In this Ropes & Gray podcast, litigation & enforcement partners Amy Roy and Rob Skinner discuss the recent decision of a federal court in Los Angeles, rejecting claims of allegedly excessive mutual fund advisory fees against Metropolitan West Asset Management. They discuss the key arguments raised in the trial over the claims, and the evidence relied upon by the court in finding in MetWest's favor across the board.
Amy Roy: First, for some context. As most of this audience is well aware, since the Supreme Court's 2010 decision in Jones v. Harris Associates came down establishing the standard of liability for claims under Section 36(b) of the Investment Company Act, the plaintiffs' bar has been very active in pursuing a new theory of liability against investment advisers pursuant to Section 36(b). In fact, nearly 30 lawsuits have been filed in the last eight years, all with a common theme: in each, the plaintiffs' allegations have centered on the so-called "gap" between advisory fees and subadvisory fees.
Rob Skinner: In that vein, the plaintiff's case against MetWest looks a lot like those brought against advisers across the industry. The fee challenged in the case was the advisory fee charged by MetWest to its flagship mutual fund, the MetWest Total Return Bond Fund, which grew to become the largest actively managed bond fund in the market. Ultimately, there were three main issues that remained at the time of trial: First, the plaintiff argued that the advisory fee MetWest charged its proprietary Total Return Bond Fund was higher than the subadvisory fee it charged to third-party subadvised funds, despite providing what plaintiff said were substantially the same services and taking on the same risks. According to the plaintiff, the fees charged to the externally-sponsored subadvised funds are the only fees negotiated at arm's-length, showing the higher fee charged to MetWest's Total Return Bond Fund to be excessive in their view.
Amy Roy: The second main argument made by the plaintiff's lawyers focused on the sheer size of the Total Return Bond Fund. They claimed that as the Fund's assets under management grew really large, MetWest must have been experiencing so-called "economies of scale" yet failed to share those economies with shareholders by either reducing fees or implementing breakpoints. According to the plaintiff's theory, it is a given that as a fund's assets grow – regardless of the size or nature of the fund – it must cost the adviser less and less to manage the incremental assets – so the fee should shrink accordingly.
Rob Skinner: The plaintiff's third argument was an attack on the Fund Board's annual process for approving MetWest's advisory fee. The plaintiff claimed the Board's process was flawed for three main reasons: First, that the Board didn't get enough information about the differences between those advisory and subadvisory services; second, that the Board didn't get enough information about economies of scale, including a quantitative analysis of the issue; and third, that the Board's supposed failure to negotiate a lower fee itself shows a weak board process.
Amy Roy: Now with all of that as background, let's look at how the court reacted to these arguments. During the seven-day trial held in federal court in downtown Los Angeles last December, the judge considered testimony from 17 witnesses – including four experts offered by the parties – and admitted nearly 500 exhibits. We are pleased to report that after reviewing the evidence over the course of several months, Judge George Wu issued a comprehensive opinion on August 5th rejecting plaintiff's allegations across the board.
Rob Skinner: As to the first argument, the court ruled that the plaintiff's proposed comparison of the Total Return Bond Fund's advisory fee to lower subadvisory fees MetWest charged to external funds was "inapt," because MetWest "provides substantially different services and takes on substantially different risks" as adviser and sponsor of a proprietary fund. The court expressly recognized various differences in services related to daily pricing and striking of the Fund's net asset value (or "NAV"), meeting shareholder redemption requests, compliance obligations, public regulatory filings, supporting the board process, overseeing third-party service providers, and client servicing. Critically, the court recognized substantial differences in responsibilities with regard to striking the Fund's NAV each day and generating sufficient liquidity, which the court noted as being two of the defining characteristics of a mutual fund. The plaintiff claimed that it wasn't MetWest who was responsible for striking the NAV, for example, but rather the Fund's third-party administrator. The court found that while the administrator carries out MetWest's instructions, it is MetWest that bears the ultimate responsibility and liability for striking the correct NAV.
