Am. Chems. & Equip. Inc. v. Principal Mgmt. Corp.

• Decision Date: 24 July 2017
• Docket Number: No. 16-1712,No. 16-1576, No. 16-1580,16-1576
• Citation: 864 F.3d 859
• Parties: AMERICAN CHEMICALS & EQUIPMENT INC. 401 (K) RETIREMENT PLAN, Plaintiff–Appellant/Cross Appellee v. PRINCIPAL MANAGEMENT CORPORATION, Defendant–Appellee/Cross Appellant
• Court: U.S. Court of Appeals — Eighth Circuit

864 F.3d 859

AMERICAN CHEMICALS & EQUIPMENT INC. 401 (K) RETIREMENT PLAN, Plaintiff–Appellant/Cross Appellee

v.PRINCIPAL MANAGEMENT CORPORATION, Defendant–Appellee/Cross Appellant

No. 16-1576

No. 16-1580

No. 16-1712

United States Court of Appeals, Eighth Circuit.

Submitted: January 11, 2017

Filed: July 24, 2017

Laura S. Dunning, Peter Mougey, Levin & Papantonio, Pensacola, FL, John Barton Goplerud, Assistant Chief Counsel, Brian Marty, Hudson & Mallaney, Michael P. Mallaney, Shindler & Anderson, West Des Moines, IA, Mark T. Johnson, Jason J. Kane, Todd M. Schneider, Kyle G. Bates, Schneider & Wallace, Emeryville, CA, Michael C. McKay, Garrett W. Wotkyns, Schneider & Wallace, Scottsdale, AZ, for Plaintiff–Appellant.

Mark Bruce Blocker, Robert N. Hochman, Lisa Erin Schwartz, Sidley & Austin, Chicago, IL, Alex J. Kaplan, Sidley & Austin, New York, NY, Angel A. West, Matthew Roger Eslick, Nyemaster & Goode, Des Moines, IA, Kevin H. Collins, Nyemaster & Goode, Cedar Rapids, IA, for Defendants–Appellees.

Before RILEY, Chief Judge,^* LOKEN and BENTON, Circuit Judges.

LOKEN, Circuit Judge.

Section 36(b) of the Investment Company Act (ICA) of 1940, 15 U.S.C. § 80a-35(b), provides that an action may be brought "by a security holder of [a] registered investment company on behalf of such company, against [its] investment adviser ... for breach of fiduciary duty in respect of [the] compensation [for services] or payments [of a material nature] paid by [the] registered investment company or by the security holders thereof to [its] investment adviser." American Chemicals & Equipment 401(K) Retirement Plan (ACE) invested in six LifeTime Funds, which are mutual funds created by Principal Funds Incorporated (PFI). The LifeTime Funds are structured as target-date "funds of funds," meaning each fund invests in a portfolio of other mutual funds designed to maximize performance for investors targeting a specific retirement date. ACE sued the LifeTime Funds' investment adviser, Principal Management Corporation (PMC), for breach of its § 36(b) fiduciary duty to the LifeTime Funds, seeking to recover "unfair and excessive" fees. ACE explicitly disclaimed a challenge to the excessiveness of the adviser fees that the LifeTime Funds paid directly to PMC. Instead, ACE based its excessiveness challenge on "all or part of" the adviser fees paid to PMC by the funds in which the LifeTime Funds invest, fees which indirectly reduced the net asset values of the LifeTime Funds. The district court¹ entered judgment in favor of PMC, concluding that ACE lacks statutory standing under § 36(b) to challenge the fees in question. Reviewing this decision de novo , we affirm.

I.

A. Responding to investment company mismanagement and abuse, Congress enacted the ICA in 1940 "to impose controls and restrictions on the internal management of investment companies." Burks v. Lasker , 441 U.S. 471, 478, 99 S.Ct. 1831, 60 L.Ed.2d 404 (1979) (emphasis and quotation omitted). "A mutual fund is an open-end investment company" subject to the ICA's controls and restrictions. Inv. Co. Inst. v. Camp , 401 U.S. 617, 625 n.11, 91 S.Ct. 1091, 28 L.Ed.2d 367 (1971). A typical mutual fund sells shares to investors and then invests the proceeds of those sales in a portfolio of securities such as stocks or bonds. A mutual fund structured as a "fund of funds," such as the LifeTime Funds, purchases shares of other, often publicly-traded mutual funds (commonly referred to as the "acquired" or "underlying" funds, while the fund of funds is referred to as the "acquiring" fund). For most mutual funds, including funds of funds, an investment adviser creates the mutual fund, selects the fund's directors, manages the fund's investments, and provides other services.

To curb perceived abuses,² including the charging of duplicative fees, the ICA initially limited mutual funds to buying up to five percent of another mutual fund's shares. See 15 U.S.C. § 80a-12(d)(1) (1940). It also authorized the Securities and Exchange Commission "to bring an action ... alleging that a person serving or acting [as an investment adviser] has been guilty ... of gross misconduct or gross abuse of trust in respect of any registered investment company." § 80a-35 (1940). After World War II, "investment companies enjoyed enormous growth." Daily Income Fund, Inc. v. Fox , 464 U.S. 523, 537, 104 S.Ct. 831, 78 L.Ed.2d 645 (1984). In 1970, Congress amended the ICA to bolster shareholder protection by giving disinterested mutual fund directors increased responsibilities and by enacting § 36(b), which "imposed upon investment advisers a ‘fiduciary duty’ with respect to compensation received from a mutual fund ... and granted individual investors a private right of action for breach of that duty." Jones v. Harris Assocs. L.P. , 559 U.S. 335, 340, 130 S.Ct. 1418, 176 L.Ed.2d 265 (2010).

