UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK
March 2, 2006
MILTON PFEIFFER, PLAINTIFF,
BJURMAN, BARRY & ASSOCIATES, AND BJURMAN, BARRY MICRO CAP GROWTH FUND, DEFENDANTS.
The opinion of the court was delivered by: Denise Cote, District Judge
OPINION AND ORDER
This Opinion addresses the question of whether an investment adviser can be held liable under Section 36(b) of the Investment Company Act of 1940, 15 U.S.C. § 80a-1 et seq. (1988) ("Section 36(b)" and "ICA"), for allegedly excessive fees paid by a mutual fund to broker-dealers. Plaintiff Milton Pfeiffer ("Pfeiffer") brought this lawsuit on the assumption that defendant Bjurman, Barry & Associates ("BB&A") continued to charge and receive marketing and distribution fees from its no-load mutual fund Bjurman, Barry Micro Cap Growth Fund (the "Fund") after the Fund had closed to new investors. Discovery has revealed that the disputed fees are not paid to BB&A for marketing and distribution expenses, but are instead service fees paid by the Fund to broker-dealers. Defendants move for summary judgment on the ground that they cannot be held liable under Section 36(b) for the payment of fees to broker-dealers. Plaintiff has filed a cross-motion for summary judgment. For the reasons stated below, defendants' motion is granted, and plaintiff's cross-motion is denied.
The following facts are undisputed or taken in the light most favorable to the plaintiff, unless otherwise indicated.*fn1
The Bjurman, Barry Funds (the "Trust") is a diversified, open-end investment company organized under the laws of Delaware and registered under the ICA. The Trust offers shares in three mutual funds, including the Fund that is the subject of this action. The Fund invests in companies with market capitalizations between $30 million and $300 million. It closed to new investors on May 30, 2003. Existing shareholders and shareholders of the Trust's other funds, however, retained the ability to make additional investments. The two principal shareholders of the Fund are Charles Schwab & Co., Inc. ("Schwab") and Fidelity Brokerage Services, Inc./National Financial Services Corp. (collectively, "Fidelity"), broker-dealers that hold shares for the benefit of their clients. As of July 3, 2004, Schwab and Fidelity investors owned over 70% of the outstanding voting shares of the Fund.
Pursuant to 17 C.F.R. § 270-12b-1 ("Rule 12b-1"), the Fund has paid fees for marketing, distribution, and account servicing. Rule 12b-1 permits a mutual fund to use a percentage of its assets to reimburse "underwriters, dealers, and sales personnel."
17 C.F.R. § 270.12b-1(a)(2). Rule 12b-1 requires a mutual fund that makes such payments to issue a written distribution plan detailing "all material aspects of the proposed financing of distribution" of its shares. 17 C.F.R. at § 270-12b-1(b). This plan must be approved at least annually by a majority of the fund's board of directors, including a majority of the disinterested directors. Id. at (b)(2).
Although Rule 12b-1 does not limit the amount that a fund's shareholders may be charged under such a plan, the NASD has limited Rule 12b-1 fees for no-load funds to a maximum of one quarter of 1% of a fund's average daily net assets per year. See NASD Rule 2830(d)(4) and (5). This limit applies to both "sales related expenses and/or service fees." Id. at (d)(4). Sales charges include fees that are "paid to finance sales or sales promotion expenses." Id. at (b)(8). Service fees are defined as "payments by an investment company for personal service and/or the maintenance of shareholder accounts." Id. at (b)(9). These limits have been approved by the SEC.
The Trust is governed by a five-member board of trustees (the "Board"). Three of the five trustees are independent; the remaining two are affiliated with BB&A. In 1999, the Board filed with the SEC a distribution plan (the "Plan") pursuant to Rule 12b-1. It provides for the reimbursement of the Advisor, Distributor or others for all expenses incurred by such parties in the promotion and distribution of shares of the Fund ... as well as any distribution or service fees paid to securities dealers or others who have executed a servicing agreement with the Trust on behalf of the Fund. (Emphasis supplied.) The Plan complies with the NASD cap on Rule 12b-1 fees of 0.25% of the Fund's average daily net assets.
The Fund entered into servicing agreements with broker-dealers, including Schwab and Fidelity. Prior to the Fund's closure, the broker-dealers provided "shelf space" on their distribution platforms, as well as service for shareholder accounts. After closure, the broker-dealers' role was limited to maintenance and servicing of the accounts. The Fund continued to make Rule 12b-1 payments, however, at a constant 0.25% rate both before and after the Fund's closure. Because the assets held by the Fund appreciated significantly in the year ending September 30, 2003, the amount paid in Rule 12b-1 fees increased substantially even after the Fund closed to new investors.
