating a violation of Section 36(b) of the Investment Company Act of 1940, as amended (the 1940 Act) and also failed to prove any actual damages. Although the Board of Trustees (the Board) for the AXA-sponsored EQ Advisors Trust (the Trust) was not named as a defendant in the case, the court concluded that the Board had not breached its fiduciary duty by approving the contracts with FMG that charged the fees in question.[2]
Section 36(b) was adopted in 1970 to permit mutual fund investors and the US Securities and Exchange Commission (SEC) to seek restitution for excessive charges imposed on fund shareholders. Under Section 36(b), a fund’s adviser has a fiduciary duty with respect to the fees it charges the fund.
Since 1982, courts have used the standard set out by the US Court of Appeals for the Second Circuit in Gartenberg to determine whether such duty has been breached.[3] In assessing fees, courts have stated that all pertinent facts and relevant factors must be considered, including the following factors:
This action was brought on behalf of holders of variable annuity contacts with AXA Equitable Life Insurance Company (AXA) (AXA and FMG together were the defendants in the action).[4] Holders of the variable annuities then select which mutual funds they want their money to be invested in, and, in turn, FMG manages the funds. At issue in the trial was FMG's "manager-of-managers" structure, whereby FMG provides advisory and management services to a fund and engages third-party service providers for certain investment and administrative services. In an amended complaint, the plaintiffs also claimed that FMG provided administrative services to the funds at excessive rates.[5] In particular, the plaintiffs argued that
In sum, the plaintiffs contended that FMG's compensation under the investment management and administrative agreements was excessive and could not have been the product of arm's-length bargaining.[6]
For the plaintiffs to be successful under Section 36(b) of the 1940 Act, the Opinion states that they would have to establish, by a preponderance of the evidence (i.e., more than 50%), each of the following elements:
The court relied considerably on trial testimony and placed great weight on its credibility determinations, noting that witnesses’ credibility had a “significant impact” on the case’s outcome. The Opinion quotes extensively from the testimony on which the court relied in making its findings. The court consistently found the testimony of the defendants’ witnesses credible, while criticizing the testimony of the plaintiffs’ expert witnesses as inconsistent and unreliable.[8]
In the Opinion, the court reviewed each Gartenberg factor and concluded that the plaintiffs failed to meet their burden of proof for any of the factors.
The court first considered the Board’s independence and conscientiousness. Although the court was concerned that the Board had an interested chairman who controlled the information presented to the Board during FMG’s contract renewal process, the court found the lead independent trustee’s testimony credible that the Board’s process and independence adequately addressed any potential conflict from the interested chairman. Interestingly, the court dedicated several pages of its Opinion to the Board’s diversity and considered whether the Board was composed entirely of “Wall Street types” with a commonality of perspective and whether that perspective represents a fair deal for investors across the United States. This focus on diversity, and the court’s finding that the Board was “sufficiently diverse,” may suggest a new standard in this regard.
In response to the plaintiffs’ assertion that the Board placed too much faith in FMG-provided information, the court cited the lead independent trustee’s testimony about information received both from third parties (including the Investment Company Institute, the Independent Directors Council, outside consultants, and counsel) and as part of the Board’s education process, which included general education sessions and, in at least one instance, a presentation from the then-head of the SEC’s Division of Investment Management.
The court further noted that the Board participated in approximately 10 telephonic meetings per year in addition to five in-person meetings (one of which was dedicated to renewing the Trust’s arrangements with FMG) and used a committee structure for audit, governance, and investment issues. Among other items, the court also noted the processes by which independent trustees were selected and trained and independent trustee compensation was determined. The court commented favorably on the role of Morgan Lewis as independent trustee counsel, both in the education process for new trustees and the ongoing operation of the Board.
The court found that the Board was impartial, diverse, and independent and that the Board’s procedures demonstrate that it robustly reviewed FMG’s compensation. The Opinion notes that the court reached these conclusions based on the lead independent trustee’s testimony.
The court then considered the advisory and administrative services that FMG and AXA provided to the Trust compared to the services contracted out to subadvisers and a subadministrator. The court dedicated the largest portion of its Opinion to this topic. Of crucial importance to the court’s assessment of the nature and quality of the services provided was its willingness to look beyond the written terms of the service contracts and consider additional services provided, based on witness testimony. The court was unpersuaded by the plaintiffs’ argument that only the contractual language regarding services should be considered, stating that this would “ignore voluminous testimony of credible witnesses.”
With respect to advisory services, the court noted that FMG retained overall supervisory responsibility with respect to the subadvisers (including performing periodic on-site due diligence, completing monthly performance attribution and analysis, and managing manager transitions) and also prepared the Trust’s registration statement, prospectuses, supplements, annual and semi-annual shareholder reports, and other periodic reports. The court also noted that FMG provided investment management services, including handling risk management, setting benchmarks, formulating investment strategies, allocating assets among subadvisers, and, in some instances, managing proprietary investment strategies.
