Recent Court Rulings Send Signals in Mutual Fund Lawsuits

By Roger P. Joseph, Lea Anne Copenhefer, Donald J. Savery and Paul B. Raymond

In the past three months, two federal district court judges in Massachusetts have issued rulings in cases alleging that mutual fund investment advisers and their affiliates have charged excessive fees. In both cases, the district court denied a motion to dismiss a claim for excessive fees (advisory fees in one case, and advisory and distribution fees in the other case). Both rulings are noteworthy because they illustrate the increasing difficulty in getting these types of cases dismissed in the relatively early stages of litigation. One is also noteworthy because it gives effect to some Massachusetts statutory provisions that may deter frivolous derivative litigation on behalf of funds that are organized as Massachusetts business trusts. Although neither case appears to have been filed as an outgrowth of the recent mutual fund scandals, a number of excessive fee cases have resulted from those scandals, and we expect that the parties in those cases, and others in the industry, will take note of these decisions.

The Putnam Ruling The Putnam¹ ruling, which is dated March 28, 2005, was issued in a case that is actually an outgrowth of the Nelson² litigation from a few years ago. This case is an example of how long it can take for a matter to make its way through the judicial process, and of the ease with which a complaint may survive a motion to dismiss.

You may recall that Nelson was a major class-action suit involving claims for breach of fiduciary duty under Section 36(b) of the Investment Company Act of 1940 based on alleged excessive advisory and distribution fees that was brought in Illinois in 2001 against 24 of the nation's largest mutual fund complexes. Early on in that litigation, the defendants won a significant procedural battle when the district court granted the defense motions to sever and transfer (meaning, for example, that the case against Putnam was to be broken off from the cases against the other defendants and was to be transferred to federal district court in Massachusetts). The plaintiffs, when faced with having to proceed individually against each fund complex in the district where the fund manager was based, voluntarily dismissed the case in its entirety without prejudice, leaving themselves free to re-file the case against the defendants in the applicable fund manager's home district.³

A plaintiff from the Nelson case (Mr. Wicks), along with an additional plaintiff, filed a lawsuit in federal district court in Massachusetts in 2004 against two Putnam entities basically repeating the claims made in Nelson but on behalf of a slightly different group of Putnam funds. Before Mr. Wicks and his cohort filed this suit in Massachusetts, however, these same two plaintiffs had filed, and then voluntarily dismissed, a second lawsuit in Illinois against the same Putnam defendants, making the same Section 36(b) claims made in Nelson. This second Illinois suit was filed on behalf of the same funds involved in the Massachusetts suit. Two of the funds were actually the subject of claims in all three suits.⁴

In a very brief memorandum in Putnam, Judge O'Toole dismissed only the claims that had been brought twice before by Mr. Wicks on behalf of the same funds and voluntarily dismissed, noting that the second voluntary dismissal of a claim counts as a substantive decision on the merits of the claim, which cannot then be revisited.⁵ The judge ruled that the pleadings with respect to the remaining claims were sufficient to allow the claims to survive.

The ING Ruling The ING⁶ ruling, which is dated May 9, 2005, also was issued in a case alleging breach of fiduciary duty under Section 36(b) of the Investment Company Act of 1940 stemming from the receipt of allegedly excessive advisory and distribution fees. The ING funds at issue paid distribution and service fees during a period when their shares were not available for public purchase. The plaintiffs alleged that the receipt of distribution and service fees (so-called Rule 12b-1 fees) while the funds were closed to new investors violated the defendants' (in this case, the ING funds' investment adviser's and distributor's) fiduciary duties under Section 36(b). The plaintiffs also alleged that the defendants received excessive advisory fees. The claims for excessive advisory fees survived the motion to dismiss; the claims for excessive distribution fees did not.

This case is one of a number of cases currently pending that allege that the receipt of distribution fees from a fund that is closed to new investors is a breach of fiduciary duty, but the facts here may distinguish this case from some others. Unlike funds that may operate for extended periods of time (often years) before they cease offering their shares to new investors, the ING funds in question (which happen to be principal protected funds) were structured to begin with a relatively short asset gathering period (in these types of funds, it is typically a few months), which was to be followed by periods when the funds operated first with, and then without, certain investment guarantees. During the asset gathering period, shares of the funds were sold to the public, but during the subsequent guaranty periods, shares would be offered only to accommodate dividend reinvestment by existing shareholders. Shares with differing load structures (including front-end and back-end loads) were offered. All of the classes paid 12b-1 fees, although two classes paid only a service (and not a distribution) fee, and all of these fees continued to be charged after the asset gathering period.⁷

Judge Tauro found that the claim for excessive 12b-1 fees was deficient because the plaintiffs had not alleged that the fees charged were so large that they bore no reasonable relationship to the distribution services actually provided.⁸ In his analysis, the judge specifically noted the absence from the complaint of any comparison of, on the one hand, the services provided during the asset gathering period (when the funds' shares were sold to the public) and during the subsequent period (when de minimis sales-related services were provided) and, on the other hand, the fees charged. Instead, the plaintiffs had only alleged that the distribution fees after the asset gathering period exceeded the services during that period. The judge noted that funds could establish fee structures that paid distribution charges up front at the time of purchase, or spread the charges out over time. He also said that Rule 12b-1 permitted the recovery of sales-related expenses previously paid out when distributing fund shares, and that compensation for past distribution services fit within the rule's definition of permissible payments for distribution. The judge also dismissed the claim that the service fees (the 0.25% per annum charge for shareholder servicing) were excessive because the plaintiffs had not alleged that the service fees exceeded the ongoing expenses associated with maintaining shareholder accounts.

