The Honorable Peter J. Sheridan, for the U.S. District Court for the District of New Jersey, ruled in favor of defendants, AXA Equitable and related entities, in a consolidated derivative action on behalf of mutual fund investors. This was a lengthy decision issued on August 25 that will reward attention by any actual or potential investors in ’40 Act funds.
The plaintiffs, Mary Ann Sivolella and others, alleged that the Board of Trustees for the mutual fund complex breached its fiduciary responsibility by approving service contracts that entailed excessive fees for management and administration of the funds. Plaintiffs demanded that some of the fees that went to the fund management group ought to be restored to the mutual fund, because the level of compensation “could not have been the product of arm’s length bargaining.”
The legal basis for this demand is section 36(b) of the ’40 Act, which specifically states that “investment company advisers owe shareholders in investment companies a fiduciary duty with respect to determining and receiving their advisory fees.” Sivolella is one of several actions brought since the U.S. Supreme Court decision in Jones v. Harris opened the door somewhat to court interference in fees arrangements. As is common in such actions, the plaintiffs focused on the distinction between the fees paid to the management team and the fees paid to the sub-managers to whom it contracted work.
The action was tried over a period of 25 days, without a jury, so Judge Sheridan made his findings on the facts and issued a detailed memorandum under 52(a) of the Federal Rules of Civil Procedure. Early on in his finding he observed that the plaintiffs in such a matter have the burden of proving a breach by a preponderance of the evidence; they cannot simply require the management team to justify its conduct.
Expertise and Credibility
The text of the opinion contains some sharp critiques of the credibility of the expert witnesses that the plaintiffs produced in their attempt to meet this burden. For example, plaintiffs called Dr. Steven Pomerantz, the possessor of a Ph.D. in Mathematics from the University of California, Berkeley. The judge’s response to Pomerantz was striking.
The court observes that Pomerantz is a “professional expert witness,” having testified in approximately two dozen excessive fee cases. Judge Sheridan complained of Pomerantz’ “inconsistencies, oversimplifications, and … sarcastic demeanor,” giving “little weight” to his support of the plaintiffs’ contentions.
The court also took a dim view of Pomerantz’ account of his own experience within the mutual fund industry. On direct, he said that he had “certainly been involved in compliance.” On cross, though, he said that his own experience involved no compliance work “that is pursuant to a legal responsibility.”
What is perhaps more surprising, the Ph.D. in mathematics seemed to have made a straightforward mathematical error in the damage calculation he offered on direct examination. On cross, he acknowledged “it would appear that there’s something wrong” with his original figures. In the eyes of the court, this undermined his credibility “on all issues.”
In general, the judge found that fund management “complied with the letter of the law to ensure the Board was not affiliated with [management],” that the Board “was … careful and conscientious in performing its duties,” and that the management group performed many vital functions beyond what it contracted out, leaving unsubstantiated the plaintiffs’ charge that management didn’t do any significant work to justify its fees.
Pomerantz had testified that the management wasn’t “really doing anything” beyond the provision of “some office space and some coffee cups” for the sub-advisers. But, as noted above, the judge was not impressed with Pomerantz.
The takeaway for investors ought to be that, even though the Supreme Court has created the running room that allows such lawsuits to survive a motion to dismiss, they remain very difficult to win.
More broadly, litigation, or the threat of litigation, is a poor substitute – actually, no substitute at all – for due diligence ahead of time. Investors should be familiar with the fee structure and with the involvement of contracting parties in management/administrative functions, before they commit assets to an investment fund.
The takeaway for managers: document, document, document. Make certain that in the unhappy but not-at-all shocking event that one becomes a defendant, one can explain to the trier of fact, judge or jury, what it is that one does that justifies ones fees.