Regarding administrative services, the court noted that FMG also retained supervisory responsibilities over the subadministrator and played a primary role with respect to updating the Board on regulatory and legislative developments and compliance issues, filing proxy materials, preparing Board materials, preparing Board meeting minutes, and other functions. Although the court recognized that the subadministrator played an important role with respect to the Trust, the court characterized this as more of a secondary role to that of FMG in most instances.
The court was also critical of the plaintiffs’ failure to admit into evidence a “comprehensive breakdown” of the fees that FMG retained compared to those paid out to subadvisers and the subadministrator. The court stated that without the information about what FMG retained, it was “nearly impossible” for the court to determine whether the fee was so disproportionately large that it bore no reasonable relationship to the services rendered. The court also faulted the plaintiffs’ fee calculations, noting inconsistencies between materials submitted during and after trial.
The court concluded that credible testimony demonstrated that AXA performs a host of services for FMG in support of the funds.
As part of the discussion about FMG’s and AXA’s services, the court devoted several pages to the topic of risk and whether risks borne by FMG justify any portion of the fees charged to the funds. Again relying on “credible testimony,” the court found that FMG bore ongoing “enterprise” risk (including litigation, reputational, operational, and business risk) that would justify a portion of the fees charged and concluded that FMG was not required to quantify that risk to justify its fees.
Next, the court addressed FMG’s profitability and related accounting issues. First, the court considered whether FMG’s treatment of subadvisory and subadministrative expenses as FMG expenses for purposes of FMG’s profitability analysis (a treatment that results in a lower profit margin) was improper. Based partly on the Board chairman’s testimony, as well as on one of the defendants’ expert’s testimony, the court concluded that reporting subadviser and subadministrator fees as FMG expenses was within ordinary accounting principles.
The court also considered whether FMG’s cost allocation methodology used to allocate indirect costs against FMG’s revenues—particularly, the use of revenue as a measure by which to allocate costs—was improper. The court noted that the plaintiffs’ expert’s testimony on this topic was inconsistent and noted that two independent accounting firms were involved in creating FMG’s cost-allocation methodology for allocating expenses based on revenue, which led the court to conclude that this was also consistent with accounting principles.
Third, the court considered a shared services agreement between FMG and AXA, but was unable to find any proof that incorrect costs were assessed under the arrangement.
The court discussed breakpoints in the various agreements, noting that “extensive evidence” showed that the Board received information regarding economies of scale and how FMG shared such economies, including the fee schedules, breakpoints, and a legal analysis of the related judicial considerations.
The court also considered product cap reimbursements, expense limitation agreements, pricing to scale, directed brokerage arrangements, and securities lending, all of which, according to the testimony of the defendants’ witnesses, resulted in tens of millions of dollars in savings that were passed on to shareholders. The court found that the defendants’ experts and methodology were more credible than the testimony of the plaintiffs’ experts and that credible testimony indicated that the Board conscientiously reviewed economies of scale.
The court noted that the parties did not agree on the proper legal standard to apply in assessing fall-out benefits but did not reach a conclusion about the proper standard, noting that an investment in a variable annuity product may have to be considered differently than an investment solely in a mutual fund.
The court discussed the plaintiffs’ contention that product wrapper fees and general account spreads were fall-out benefits associated with the funds and concluded that the plaintiffs had not demonstrated that this was the case. On the other hand, the court noted that fees paid to an affiliated investment adviser had in fact been characterized as fall-out benefits and considered as such by the Board as part of its consideration of FMG’s fees.
The final Gartenberg factor that the court considered was comparative fees, noting that the plaintiffs did not dispute that the Board received comparative fee information, but rather claimed that the information that the Board received was unreliable. The court concluded that the plaintiffs’ experts had given inconsistent testimony about the alleged problems with the comparative fee data provided to the Board, that the defendants’ expert had given credible testimony about the data provided, and that the Board recognized that the data provided “was not an exact comparison.” The court also noted that one of the plaintiffs’ experts even admitted to using comparative fee data from the same source he criticized when creating his own comparative fee analysis.
The court also discussed the topic of fund performance, noting that “although not a Gartenberg factor,” plaintiffs contended that poor performance was an indication that the services provided were of an insufficient quality. Again, the court found the defendants’ witness testimony to be reliable and gave little weight to the testimony of the plaintiffs’ experts. The court noted that the credible testimony of the defendants’ witnesses indicated that the vast majority of the funds performed at or above expectations. The court also cited to prior case law noting that courts are hesitant to attach “too much significance to a fund’s financial performance”[9] and that “allegations of underperformance alone are insufficient to prove that an investment adviser’s fees are excessive.”[10]
The court, noting that Jones requires a court to look beyond the Gartenberg factors and to weigh all pertinent facts, found that filing the complaint “engendered positive change,” including changes in Board composition, “a more scrupulous and rigorous examination of Board expenses,” and an improvement in the quality of materials provided to the Board.[11] The court expressed skepticism that the changes it identified were part of the Board’s ongoing efforts to make improvements every year.
