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In re Franklin Mutual Funds Fee Litigation

March 13, 2007


The opinion of the court was delivered by: Martini, U.S.D.J.


This matter comes before the Court on Defendants' motion to dismiss Plaintiffs' Second Amended Derivative Complaint for failure to state a claim under Federal Rule of Civil Procedure 12(b)(6). For the following reasons, Defendants' motion is GRANTED and Plaintiffs' Second Amended Derivative Complaint is DISMISSED WITH PREJUDICE.


For purposes of the present motion, it is necessary to provide some background regarding this matter. On October 4, 2004, three shareholders of three Franklin and Templeton mutual funds filed a Consolidated Amended Complaint (the "Class Action Complaint" or "C.A.C."). The suit was brought on behalf of all investors owning shares in 103 Franklin and Templeton Mutual Funds between March 2, 1999 to November 17, 2003.*fn1 The Class Action Complaint named as defendants Franklin Resources, Inc., which is the parent company of all the defendants, the funds' investment advisors and distributors, and the funds' directors, officers, and trustees. Also named as nominal defendants were the funds themselves.

The gravamen of the Class Action Complaint was that the defendants engaged in a kickback scheme with securities brokers that benefitted everyone involved but the funds and their shareholders. See generally In re Franklin Mut. Funds, 388 F. Supp. 2d 451, 457 (D.N.J. 2005). Essentially, the plaintiffs claimed that the defendants made undisclosed payments to brokers to encourage them to push the funds onto unsuspecting investors. Under agreements known as "shelf-space arrangements," the brokers would give the funds priority placement when encouraging investors to invest in mutual funds. Plaintiffs claimed this led to more people investing in the funds, causing the funds' net asset value to grow. As the net asset value of the funds grew, the defendants began collecting greater compensation because they charged the funds fees as a percentage of net asset value. As the defendants collected greater compensation they, in turn, continued making payments to brokerage firms to induce brokers to steer more investors into the funds. As this circle continued, and the Funds expanded, the brokers and the defendants reaped the pecuniary rewards while the investors were left owning shares in ever-larger, less dynamic mutual funds laden with excessive fees. The plaintiffs also claimed that this scheme directly harmed investors because it reduced the funds' net asset value per share, decreasing the amount by which each shareholder was entitled to redeem his or her shares.

The Class Action Complaint contained ten counts. Only Counts Three through Four and Seven through Ten, though, are relevant to the motion presently before the Court. Count Three purported to assert a class action claim under § 36(b) of the Investment Company Act of 1940 (the "ICA"), 15 U.S.C. §§ 80a-35(b). It alleged that the Funds' investment advisors and distributors breached their fiduciary duty to the Funds by engaging in the above-mentioned kickback scheme. Count Four, which relied on Count Three as a predicate for liability, claimed that Franklin Resources Inc. was liable under § 48(a) of the ICA, 15 U.S.C. § 80a-47(a), for causing the funds' investment advisors and distributors to violate § 36(b). Finally, Counts Seven through Ten purported to assert various state law claims against the defendants.

On September 9, 2005, this Court dismissed all ten counts of the Class Action Complaint. See In re Franklin Mut. Funds, 388 F. Supp. 2d 451. As to Counts Three and Four, the Court dismissed them because a § 36(b) claim may only be maintained derivatively and not on behalf of a class. Id. at 467-69. The Court, though, granted the plaintiffs an opportunity to replead those counts derivatively. Id. at 474. As to the plaintiffs' state law claims in Counts Seven through Ten, the Court dismissed them as preempted under the Securities Litigation Uniform Standards Act ("SLUSA"), 15 U.S.C. § 78bb(f). Id. at 471-73.

In response to our invitation to replead Counts Three and Four derivatively, the plaintiffs filed a Second Amended Derivative Complaint (the "Derivative Complaint" or "D.C.") on March 10, 2006. The Derivative Complaint is now brought by seven plaintiffs ("Plaintiffs") on behalf of twelve Franklin and Templeton Mutual Funds (the "Franklin Fund(s)" or "Fund(s)") in which they are shareholders.*fn2 (D.C. ¶¶ 12-18.) The defendants in the Derivative Complaint are: (1) Franklin Resources, Inc.; (2) the Funds' investment advisors (the "Investment Advisor Defendants"); and (3) the Funds' distributors and underwriters (the "Distributor Defendants") (collectively, the "Defendants"). (Id. ¶¶ 19-31.). The Derivative Complaint contains two counts. Count One attempts to allege a derivative § 36(b) claim and Count Two attempts to assert a derivative § 48(a) claim.

