On July 24, 2017, the U.S. Court of Appeals for the Eighth Circuit (the Eighth Circuit) affirmed the decision of the U.S. District Court for the Southern District of Iowa (the District Court) entering summary judgment in favor of Principal Management Corporation (Principal) and dismissing a complaint filed by American Chemicals & Equipment Inc. 401(K) Retirement Plan (ACE) alleging that Principal breached its fiduciary duty under Section 36(b) of the 1940 Act by charging unfair and excessive fees.

Background

Section 36(b) of the 1940 Act provides that “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser.” Section 36(b) further provides for a private right of action “by a security holder of such registered investment company on behalf of such company, against such investment adviser, or any affiliated person of such investment adviser. . . .”

ACE was a shareholder in six of the Principal LifeTime Funds, which were structured as target-date “funds of funds,” meaning each LifeTime Fund invests in a portfolio of other mutual funds (i.e., underlying funds) designed to “maximize performance for investors targeting a specific retirement date.”  ACE sued Principal, the investment adviser for both the LifeTime Funds and the underlying funds, alleging that the management fees paid by the underlying funds in which the LifeTime Funds invested were “unfair and excessive” and indirectly reduced the net asset values of the LifeTime Funds.  On February 3, 2016, the District Court, in entering summary judgment in favor of Principal, concluded that ACE lacked “statutory standing” under Section 36(b) because ACE – which was neither a shareholder of the underlying funds nor challenging the management fee that the LifeTime Funds paid directly to Principal – had no cause of action under Section 36(b).

Appeal

As explained in the Eighth Circuit’s decision, consistent with SEC disclosure requirements, Principal calculated and disclosed the “Acquired Fund Fees and Expenses” (or AFFE) for each LifeTime Fund, which “reflects the underlying funds’ total expenses, including management fees, apportioned according to the percentage of shares that the fund of funds [i.e., the LifeTime Fund] holds in the underlying funds and expressed as a percentage of the fund of funds’ total assets.”  Consequently, the management fees that the underlying funds pay directly to Principal for its advisory services to those funds are reflected in the LifeTime Funds’ AFFE, “weighted in accordance with the SEC’s disclosure formula.”  On appeal from the District Court, in a claim described by the Eighth Circuit as “convoluted,” ACE challenged and sought recovery of the AFFE’s “revenue portion,” i.e., “the proportional share of the overall management fee that is attributable to [Principal’s] management of the assets in the Underlying Fund owned by the LifeTime Funds.”    

The Eighth Circuit, which reviewed the District Court’s decision de novo , cited the District Court’s conclusion that ACE was in fact challenging fees paid by the underlying funds “at a level once removed from [ACE’s] security interest.”  Since Section 36(b) “only allows security holders to challenge fees paid by the entity in which they have an interest,” the question was whether ACE asserted a claim in respect of compensation or payments “ paid by ” the LifeTime Funds to PMC.  

In affirming the decision of the District Court that ACE lacked “statutory standing” to sue Principal under Section 36(b), the Eighth Circuit stated that the AFFE is not “compensation for services.”  Instead, the Eighth Circuit explained, the AFFE “simply estimates the fund of funds’ costs of investing in other funds” (emphasis in original).  Similarly, the AFFE is not a “payment of a material nature,” since no entity pays the AFFE.  As the Eighth Circuit stated, Section 36(b) is “ expressly limited to claims regarding compensation or payments of a material nature paid by the LifeTime Funds or its shareholders” (emphasis in original).  

On appeal, ACE also claimed that because the LifeTime Funds and the underlying funds are a part of the same registered investment company, Principal Funds, Inc. (Principal Funds), ACE may assert a Section 36(b) claim as a shareholder of this single entity.  However, the Eighth Circuit noted that Principal Funds is organized as a “series company,” a single corporation offering multiple investment options that are each treated by the courts and the SEC as separate registered investment companies for purposes of applying Section 36(b).  Thus, the Eighth Circuit held that because each mutual fund is a separate registered investment company, ACE cannot sue on behalf of the underlying funds in which it lacks a security interest.