The court dedicated the last few pages of its Opinion to damages, noting that the court was not required to assess damages because the plaintiffs had failed to meet their burden of proof on the merits. Nonetheless, the court noted that had the plaintiffs met their burden of proof on the merits, based on relevant case law, the amount of damages would have been the difference between the fees paid and a fee that would have been fair and negotiated at arm’s length.
The court noted that the plaintiffs’ comparison against a low-cost mutual fund complex would have failed because there was no credible evidence to demonstrate that the services that the low-cost provider supplied were appropriately comparable to the services that FMG provided.
The court concluded that the Board followed a robust process for evaluating the services that FMG provided and the fees that the funds paid for those services, and that, contrary to the plaintiffs’ contention, FMG had not delegated away substantially all of its responsibilities. As a result, the court determined that the plaintiffs had been unable to provide sufficient evidence applying any one of the Gartenberg factors that FMG charged plaintiffs excessive fees, let alone the totality of the factors.
This resolution of the AXA excessive fee case maintains the industry’s perfect record at trial. Although the Opinion’s fact- and testimony-intensive nature may limit its utility to other courts, this same nature may provide insight to boards and advisers.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Boston
David C. Boch
Lea Anne Copenhefer
Barry N. Hurwitz
Roger P. Joseph
Jeremy B. Kantrowitz
Jason S. Pinney
Paul B. Raymond
Toby R. Serkin
Mari Wilson
Orange County
Laurie Dee
Washington, DC
Laura E. Flores
Thomas S. Harman
W. John McGuire
Christopher D. Menconi
Mana Behbin
Magda El Guindi-Rosenbaum
Kathleen M. Macpeak
Philadelphia
Sean Graber
Timothy W. Levin
John J. O’Brien
[1] Sivolella et al. v. AXA Equitable Life Insurance Company et al., Civ. Action No.: 11-vc-4194 (PGS) (DEA) (D. N.J. Aug. 25, 2016) at 2 [hereinafter, Opinion].
[2] Morgan Lewis serves as counsel to the Trust’s independent trustees.
[3] Gartenberg v. Merrill Lynch Asset Management, Inc. 694 F.2d 923 (2d Cir. 1982) at 928. The Gartenberg approach was affirmed by the US Supreme Court in the Jones v. Harris case in 2010. See 559 U.S. 335 (2010).
[4] In an order issued on September 21, 2012, the court ruled in favor of the plaintiff on the issue of statutory standing. In so ruling, the court interpreted the definition of “security holder” as used in Section 36(b) of the 1940 Act to refer to a security’s equitable or beneficial owner rather than a security’s legal or record owner. See Sivolella v. AXA Equitable Life Ins. Co. and AXA Equitable Funds Mgmt. Group, LLC, No. 11-4194 (PGS) (D. N.J. Sep. 21, 2012) (order denying in part and granting in part defendants’ motion to dismiss).
[5] See Second Amended Complaint, Sivolella et al. v. AXA Equitable Life Ins. Co. and AXA Equitable Funds Mgmt. Group, LLC, Civ. Action No.: 11-vc-4194-PGS-DEA (Apr. 15, 2013).
[6] Opinion at 8.
[7] Section 36(b)(3) of the 1940 Act provides that no damages shall be recoverable for any period prior to one year before the action was instituted. In the AXA case, because certain funds were added after the initial complaint and because administrative fees were claimed in a subsequent complaint, there were three different damage periods.
[8] The defendants’ witnesses included the Board’s chairman (who is also FMG’s president and chief executive officer), FMG’s associate general counsel, the Board’s lead independent trustee, and three expert witnesses. The plaintiffs’ witnesses included one of the plaintiffs, five FMG employees as adverse witnesses (including the president and chief executive officer and the associate general counsel), and four experts. Deposition testimony was also read into the record for three independent trustees (including the lead independent trustee), one employee of the Trust’s auditor, and others, but the court noted that the deposition testimony was of little assistance in assessing the merits. Interestingly, three of the plaintiffs’ four expert witnesses are also serving as experts in a separate case, Kasilag et al. v. Hartford Investment Financial Services, LLC, that is currently proceeding in the District of New Jersey. Further, the plaintiffs and defendants in Hartford have the same counsel as in the AXA case, so throughout the AXA trial, the parties used deposition materials from Hartford for impeachment purposes. The Hartford case is currently scheduled for trial in December 2016.
[9] Opinion at 139 (citing In re Franklin Nat’l Bank, 478 F. Supp. 2d 577, 687 (E.D.N.Y. 1979)).
[10] Opinion at 139.
[11] Opinion at 140-142. We note that the Opinion indicates that a new lead independent trustee was appointed after the complaint was filed. We understand that the change in board leadership was part of a Board succession plan that was in place before the complaint was filed. See Opinion at 140. We also note that, contrary to the Opinion, the Board received specific information regarding the portion of the advisory fee that FMG retained, in the “Gary Charts,” prior to the commencement of the lawsuit. Opinion at 34.