The 1970 amendments also extended § 12(d)(1)'s restrictions on funds of funds investing to unregistered and foreign funds. See § 80a-12(d)(1)(A)-(B). Since 1970, however, Congress and the SEC have concluded that carefully regulated fund-of-funds structures offer advantages to small investors. Using its general exemption authority, § 80a-6(c), the SEC first allowed several large mutual fund complexes to create "affiliated" funds of funds free from the percentage restrictions in § 12(d)(1). See, e.g. , Vanguard Special Tax-Advantaged Retirement Fund, Inc. , Investment Company Release No. 14361, 1985 WL 548623 (1985). In 1996, Congress amended the ICA to codify these exemptions. With some restrictions, § 12(d)(1) now does not apply when the fund of funds and the underlying funds "are part of the same group of investment companies," defined as a group "that hold themselves out to investors as related companies for purposes of investment and investor services." § 80a-12(d)(1)(G)(i)(I), (ii).

Experience persuaded the SEC that the public disclosures of affiliated funds of funds limited the investor's ability to compare their management costs with other mutual funds by obscuring the indirect costs incurred from investing in other mutual funds. See Fund of Funds Investments, Proposed Rules, 68 Fed. Reg. 58,226, at 58,234 (Oct. 8, 2003). In 2006, the SEC promulgated a rule that requires funds of funds to disclose their "Acquired Fund Fees and Expenses," or AFFE. The rule, which formed the basis of ACE's Complaint, was "designed to provide investors with a better understanding of the actual costs of investing in a fund that invests in other funds." Fund of Funds Investments, Final Rule, 71 Fed. Reg. 36,640, at 36,645 (June 27, 2006) (codified at 17 C.F.R. § 274.11 ). The AFFE reflects the underlying funds' total expenses, including management fees, apportioned according to the percentage of shares that the fund of funds holds in the underlying funds and expressed as a percentage of the fund of funds' total assets. The AFFE discloses indirect costs the fund of funds incurs, including management fees paid by the underlying funds. It does not disclose payments made by the fund of funds.

B. ACE holds shares in six LifeTime Funds, which are affiliated funds of funds that invest in twenty-or-so underlying funds under the § 80a-12(d)(1)(G) exemption. PMC is the investment adviser for both the LifeTime Funds and the underlying funds. Each LifeTime Fund pays PMC a management fee of 3 basis points (0.03% of the LifeTime Funds' total net assets) for its services to these funds of funds, which PMC pays to an affiliated sub-adviser, Principal Global Investors. PMC also calculates and discloses the AFFE for each LifeTime Fund in accordance with SEC disclosure requirements. In 2013, the AFFE of the six LifeTime Funds at issue ranged from 0.59% to 0.75% of the fund's total net assets. The management fees that the underlying funds pay directly to PMC for its advice and services to those funds are reflected in the LifeTime Funds' AFFE, weighted in accordance with the SEC's disclosure formula.

Count I of ACE's Complaint alleged that PMC breached its § 36(b) fiduciary duty by charging fees for advisory services that "are unfair, excessive, and were not negotiated at arm's length in light of all the surrounding circumstances." The Complaint alleged that ACE "does not challenge" the 3-basis-point management fee the LifeTime Funds pay directly to PMC. "Instead, [ACE] here challenges and seeks recovery of part or all of a fee charged to investors in the LifeTime Funds" that PMC calls the AFFE. As ACE's Reply Brief described this convoluted claim on appeal, for purposes of § 36(b) PMC received as "compensation" or "payments of a material nature" the AFFE's "revenue portion," that is, "the proportional share of the overall management fee that is attributable to PMC's management of the assets in the Underlying Fund owned by the LifeTime Funds." To recover on this claim, ACE has the burden to prove, based on consideration of all relevant procedural and substantive factors, that the fee was "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." Jones , 559 U.S. at 346-47, 130 S.Ct. 1418 ; see Gallus v. Ameriprise Fin., Inc. , 675 F.3d 1173, 1178 (8th Cir. 2012).

Ruling on PMC's motion for summary judgment, the district court held that ACE lacked a cause of action under § 36(b). As ACE was not challenging the 3-basis-point management fee the LifeTime Funds pay directly to PMC, and undisputed evidence showed that the AFFE includes "fees charged by advisors to the Underlying Funds" and "does not reveal what shareholders in the LifeTime Funds pay" to PMC, the court concluded that ACE was in fact challenging fees paid by the underlying funds "at a level once removed from [ACE's] security interest." ACE admitted that it was not a security holder in the underlying funds, and § 36(b) "only allows security holders to challenge fees paid by the entity in which they have an interest." Am. Chems. &...