1. What is Section 36(b)?
Mutual funds have long been an important vehicle for individuals to invest their savings in a relatively cost-effective, diversified manner.[1] These investment vehicles are generally organized under state laws and governed by the Investment Company Act of 1940 (“1940 Act”), which lays out rules regarding mutual fund operation and management. Section 36(b) of the 1940 Act provides a cause of action for the SEC, and individual security holders in a registered investment company, to sue investment advisers for excessive payments in breach of fiduciary duty.[2]
For a plaintiff to prevail in a § 36(b) excessive fees claim, “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.”[3] The United States Supreme Court clarified this standard by adopting the Gartenberg test, which consists of the six following factors: “(1) the nature and quality of services provided to fund shareholders; (2) the profitability of the fund to the adviser-manager; (3) fall-out benefits; (4) economies of scale; (5) comparative fee structures; and (6) the independence and conscientiousness of the trustees.” [4] This test is the prevailing standard but it has continued to face criticism on both sides of the investor-adviser aisle.[5] While prevailing under § 36(b) appears to be a daunting challenge for a plaintiff,[6] advisers have raised concerns about the costs of litigation.[7] Recently, a bill introduced in Congress seeks to make important changes to this provision.[8]
2. What is H.R. 4738 Seeking to Change?
H.R. 4738 was introduced in the House of Representatives on January 8, 2018. It would amend § 36(b) in two ways. First, it would require a plaintiff’s complaint to have more specific facts to support an allegation of a breach of fiduciary duty. Second, a plaintiff would have to demonstrate the breach of fiduciary duty by “clear and convincing evidence.”[9]
i. Heightened Pleading
The first proposed provision would raise the pleading standard. Currently, a plaintiff can survive a motion to dismiss if “when taken as a whole, the complaint demonstrates a plausible claim for relief under § 36(b).”[10] While addressing all of the Gartenberg factors is not required to withstand a Rule 12(b)(6) motion to dismiss, the complaint should create a plausible inference that the fees paid to defendants fell outside the Jones ‘arms-length bargaining’ range.[11] Conversely, merely discussing all six Gartenberg factors in the complaint is not necessarily sufficient to withstand a motion to dismiss.[12] As such, applying the Gartenberg standard in the early stages of litigation seems to already provide a fairly robust mechanism to filter out relatively weaker claims.
Requiring particularity would elevate the pleading standard similar to that of the Public Securities Litigation Reform Act of 1995 (“PSLRA”).[13] Under the PSLRA, plaintiffs must “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”[14] Proponents of H.R. 4738 argue that the higher pleading standard of the PSLRA has successfully reduced abusive securities litigation practices, which would certainly be beneficial in § 36(b) cases, particularly in these types of bet-the-company litigations.[15] However, there is some evidence that the PSLRA has increased the number of suits being filed, thus weakening the claim of a notable filtering effect for nuisance-value or weaker suits.[16] Under this heightened standard, a similar outcome could result in § 36(b) actions, where the reduced filing of excessive fees claims does not correlate to how meritorious those claims may have been. Further, this requirement would seemingly put plaintiffs in a precarious position. In the early stages of litigation, they may not be able to provide specific facts alleging excessive fees. This can make them more susceptible to a motion to dismiss.[17]
ii. Elevated Burden of Proof
H.R. 4738 would also raise the evidentiary standard to “clear and convincing evidence.”[18] Under the current standard, the plaintiff must prove his or her case by a preponderance of the evidence, which is a showing that the plaintiff’s claims are more likely true than not.[19] The Third Circuit notes that clear and convincing evidence “involves a higher degree of persuasion” and the Ninth Circuit states that the evidence should leave the trier of fact “with a firm belief or conviction that it is highly probable that the factual contentions of the claim or defense are true.”[20] This higher standard of proof had originally been placed in the 1970 House bill that implemented § 36(b), but was dropped because legislators did not believe it would deter meritless suits.[21] Supporters of H.R. 4738 argue that this burden of proof aligns with other federal claims such as certain federal whistleblower statutes.[22] This amended standard would likely serve as another higher hurdle that plaintiffs must overcome.[23]
3. Closing Remarks
H.R. 4738 was reported by the Committee on Financial Services on May 7, 2018 to the House and is currently on the Union Calendar. It remains to be seen how far this bill advances given some of the other more pressing matters on Congress’s agenda, such as the numerous appropriations bills needed to fund certain federal agencies prior to the December 7, 2018 deadline. The partisan nature of this bill is also a relevant consideration in determining the likelihood of its enactment. None of the Democrats voted yes and none of the Republicans voted no on the bill in the Committee on Financial Services.[24] The results of midterm election could certainly determine whether this bill will have a new breath of life or will be effectively shelved. It is rather clear, however, that the proposed amendment of § 36(b) will significantly raise the already high bar for plaintiffs to prevail in excessive fees litigations.