Amy Roy: In a unique and helpful departure from previous cases, MetWest was able to successfully demonstrate that even the portfolio management services provided for the Fund were different both in nature and scope from those provided to the subadvised funds. In particular, Judge Wu found portfolio management services provided to the Fund to be "more difficult and involve exponentially more work than managing the portfolios of the Subadvised Funds." In addition to recognizing substantial differences in services, the court also concluded that MetWest takes on far more risk as adviser to the Fund than as subadviser to the subadvised funds. According to Judge Wu, these differences in reputational, financial, litigation, regulatory, and business risks can justify (at least in part) the difference between advisory and subadvisory fees.
Rob Skinner: As for comparative fees, the court found peer mutual fund comparative data from industry consultant Broadridge to be more persuasive than the plaintiff's proposed subadvisory fee comparison. While he noted that Broadridge comparative fee data was not dispositive by itself, Judge Wu did find such data persuasive. Specifically, he found that when comparing the Fund to its peer groups selected by Broadridge, the Fund's advisory fee consistently hovered below the median. This ranking was persuasive in part because the judge found that the funds included in the comparator groups actively competed with the Total Return Bond Fund.
Amy Roy: Next, turning to plaintiff's argument on economies of scale, Judge Wu found that the plaintiff failed to meet his two-pronged burden to show that economies of scale were both realized and not sufficiently shared with investors. Judge Wu did not credit an analysis conducted by the plaintiff's expert that supposedly showed economies of scale, but only after ignoring certain expenses (such as portfolio manager compensation). The court recognized that the removal of these costs from the expert's calculations was done without any factual basis and that, when such costs were considered, the plaintiff's expert actually demonstrated diseconomies of scale. In contrast, Judge Wu did find persuasive the testimony of the Fund's portfolio manager, who detailed how increased scale can require more resources, particularly in the case of bond funds.
Rob Skinner: Further, the court found that if there were any economies of scale realized, the plaintiff had not shown that they weren't shared. The court pointed to evidence that, during periods of the Fund's asset growth, MetWest reinvested its profits through adding new employees, improving technology systems, and by increasing compensation to existing employees for retention purposes. Judge Wu also cited evidence that MetWest priced the Fund to scale at the outset, meaning that it priced the Fund below the level necessary to recoup costs in order to attract investor assets.
Amy Roy: As to plaintiff's third argument, Judge Wu found that the process by which the Board annually approved the Fund's advisory fee was robust – citing repeatedly to the testimony of the Board's independent chair. The court rejected the plaintiff's arguments that the Board did not receive sufficient information relating to services provided to the subadvised funds and economies of scale. In particular, Judge Wu rejected the plaintiff's contention that the fact that the Board did not review the contracts with the subadvised funds constituted a deficiency, when the Board did receive information on the actual services provided to the subadvised funds and the fees charged.
Rob Skinner: Along the same lines, the plaintiff failed to persuade the court that the lack of a quantitative economies of scale analysis somehow showed a flawed process, especially when the Board frequently discussed breakpoints and considered that the Fund was already one of the lowest cost mutual fund providers in the U.S. Critically, the court rejected an argument often advanced by plaintiffs in Section 36(b) litigation, that the Board's failure to negotiate a lower advisory fee by itself negates any deference owed to the Board's decisions. Consistent with well developed case law on this issue, Judge Wu found that it was not the Board's duty to "negotiate" fees, and that the Board did fulfill its duty to ensure that the fees were fair and reasonable.
Amy Roy: Finally, it's worth noting the additional impact Judge Wu's decision may have beyond its comprehensive rejection of the plaintiff's three go-to arguments from recent years. The decision expressly recognizes important market realities facing mutual fund advisers today, which provide crucial context for any consideration of fees. Judge Wu held that "Each day, investors can decide whether to redeem their shares of the Fund and move their monies elsewhere, resulting in a competitive business environment in which the managers and sponsors of mutual funds compete for investor assets."
Rob Skinner: This finding runs counter to the common plaintiff theme that mutual funds are "captives" of their advisers, and therefore can set advisory fees at will without fear of market repercussions. Although not adopting them formerly for purposes of his ruling, Judge Wu pointed to the "persuasive" findings of MetWest's expert witness, economist John Coates, regarding competition in the mutual fund industry.
Amy Roy: We hope this discussion has been helpful and informative. For more information, please visit our website www.ropesgray.com, and please don't hesitate to be in touch with either of us if you'd like to discuss these issues further.
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