The Chairman of the Financial Services Committee of the U.S. House of Representatives, Jeb Hensarling (R-TX), on April 19, 2017 released an updated discussion draft of the Financial CHOICE1 Act (Bill), and the Committee held a public hearing on the Bill on Wednesday, April 26, 2017. Title VIII, Section 831, of the Bill (Title VIII) proposes to impose a heightened pleading requirement, and to raise the burden of proof that a plaintiff must meet to pursue a claim against an investment adviser under Section 36(b) of the Investment Company Act of 1940 (1940 Act). The Bill is only at the Committee stage, and whether it will become law is uncertain.2 If Title VIII passes as drafted and works as intended, however, it is likely both to disincentivize plaintiffs’ firms from bringing Section 36(b) cases in the first instance and to improve defendants’ chances of obtaining dismissal or a favorable judgment earlier in the litigation.
Section 36(b) of the 1940 Act imposes a fiduciary duty on the investment adviser of a mutual fund with respect to the fees charged to the fund, and creates a private right of action permitting shareholders to challenge the fees paid to the adviser. In Jones v. Harris Associates, L.P.,3 the Supreme Court established the standard that must be met to determine that a fee is excessive under Section 36(b). According to the Jones Court, fees are excessive only if “so disproportionately large that they bore no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.” The Jones Court acknowledged six non-exclusive factors, first espoused in the seminal Gartenberg case,4 which can be considered in determining whether an advisory fee paid by a mutual fund meets this standard. These “Gartenberg factors” are: (i) the nature, extent, and quality of the services provided by the adviser to the mutual fund; (ii) the profitability to the adviser of managing the fund; (iii) “fall-out” benefits that accrue to the adviser as a result of serving as the adviser to the fund; (iv) the existence of any economies of scale achieved by the adviser as a result of growth in fund assets under management, and whether such savings are shared with fund shareholders; (v) fee structures utilized by other similar funds; and (vi) the expertise of the fund’s independent directors, whether the independent directors are fully informed about all of the facts bearing on the adviser’s service and fee, and the extent of care and conscientiousness with which the independent directors perform their duties with respect to the adviser’s fee.
The motion-to-dismiss stage is a crucial moment in many lawsuits; it is the point at which the judge decides whether a case is dismissed or permitted to grind into discovery. As currently written,5 Title VIII would make two changes that would affect the likelihood of cases clearing this procedural hurdle.
First, Title VIII would require that a complaint brought under Section 36(b) “state with particularity all facts establishing a breach of fiduciary duty.” If such facts are “based on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” Generally, under such a particularity standard, a complaint must specify the “who, what, when, where, and how” of evidence used to support a fact in a pleading.6 Conclusory statements or boilerplate language are not acceptable under this heightened pleading standard. Given that many of the opinions denying motions to dismiss in Section 36(b) cases rely in significant part on the fact that the court must take the allegations in the complaint as true and draw all reasonable inferences in favor of plaintiffs under the prevailing standard, imposing a heightened pleading standard has the potential to change the dynamics of Section 36(b) cases at the motion-to-dismiss stage. Such a standard would likely impose a significant new burden on Section 36(b) plaintiffs, who would be required to plead particularized facts supporting broad-brush allegations that, for example, fund boards are not independent, or that economies of scale exist and are not shared with fund shareholders.
Second, Title VIII would increase the Section 36(b) plaintiff’s burden of proof to a “clear and convincing evidence” standard. The current burden of proof in Section 36(b) cases, which is the burden applicable in most civil cases, is the “preponderance of the evidence” standard, which requires proof that what the plaintiff claims is more likely than not. In contrast, the “clear and convincing evidence” standard requires evidence that produces an abiding conviction that the truth of the plaintiff’s factual contentions is highly probable.7 Although no plaintiff has prevailed on a Section 36(b) claim, even under the more lenient “preponderance of the evidence” standard now applicable to such cases, increasing the burden of proof may further deter the plaintiffs’ bar from bringing such cases.
Over the past five years, the mutual fund industry has seen a significant increase in the number of Section 36(b) cases challenging fees charged by mutual fund advisers. Although to date, no plaintiff in a Section 36(b) case has prevailed at trial against an investment adviser, the time, effort and expense required to defend against a Section 36(b) claim is significant for the investment adviser and the fund’s board of directors. The recent rise in Section 36(b) lawsuits filed, despite defendants’ unbroken record of trial victories, suggests that the increase in litigation may be driven by plaintiffs’ firms seeking financial incentives rather than shareholders asserting bona fide claims. In proposing Title VIII, the Bill’s sponsors appear to be trying to dampen such abusive practices.
If the Bill becomes law, plaintiffs will have greater difficulty—even more than now—in ultimately succeeding in a Section 36(b) case. First, the heightened pleading standard would likely increase the chance of the adviser prevailing at the motion-to-dismiss stage, which also would have the important side effect of minimizing the likelihood of any Section 36(b) proceeding to the discovery stage. Second, increasing the plaintiffs’ burden of proof would likely reduce the number of cases proceeding to summary judgment or trial, which could reduce litigation costs to defendants and may further discourage plaintiffs' firms from filing the cases in the first instance. Ultimately, the Bill does have the very real potential to chill the filing of Section 36(b) cases.
Whether or not the Bill is enacted, the responsibilities of investment advisers and mutual fund boards would remain unchanged. Advisers would continue to bear a fiduciary duty to the funds they advise, and mutual fund boards continue to fulfill the role of “independent watchdogs” who “furnish an independent check upon the management of investment companies.”8 Consideration of investment advisory contracts is one of the essential duties of mutual fund boards, and the outcome of any particular Section 36(b) case may turn on fund directors’ care and consideration regarding the reasonableness of advisory fees charged to a fund. While the passage of Title VIII would be a welcome signal to industry participants weary (or wary) of being forced to incur significant time and expense to defend against an increasing number of Section 36(b) cases that ultimately prove unmeritorious, industry participants should continue to take seriously the advisory contract review process and their duties under the various provisions of the 1940 Act.
1) CHOICE stands for Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs. SeeExecutive Summary, The Financial CHOICE Act: Creating Hope and Opportunity for Investors, Consumers, and Entrepreneurs.
2) An earlier version of the Bill passed the House Financial Services Committee last September. However, that version did not include the amendment to Section 36(b) contained in the current Financial CHOICE Act.
3) 559 U.S. 335 (2010).
4)Gartenberg v. Merrill Lynch Asset Mgt., Inc., 694 F.2d 923 (2d Cir. 1982).
5) The text of Section 831, Title VIII, as of this writing, states in relevant part:
Section 36(b) of the Investment Company Act (15 U.S.C. 80a 35(b)) is amended by adding at the end the following:
(7) In any such action brought by a security holder of a registered investment company on behalf of such company—
(A) the complaint shall state with particularity all facts establishing a breach of fiduciary duty, and, if an allegation of any such facts is based on information and belief, the complaint shall state with particularity all facts on which that belief is formed; and
(B) such security holder shall have the burden of proving a breach of fiduciary duty by clear and convincing evidence.
6)See In re CDNOW, Inc. Sec. Litig., 138 F. Supp. 2d 624, 640 (E.D. Pa. 2001).
7)Colorado v. New Mexico, 467 U.S. 310, 316 (1984).
8)Burks v. Lasker, 441 U.S. 471, 484 (1979) (internal quotation marks omitted).