It is possible to sense some exasperation from Judge Tauro in this ruling. He stated at the outset, while noting that courts were not permitted to "'conjure up unpled allegations' to save an otherwise deficient compliant,"⁹ that it was significant that the motion to dismiss did not come at the start of the litigation, but rather more than a year into the process. He noted that the parties had engaged in substantial discovery, and that the plaintiffs had filed two amended complaints. Perhaps it is this frustration that leads him to lay out clearly what the complaint should have included and the supporting arguments. Certainly, the judge's statements about the recovery of past distribution expenses and the share class structure as a means of paying distribution expenses over time are arguments that practitioners make to justify the continued payment of 12b-1 fees by funds closed to new investors, and one takes some comfort from seeing them reflected in Judge Tauro's opinion.

But it is also possible to take away a different message from this ruling. Last August, in a ruling that received a fair amount of publicity at the time, a federal district court judge in New York denied a motion to dismiss a claim that an investment adviser had violated its fiduciary duties by charging 12b-1 fees after the fund had been closed to new investors.¹⁰ Judge Tauro cited repeatedly to this New York ruling in the ING decision. In a footnote, Judge Tauro noted that the New York plaintiff had survived the motion to dismiss by alleging that the increase in 12b-1 fees was the result of the substantial appreciation in the fund's assets and lacked any reasonable relationship to actual expenses incurred for promotion and distribution.¹¹ We understand that there has not yet been a substantive ruling on the issues in the New York case (defendants' motion for summary judgment is reportedly due later this month), but if the plaintiff were to prevail on the theory that the 12b-1 fees lacked any reasonable relationship to the expenses incurred for distribution and merely went up as a result of increased assets, that could make things more difficult for funds that have closed to new investors after reaching target asset size.

ING: Demand on Trustees Not Excused The ING ruling also contains some other interesting tidbits. The plaintiffs had sued the ING funds' independent trustees, as well as the funds' adviser and several others, under state law as part of one iteration of the complaint, and the defendants sought to have the claims dismissed because the plaintiffs had not made demand on the funds' board of trustees before bringing the lawsuit. Judge Tauro, in dismissing the claims, did three things. First, he rejected the plaintiffs' argument that the demand requirement under the Massachusetts corporations law applied only to corporations, and not to business trusts, stating his belief that Massachusetts courts would apply the demand requirement to business trusts because of their similarities to corporations.¹² This is a useful confirmation that this corporate principle applies to Massachusetts business trusts. Second, he applied the recently enacted Massachusetts "universal demand" statute, which requires that a written demand for action be made on a board "prior to the commencement of every derivative action."¹³ And third, in rejecting the plaintiffs' argument that, as to claims first brought prior to the effective date of the "universal demand" statute, demand would have been futile because the trustees had approved the fees at issue (and should therefore not be treated as independent), he applied the relatively recent Massachusetts statute that provides that trustees of a Massachusetts business trust that are not "interested persons" under the 1940 Act are independent and disinterested when taking any action as a trustee.¹⁴ This too is a helpful endorsement of a Massachusetts state law applicable to many mutual fund trustees.

At least one recent news article has referred to the Putnam ruling as "unprecedented."¹⁵ The article goes on to state that excessive fee cases typically have been dismissed before they even get to trial. Even assuming that statement has been true in the past, query whether it holds true today. The Putnam and ING decisions demonstrate that a properly pled excessive fee case will survive until at least the summary judgment stage of the case. We will be monitoring these cases closely to see whether they survive beyond that stage. In the meantime, funds organized as Massachusetts business trusts, and their trustees, can take some comfort from Judge Tauro's ruling giving effect to the Massachusetts corporate law requirement of demand before a derivative suit can be brought, and giving effect to the Massachusetts statutory affirmation of the independence of trustees who are not "interested" under the 1940 Act.

Callouts

• Both rulings illustrate the increasing difficulty in getting these types of cases dismissed in the relatively early stages of litigation.
• The funds at issue paid 12b-1 fees during a period when the funds were closed to new investors.
• The judge noted that Rule 12b-1 permitted the recovery of sales-related expenses previously paid out when distributing fund shares, and that compensation for past distribution services fit within the rule’s definition of permissible payments for distribution.
• The judge applied the Massachusetts "universal demand" statute to a Massachusetts business trust.

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