As the investment adviser to the Fund, BB&A determines which securities the Fund will buy or sell, and, together with the Trust's officers, administers the Fund's daily operations. The amount of the investment advisory fee that the Fund pays to BB&A is not the subject of this lawsuit. BB&A also pays broker-dealers service fees in excess of the 0.25% cap established by the Plan. Schwab and Fidelity, for example, charge 0.40% and 0.35% respectively for their services. After the Fund contributes 0.25%, BB&A covers the remaining 0.15% and 0.10% due under the service agreements.
The plaintiff contends that the 0.25% paid by the Fund to Schwab and Fidelity is funneled through BB&A. Its sole evidence of this is the Board Minutes of September 29, 2003, which state: the Funds will pay to the Adviser [BB&A], on a monthly basis, up to one-twelfth of 0.25% of average daily net assets of distribution expenses ... and that the Adviser [BB&A] will pay to IFS Funds Distributors, Inc., the Funds' distributor, the total amounts owed for distribution expenses, such payment to include the Funds' payment to the Adviser and any additional amounts that are necessary.
IFS Funds Distributors, Inc. is Integrated Funds Services, Inc. ("Integrated"). Integrated is the Fund's transfer agent and administrator.
Defendants contend that the Board merely authorized the payments to be made in this manner, but that all of the documentation for the transfers establish that the Fund continued to make its payments to Schwab and Fidelity either directly or via Integrated. Plaintiff, however, argues that the minutes are sufficient to show that the payments flowed through BB&A. As described below, the parties dispute the significance of BB&A serving as a transfer agent for Rule 12b-1 fees destined for Schwab and Fidelity.
On December 9, 2003, plaintiff commenced this lawsuit as a derivative action against BB&A on behalf of the Fund. Plaintiff filed a First Amended Complaint on February 20, 2004. Plaintiff then provided defendant and this Court with a Second Amended Complaint on April 30, 2004.*fn2 Plaintiff alleges that BB&A breached its fiduciary duty under Section 36(b) of the ICA by charging the Fund for promotion, distribution, and "other expenses" in proportion to the Fund's assets, rather than the services rendered. Plaintiff seeks to recover the allegedly improper Rule 12b-1 fees that the Fund paid to BB&A, to recover a portion of BB&A's advisory fees because it breached its fiduciary duty to the Fund, and to enjoin the Fund from allowing BB&A to overcharge and BB&A from overcharging for Rule 12b-1 fees going forward.
On August 26, 2004, the claims with respect to administrative, transfer agent, and "other fees" were dismissed because Integrated, rather than BB&A, was the recipient of the compensation. Pfeiffer, 2004 WL 1903075 at *3 n.11. As of that time, it appeared that the remaining claims concerned solely marketing, distribution, and servicing fees paid to BB&A, which it represented were principally used to compensate Schwab and Fidelity. In opposing the motion to dismiss, the defendants argued that the payment of the Rule 12b-1 fees were per se reasonable since they did not exceed the 0.25% cap. They also argued that it was reasonable, in the event that the Rule 12b-1 expenses in one year were less than the maximum amount permitted, to use Rule 12b-1 funds to pay unreimbursed Rule 12b-1 expenses from prior years.
Summary judgment may not be granted unless all of the submissions taken together "show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." Rule 56(c), Fed. R. Civ. P. The moving party bears the burden of demonstrating the absence of a material factual question, and in making this determination, the court must view all facts in the light most favorable to the non-moving party. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247 (1986); Celotex Corp. v. Catrett, 477 U.S. 317, 323 (1986). When the moving party has asserted facts showing that the non-movant's claims cannot be sustained, the opposing party must "set forth specific facts showing that there is a genuine issue for trial," and cannot rest on the "mere allegations or denials" of the movant's pleadings. Rule 56(e), Fed. R. Civ. P.; accord Burt Rigid Box, Inc. v. Travelers Property Cas. Corp., 302 F.3d 83, 91 (2d Cir. 2002).
