In a split decision issued October 31, the U.S. Court of Appeals for the Tenth Circuit reversed a trial court's ruling imposing sanctions against plaintiffs' lawyers who pursued meritless claims for excessive mutual fund advisory fees under Section 36(b) of the Investment Company Act of 1940.
Following a bench trial in the District of Colorado that resulted in the dismissal of all claims against defendant Empower Capital Management and its affiliates, the trial judge concluded plaintiffs' counsel "recklessly pursued their claims through trial despite the fact that they were lacking in merit." She ordered plaintiffs' counsel to pay $1.5 million of Empower's trial costs and attorneys' fees, a fraction of Empower's total defense costs for the multi-year litigation.
A 2-1 majority of the Tenth Circuit appellate panel disagreed, concluding that the district court abused its discretion in imposing this sanction. The majority relied heavily on the fact that the district court judge had earlier declined to grant pretrial summary judgment to the adviser and had found plaintiffs' expert sufficiently qualified to testify at trial.
But the majority was unwilling to credit the district court judge's findings – which she made after hearing the trial evidence first-hand – that plaintiffs' key expert was "thoroughly discredited on cross examination" and their damages theories were "fundamentally flawed." The third judge on the panel wrote in a dissent: "The unintended but predictable consequence of the majority opinion is to provide a safe harbor for parties who unreasonably proceed to trial after persuading a court to deny a motion for summary judgment" or a motion to exclude experts.
Crucially, the majority decision does nothing to weaken the rigorous legal standard governing the merits of excessive fee claims under Section 36(b). That standard was set forth definitively in the Supreme Court's 2010 decision in Jones v. Harris Associates, requiring plaintiffs to prove that a challenged fee 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." No plaintiff has yet won a claim under this standard, and the Tenth Circuit majority opinion in no way questions the trial court's ruling on the merits rejecting the claims against Empower in this case under the Jones standard.
Instead, the majority decision stands as another example of the unfortunate unwillingness of U.S. courts to penalize plaintiffs' lawyers for bringing far-fetched claims that impose huge defense costs on the fund industry. By contrast, in many non-U.S. jurisdictions, the default rule is that the losing party must reimburse the defense costs (including attorney fees) of the victorious adversary, creating an important financial incentive for litigants and their lawyers not to press frivolous claims and defenses.
U.S. judges have discretion to impose such fee-shifting where litigants have pressed positions having no reasonable basis, but they seldom deploy this tool. Instead, defendants who spend millions defending against baseless allegations are typically left recovering only specified out-of-pocket trial costs (but not their attorney fees), as has happened only on occasion.
At the end of the day, this week's Tenth Circuit majority decision does not make it any easier for shareholders to prove excessive fee claims under Section 36(b). On the margin, however, the ruling may unhelpfully weaken a financial disincentive for the plaintiffs' bar to launch the next wave of 36(b) cases based on far-fetched theories.
Indeed, the majority decision even went so far as to express concern that imposition of sanctions would "chill legitimate, zealous advocacy in an area where plaintiffs already face a high barrier to success on the private right of action provided by Congress." But it hardly seems to strike the right balance to deny trial judges the discretion to conclude that evidence presented to them is sometimes so weak as to fall outside "legitimate, zealous advocacy."
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