The Derivative Complaint differs substantially from the Class Action Complaint. As will be discussed below, Plaintiffs now attempt to assert a traditional "Gartenberg-style" action. The gravamen of their Derivative Complaint is that the Investment Advisor and Distributor Defendants charged the Funds excessive fees that were grossly disproportionate to the value of the services they provided, and were not within the bounds of what would have been negotiated at arm's-length. (Id. ¶¶ 1-4.) The fees primarily at issue here are Investment Advisor Fees and "Rule 12b-1 Fees." (Id. ¶¶ 3-4, 34-38.) The Investment Advisor Defendants received Investment Advisor Fees, while the Distributor Defendants received Rule 12b-1 Fees. (Id. ¶ 35.) Both fees are calculated as a percentage of assets under management. (Id. ¶¶ 34-35.) Therefore, the dollar amount of such fees increase as the size of the Fund grows. (Id.)

Essentially, Plaintiffs claim that Defendants' fees were excessive for two reasons. First, Defendants failed to pass onto the Funds the benefits of "economies of scale." (Id. ¶¶ 2-4, 43-44.) Open-ended mutual funds, such as the Franklin Funds, can experience economies of scale. (Id. ¶ 43.) Because of economies of scale, it does not cost more on a per share basis to manage additional assets in a growing mutual fund. (See id. ¶ 44.) For instance, many of the costs, such as research costs, remain fixed regardless of the amount of assets in a given fund. (See id.) Therefore, the cost of maintaining a shareholder's account is typically the same for all shareholders, regardless of the relative size of their accounts. (See id.) Here, Plaintiffs claim that the Funds' assets grew dramatically. (Id. ¶ 41.) As a result, this created substantial economies of scale. (Id. ¶ 42-45.) Plaintiffs allege, however, that Defendants never passed along the benefits of those economies of scale by lowering their fees or providing additional services.

Plaintiffs' second explanation for the excessive fees mirrors their allegations in the Class Action Complaint. They claim that the kickback scheme, as described above, harmed the Funds because it increased the Defendants' fees while not resulting in the Funds receiving any additional services. (Id. ¶¶ 5, 59, 64, 83, 87, 91.) As such, Plaintiffs claim that Defendants received "something for nothing." (Id. ¶ 5, 64.)

Plaintiffs further allege that the board of directors (the "Directors") of the Funds failed to exercise due care when approving the Rule 12b-1 Fees paid to Defendants. Plaintiffs claim that the uninformed adoption and renewal of these distribution agreements resulted in the charging of Rule 12b-1 fees that did not benefit the Funds. (Id. ¶ 97.) Moreover, Plaintiffs allege that the Directors failed to obtain the information necessary to evaluate the use of Rule 12b-1 Fees for the Investment Advisor and Distributor Defendants' shelf-space arrangements. (Id. ¶ 98.) Plaintiffs also allege that the independent Directors were actually controlled by the Investment Advisor Defendants. (Id. ¶¶ 104-107.) Plaintiffs also claim that, because of various professional and social relationships, the independent Directors had no incentive to question the actions of the non-independent Directors. (Id. ¶¶ 109-110.)

In lieu of answering, Defendants filed a motion to dismiss Plaintiffs' Derivative Complaint under Rule 12(b)(6) for failure to state a claim. Plaintiffs oppose this motion and argue that their Derivative Complaint satisfies the standard for pleading claims under §§ 36(b) and 48(a). Defendants' motion is now before the Court.


I. Standard of Review

In deciding a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6), all allegations in the complaint must be taken as true and viewed in the light most favorable to the plaintiff. Warth v. Seldin, 422 U.S. 490, 501 (1975); Trump Hotels & Casino Resorts, Inc. v. Mirage Resorts Inc., 430 F.3d 478, 483 (3d Cir. 1998). In evaluating a Rule 12(b)(6) motion to dismiss for failure to state a claim, a court may consider only the complaint, exhibits attached to the complaint, matters of public record, and undisputedly authentic documents if the plaintiff's claims are based on those documents. Pension Benefit Guar. Corp. v. White Consol. Indus., 998 F.2d 1192, 1196 (3d Cir. 1993). If, after viewing the allegations in the complaint in the light most favorable to the plaintiff, it appears beyond doubt that no relief could be granted "under any set of facts ...

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