Under Section 36(b) of the ICA, an investment advisor has "a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature" made to it or its affiliates by a registered investment company. This duty extends not only to fees paid for advisory services, but also to other payments made pursuant to Rule 12b-1 plans. Meyer v. Oppenheimer Mgmt. Corp., 895 F.2d 861, 866 (2d Cir. 1990). In order to fall within the ambit of Section 36(b), however, the advisor or its affiliates must actually receive such compensation: "No [Section 36(b)] action shall be brought ... and no damages or other relief shall be granted against any person other than the recipient of such compensation or payments." 15 U.S.C. § 80a-35(b)(3). Accord Krinsk, 875 F.2d 404, 413 (2d Cir. 1989). Therefore, a threshold issue in cases alleging a breach of the Section 36(b) fiduciary duty is whether the defendant is a recipient of any of the payments that are the subject of the action.
Section 36(b) does not define "recipient." Congress, however, provided ample evidence of the conduct it aimed to combat with the ICA:
Since a typical fund is organized by its investment adviser which provides it with almost all management services and because its shares are bought by investors who rely on that service, a mutual fund cannot, as a practical matter sever its relationship with the adviser. Therefore, the forces of arm's-length bargaining do not work in the mutual fund industry in the same manner as they do in other sectors of the American economy.
S. Rep. No. 91-184 (1970), reprinted in 1970 USCCAN 4897, 4901. Congress's concern, then, was the "potential [for] conflicts of interest involved in the setting of [mutual fund management] fees." Id. at 4898. In other words, Congress hoped to prevent investment advisors from improperly profiting from their ability to determine the level of compensation they would receive.
Few courts have confronted the issue of what constitutes "receipt" of payments under Section 36(b). Those that have ruled on the issue, however, have looked to Congressional intent and have only allowed claims to proceed against parties that have potentially benefitted from the lack of arm's-length bargaining. See, e.g., Meyer v. Oppenheimer Mgmt. Corp., 764 F. 2d 76, 79 (2d Cir. 1985) (allowing Section 36(b) claims against firms that "owned all of the stock in the Fund's investment adviser"); In re Goldman Sachs Mutual Funds, ___ F. Supp. 2d ___, 2006 WL 126772, *7-8 (S.D.N.Y. Jan. 17, 2006) (dismissing Section 36(b) claims against mutual fund trustees and officers on the ground that their compensation did "not constitute receipt of payments for advisory services or Rule 12b-1 fees"); Levy v. Alliance Capital, 1998 WL 744005, *4 (S.D.N.Y. Oct. 26, 1998)(endorsing a "narrow" reading of Section 36(b) to allow claims "only [against] those who receive money paid by the investment company"); Jerozal v. Cash Reserve Management, Inc., 1982 WL 1363, *6 (S.D.N.Y. Aug. 10, 1982) (holding that the right of action under Section 36(b) is aimed at "tracing compensation or payment for advisory services to the ultimate beneficiary"). In other words, courts have typically not imposed on investment advisors a generalized fiduciary duty with respect to all payments made by mutual funds, but only with respect to those payments that accrue to an advisor or its affiliates.
Pfeiffer claims that BB&A is a recipient of Section 36(b) payments in two ways. First, plaintiff alleges that the Fund's Rule 12b-1 payments to Fidelity and Schwab flowed through BB&A --that is, the Fund disbursed money to BB&A, which passed it along to Integrated, which then paid the broker-dealers. Second, plaintiff claims that BB&A effectively received payments from the Fund when the Fund failed to terminate the Fidelity and Schwab service agreements under which the Fund was paying allegedly excessive fees. Pfeiffer contends that if the contracts had been terminated, BB&A alone would have been liable for the servicing fees charged by Schwab and Fidelity. Therefore, according to plaintiff, BB&A was a constructive recipient of the money that flowed from the Fund to Fidelity and Schwab.
Neither of Pfeiffer's theories, however, is legally sufficient to establish BB&A's liability under Section 36(b). Pfeiffer's first contention -- that BB&A was the initial recipient of Rule 12b-1 fees ultimately bound for Fidelity and Schwab -- is contested by defendants. Pfeiffer points to the minutes from the September 2003 Board meeting, which reflect the trustees' agreement "that the Funds will pay to [BB&A], on a monthly basis, up to one-twelfth of 0.25% of average daily net assets." The minutes go on to say that BB&A will then pay to Integrated the "total amount owed for distribution expenses," including the Funds' initial payments to BB&A. Defendants claim that the Board merely "authorized BB&A to act as a pass-through intermediary of 12b-1 payments by the Fund," but that the Fund never actually used BB&A in that capacity. Although the parties make much of this dispute, it is immaterial to the issue of BB&A's liability under Section 36(b), since plaintiff concedes that BB&A did not actually retain any of the money that may have been paid to it by the Fund. Although the Second Circuit has never explicitly addressed this point, serving as a pass-through entity for Rule 12b-1 payments does not constitute "receipt" under the ICA.
