July 27, 1990
TO: SEC RULES MEMBERS NO. 55-90
RE: DISTRICT COURT DISMISSES 36(b) CLAIMS IN
KALISH v. FRANKLIN ADVISERS, INC.
__________________________________________________________
The United States District Court for the Southern District
of New York has dismissed a suit brought by shareholders in a
GNMA fund claiming excessive advisory fees pursuant to Section
36(b) of the Investment Company Act. A copy of the court's
opinion in the case, Kalish v. Franklin Advisers, Inc., is
attached.
In dismissing the plaintiffs' suit, the court stressed four
factors, in reliance on the Gartenberg and Krinsk cases. The
four factors were (1) the nature and quality of the services
provided by the fund's adviser, (2) the profitability of the fund
to the adviser, (3) whether economies of scale were realized by
the adviser and shared with the shareholders and (4) the role
played by the fund's independent directors. The court also
stated that some consideration could be given to fees charged by
similar advisers.
Plaintiffs had argued that the adviser had misallocated
certain costs, including promotional and advertising expenses,
thereby understating profits earned from the fund and misleading
the directors. While the court expressed some doubts about the
allocation, it concluded that the directors were fully aware of
the rationale underlying the allocation, which was deemed
reasonable by an independent auditing firm. The court did state,
however, that the directors' duty to prevent the indirect use of
fund assets for distribution purposes "forms an integral part of
evaluating the fairness of the manager-adviser's fee". (The fund
had no 12b-1 plan.)
The court noted that even if expenses had been
misallocated, the fund's profitability to the adviser did not
appear to exceed 35%, which was comparable to the profitability
found in the Schuyt and Krinsk cases. The court stated that
"[profitability] alone does not violate the Act" and gave no
weight to the plaintiffs' comparison of the fund's profitability
with that of different types of financial service firms.
As in prior decisions involving Section 36(b) claims, the
court placed heavy emphasis on the role of the independent
directors, noting, among other things, their education and
professional experience, the advice received from independent
counsel and the fact that the directors did not act passively,
but requested a product-line analysis of cost and revenues and
questioned the allocation of expenses contained in the resulting
report. The court stated that the fact that counsel to the
directors also served as counsel to the fund did not disqualify
him "from performing the important function as counsel to the
independent directors".
With respect to the nature and quality of the services
provided by the adviser, the court noted that the fund generally
had high total returns and low expense ratios as compared to
similar funds.
The court also held that the burden of proof was on the
plaintiffs to show that the fund realized economies of scale and
could not rely simply on the fact that the fund increased in
size. The court concluded that the plaintiffs had failed to show
that economies were realized or that, if they were, they were not
shared with investors.
Craig S. Tyle
Associate General Counsel
Attachment