Section 36(b) of the Investment Company Act imposes a fiduciary duty on advisers with respect to receipt of compensation for services they provide to registered investment companies. The only U.S. Supreme Court decision to consider section 36(b), Jones v. Harris Associates L.P., was handed down on March 30, 2010—a full decade ago. In Jones, the Court upheld the standard first adopted by the Second Circuit in Gartenberg v. Merrill Lynch. That is, “to face liability under § 36(b) [of the Investment Company Act], an investment adviser must charge a fee that 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.”
The Jones decision underscored the importance of the board’s role in approving a fund’s investment advisory agreement and related compensation. Specifically, the Court said that “scrutiny of investment adviser compensation by a fully informed mutual fund board is the cornerstone of the … effort to control conflicts of interest within mutual funds” (internal citations omitted). Accordingly, “[w]here a board’s process for negotiating and reviewing investment adviser compensation is robust, [and] the disinterested [trustees] considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently.”
In the decade since Jones, several section 36(b) cases have gone to trial. Courts in those cases have continued to emphasize the importance of both the independence and conscientiousness of fund boards, and the robustness of their contract renewal process. The resulting decisions provide insight into current best practices at some of the leading fund complexes. Since the plaintiffs’ bar continues to bring actions under section 36(b), careful review of the decisions since Jones can help a board (and its counsel) evaluate whether its processes are sufficiently robust to mitigate the possibility of a challenge to their advisory contract renewal process and the fees received by the fund’s adviser.
As noted, in order to prevail in a Section 36(b) case, a plaintiff must prove that a fund adviser’s 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.” Since 1982, when the Gartenberg factors were first adopted, boards have considered the following when making this assessment:
- the nature, extent, and quality of the services provided by an adviser to a fund;
- the profitability to the adviser of managing the fund;
- “fall-out” benefits;
- the existence of any economies of scale achieved by the adviser as a result of growth in fund assets under management, and whether such savings are shared with fund shareholders;
- fee structures utilized by other similar funds; and
- the independence and expertise of the fund’s independent trustees and the extent of care and conscientiousness with which the independent trustees perform their duties with respect to the adviser’s fee.
Although courts have consistently held that plaintiffs in section 36(b) actions do not have to prove all, or any particular number, of the Gartenberg factors to prevail in a case, the one factor that appears to be non-negotiable is the independence and conscientiousness of the fund’s board. Accordingly, a board should ensure that it considers each of the Gartenberg factors when considering an advisory contract and related fees or, if a particular factor is not relevant or is deserving of lesser weight in a particular evaluation, the board should recognize and address that determination.
Board Process, Composition
It is clear in each of the decisions since Jones that the evaluation of a claim under section 36(b) is a fact-intensive process. Boards (and counsel) should take pains to ensure that the materials provided in connection with the contract evaluation process address each of the Gartenberg factors. Boards should also consider how their evaluation is reflected in board minutes and in shareholder reports and ensure that these materials appropriately reflect the factors considered to be the most important by the board. These materials should not be “boilerplate,” but should accurately reflect boardroom discussions regarding each fund.
Importantly, this disclosure should address not only the positive factors supporting approval, but also acknowledge and address factors that might not weigh so favorably on the decision. For example, not all funds will outperform their peers all the time or have below-median fees. Boards should understand the reasons for underperformance or higher-than-average fees, and should ensure that shareholder disclosure reflects those reasons. Boards may also want to develop “focus lists” of funds that consistently underperform or appear in the top quartiles of fees versus their peer group.
The use of third-party advisors and experts can be of particular importance in defeating a section 36(b) case. Similarly, if the overall process of identifying and hiring of such experts is led by the independent trustees, this can positively influence the view of a court. Finally, a fund board with members representing a diversity of backgrounds and experience, and that demonstrably values and encourages discussion regarding different views, may be a positive factor if an adviser is faced with a section 36(b) case.
A board and its counsel should consider not only the approval of advisory contracts annually, but also the surrounding process. This includes, for example, considering whether new funds, regulations, market developments, or enforcement actions warrant changes to the board’s existing due diligence approach. Similarly, each new section 36(b) decision is an opportunity to review and potentially refine a board’s existing contract approval process.
Boards are not required to negotiate fee reductions to be entitled to substantial deference. They are, however, expected to engage in a robust and thorough evaluation of the Gartenberg factors. Doing so, and appropriately documenting that evaluation, may be the most compelling defense to a section 36(b) challenge.
Kelley Howes is vice chair of Morrison & Foerster’s Investment Management Group. She counsels independent fund directors on governance issues and has advised mutual funds on mergers, reorganizations, compliance, and regulatory issues, including examinations and enforcement matters.