This result is consistent with previous cases, discussed supra, which have conferred Section 36(b) liability only upon those parties that benefitted from contested payments. It also conforms to Congress's stated desire to prevent investment advisers from profiting from their power over funds' disbursements. Conversely, to hold BB&A liable by virtue of its temporary possession of money ultimately bound for broker-dealers would abrogate the limitations Congress placed on Section 36(b) liability.
Plaintiff's second theory of liability -- that BB&A constructively received payments from the Fund because BB&A would have had to assume the entirety of the Fund's obligations to the broker/dealers if the Fund had terminated its service agreements with Schwab and Fidelity --would also expand Section 36(b) liability beyond what Congress envisioned. Defendants dispute Pfeiffer's claim that BB&A would have been obligated to pay the Rule 12b-1 fees if the Fund had terminated the service agreements. But even if plaintiff's reading of the contracts were correct, it would not make BB&A liable under Section 36(b).
Plaintiff has not pointed to any precedent for reading "recipient" to cover parties who do not in fact receive any funds.
Finally, Pfeiffer argues that because defendants did not raise the "'recipient defense'" in previous filings, they cannot do so now. Plaintiff cites Rule 8(c) of the Fed. R. Civ. P., which requires parties to include all "matter[s] constituting an avoidance or affirmative defense" in their pleadings. This argument fails, however, as plaintiff bears the burden of proving that defendants were recipients of the payments in question. In other words, it is an element of plaintiff's prima facie case, and therefore is not an affirmative defense under Rule 8(c).
See, e.g., National Market Share, Inc. v. Sterling Nat. Bank, 392 F.3d 520, 526-27 (2d Cir. 2004).
Because BB&A is not a recipient of the Rule 12b-1 payments, it is unnecessary to reach the defendants' argument that the amount of the service fees paid to the broker-dealers is reasonable as a matter of law.*fn3 In addition, since BB&A cannot be found to have violated Section 36(b), plaintiff's demand for an injunction prohibiting the Fund from allowing BB&A to continue charging improper Rule 12b-1 fees must be denied as moot.
Nonetheless, it must be observed that the defendants' delay in raising the argument that they did not actually receive the contested funds is curious. A companion case was resolved without the need for any motion practice because the defendants in that litigation complied with the Court's order that they meet with the plaintiff to explain their fund's structure of its payment of Rule 12b-1 fees. See Pfeiffer, 2004 WL 1903075, at *3. Neither BB&A nor the Fund were willing to participate in such discussions. Moreover, as described above, in their motion to dismiss neither defendant argued that BB&A was not a "recipient" of the Rule 12b-1 fees and therefore that the defendants could not be liable for a violation of Section 36(b). Indeed, it was not until discovery had closed that the defendants advised the plaintiff that the case should be dismissed because BB&A was not a recipient of the fees. The failure to identify this legal deficiency in the plaintiff's theory earlier in this litigation is particularly mystifying since it has added to the length and expense of the litigation.*fn4 Defendants have shown, nonetheless, that they are entitled to summary judgment on the Section 36(b) claim.
Plaintiff has raised one additional troubling issue concerning the defendants' conduct of this litigation. The plaintiff points to evidence that immediately after this lawsuit was filed, outside counsel for the defendants may have fabricated minutes for a Board meeting by inserting a comprehensive discussion of the issue of Rule 12b-1 fees into the minutes.*fn5
The attorney was with the same law firm that has represented the defendants in this litigation. While the minutes were apparently altered to assist in the defense of this litigation, the defendants then chose not to produce these Board minutes or the related documents in discovery to the plaintiff.*fn6 Because of this conduct, the plaintiff asks for a finding that the Board for the Fund "never had any discussion regarding terminating the 12b-1 Plan since the Fund's closure as required under Rule 12b-1." Because the lawsuit against the defendants is premised on the alleged improper payment of Rule 12b-1 fees to BB&A, and because that theory has failed, this additional request for relief is denied as moot.
For the reasons stated above, defendants' motion for summary judgment is granted, and plaintiff's cross-motion for summary judgment is denied. The Clerk of the Court shall close the case.
DENISE COTE United States District Judge