[1] Regan Ray, The Advantages of Mutual Funds, Investopedia (June 12, 2018 3:04 PM), https://www.investopedia.com/investing/advantages-of-mutual-funds/.
[2] 15 U.S.C. § 80a-35.
[3] Jones v. Harris Assocs. L.P., 559 U.S. 335, 346 (2010).
[4] Amron v. Morgan Stanley Inv. Advisors Inc., 464 F.3d 338, 340 (2d Cir. 2006); see id. at 353; Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923, 929–32 (2d Cir. 1982).
[5] See, e.g., Quinn Curtis & John Morley, The Flawed Mechanics of Mutual Fund Fee Litigation, 32 Yale J. on Reg. 1, 39–43 (2015) (discussing such proposals as replacing the Gartenberg factors, implementing a heightened pleading regime, and creating a mechanical test of liability); John P. Freeman et al., Mutual Fund Advisory Fees: New Evidence and a Fair Fiduciary Duty Test, 61 Okla. L.Rev. 83, 86 (2008) (referring to the Gartenberg standard as “an unworkable, unfair, scavenger hunt-style liability test”).
[6] In re BlackRock Mut. Funds Advisory Fee Litig., No. 14-1165, 2015 WL 1418848, at *8 (D.N.J. Mar. 27, 2015) (noting the “onerous standard for liability under Section 36(b)”).
[7] According to the Investment Company Institute, “[s]ome defense counsel have informally estimated that litigation costs in section 36(b) lawsuits may range from three to four times higher for advisers than for plaintiffs.” Section 36(b) Litigation Since Jones v. Harris: An Overview for Investment Advisers and Fund Independent Directors, ICI Mut. (July 2016).
[8] Mutual Fund Litigation Reform Act, H.R. 4738, 115th Cong. (2018).
[9] Id.
[10] Kasilag v. Hartford Inv. Fin. Servs., LLC, Civ. No. 11-1083, 2012 WL 6568409, at *2 (D.N.J. Dec. 17, 2012).
[11] Id.; Paskowitz v. Prospect Capital Mgmt. L.P., 232 F. Supp. 3d 498, 509 (S.D.N.Y. 2017).
[12] See, e.g., Pirundini v. J.P. Morgan Inv. Mgmt. Inc., 309 F. Supp. 3d 156 (S.D.N.Y. 2018) (granting defendant’s motion to dismiss because five of the factors point towards dismissal with the fall-out benefits factor weighing in neither party’s favor), appeal docketed, No. 18-733 (2d Cir. Mar. 16, 2018).
[13] 15 U.S.C. § 78u-4.
[14] Id.
[15] Letter from Paul Schott Stevens, President and CEO, Inv. Co. Inst., to Jeb Hensarling, Chairman, Comm. on Fin. Servs. (Jan. 16, 2018) (on file with author).
[16] Stephen J. Choi et al., The Screening Effect of the Private Securities Litigation Reform Act, 6 J. Empirical Legal Stud. 35, 65 (2009).
[17] Letter from Joseph P. Borg, President, N. Am. Sec. Adm’r Ass’n, Inc., to Jeb Hensarling, Chairman, Comm. on Fin. Servs. (Jan. 16, 2018) (on file with author).
[18] Mutual Fund Litigation Reform Act, H.R. 4738, 115th Cong. (2018).
[19] See Kasilag v. Hartford Inv. Fin. Servs., LLC, No. 11-1083, 2017 WL 773880, at *2 (D.N.J. Feb. 28, 2017).
[20] Manual of Model Civil Jury Instructions for the District Courts of the Ninth Circuit § 1.7 Burden of Proof – Clear and Convincing Evidence (Sept. 2018), http://www3.ce9.uscourts.gov/jury-instructions/sites/default/files/WPD/Civil_Instructions_ 2018_9_0.pdf; Model Civil Jury Instructions for the District Courts of the Third Circuit § 1.11 Clear and Convincing Evidence (Oct. 2017), http://www.ca3.uscourts.gov/sites/ca3/files/1_Chaps_1_2_3_2017_October.pdf.
[21] Krinsk v. Fund Asset Mgmt., Inc., No. 85 Civ. 8428 (JMW), 1996 WL 205, at *4 n.7 (S.D.N.Y. May 9, 1986).
[22] Stevens, supra note 15.
[23] Borg, supra note 17.
[24] H.R. Rep. No. 115-662, pt. 1, at 5 (2018).
