Legal recourse as a tool for chance.

• Author: Freeman, John P.
• Position: The Mutual Fund Distribution Expense Mess

1. Introduction

   If load fund boardrooms seem like an inhospitable place to look for 12b-1 reform, the same is true of the nation's courtrooms, at least to date. No lawsuit attacking 12b-1 plans has succeeded, and, as discussed above, suits contesting Class B share sales (funded with 12b-1 fees) on fraud or suitability grounds have not met much success. Derivative suit attacks mounted under state law on boards who approve 12b-1 plans are destined to fail in the face of directors' impressive defensive weaponry, consisting of the demand requirement, (391) special litigation committees, (392) the business judgment rule, and various statutes capping damages. Direct class action claims asserting state causes of action risk preemption under Securities Litigation Uniform Standards Act of 1998393 ("SLUSA"). No court has upheld a claim asserting an implied right of recovery under Rule 12b-1.

2. Section 36(b) Standards

   Offering more promise to plaintiffs is the assertion of claims premised on violations of section 36(b) of the Investment Company Act. (394) Claims alleging misconduct as to 12b-1 fees have been upheld under section 36(b) of the Investment Company Act of 1940 at the pleading stage. (395)

   Proving a violation of section 36(b) requires a strong showing: "[T]he adviser-manager 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." (396) Under section 36(b), some fund shareholders challenging the 12b-1-fee drain have been able to state causes of action. (397) One contention that has found favor at the pleading stage is that the payment by fund shareholders of money for no benefit, a "something for nothing" exchange, meets the statutory test under section 36(b) as an improper disproportionate payment. (398)

   In the context of cases challenging fund advisory fees, it has been held that in assessing whether section 36(b)'s demanding fiduciary duty breach test (399) has been satisfied, "all pertinent facts must be weighed," (400) including (a) the nature and quality of services provided to fund shareholders; (b) the profitability of the fund to the adviser-manager; (c) fall-out benefits; (401) (d) economies of scale; (e) comparative fee structures; and (f) the independence and conscientiousness of the trustees. (402) Section 36(b) holds out promise, but only that; never has a dissident shareholder plaintiff won a trial contesting fee payments under the section. (403)

   This test may be of some use in the advisory fee context, but the factors are of limited value in assessing 12b-1 payments. For 12b-1 outlays, the "something for nothing" test should apply because, as recently observed by the district court in Siemers v. Wells Fargo & Co., (404) fiduciary duties are not reducible to a fixed, immutable formula and "often include duties of candor and fair dealing." (405) The lack of any proof that 12b-1 payments produce tangible financial benefits for fund shareholders suggests that 12b-1 payments ought to be a fertile ground for shareholder litigation.

   At a minimum, directors challenged to prove they have discharged their fiduciary duties in adopting 12b-1 plans had better be prepared to turn over the data they considered and calculations they made when they voted on implementing or continuing Rule 12b-1 plans. When it adopted Rule 12b-1, the SEC referred to various factors boards might weigh in deciding whether to adopt or continue 12b-1 plans. They were: the involvement of independent legal counsel or experts; the nature and causes of the fund's specific distribution problems or circumstances; the manner in which the 12b-1 plan addresses problems or circumstances; the merits of possible alternative plans; the inter-relationship between the plan and activities of other persons; possible benefits of the plan to any other person relative to those expected to inure to the fund; the effect of the plan on existing shareholders; and evaluation of success of the plan. (406)

   The rule allows implementation of a...