On March 13, 2018, the U.S. District Court for the Northern District of Illinois granted a motion for summary judgment in a suit brought against Harbor Capital Advisors, Inc. (the Adviser) under Section 36(b) of the Investment Company Act of 1940, as amended (the 1940 Act), by shareholders of the Harbor International Fund and the Harbor High Yield Bond Fund (together, the Funds).
The Adviser employs a “manager-of-managers” business model, using sub-advisers selected and paid by the Adviser and approved by the Board of Trustees fo the Funds (the Board) to make day-to-day investment decisions.
The Adviser pays the sub-adviser’s fees from the management fees it receives from the Funds. The plaintiffs’ theory of liability, according to the Court, was that “the revenue [the Adviser] collects from the Funds compared to the costs it incurs for the services it purportedly provides is so disproportionately large that its fees bear no reasonable relationship to the services rendered and could not have been the product of arm’s length negotiations.” In this regard, the plaintiffs contended that only those advisory services directly performed by the Adviser should be considered when determining whether its fees were excessive and those provided by the sub-advisers retained by the Adviser should be excluded. The Court disagreed.
Under Section 36(b) of the 1940 Act, investment advisers owe a fiduciary duty with respect to the compensation they receive for providing investment advisory services to registered funds, and fund shareholders have an express private right of action to enforce this duty against investment advisers and their affiliates that receive compensation from funds. In such cases, plaintiffs have the burden of proof to show, by a preponderance of the evidence, that investment advisory fees are excessive, i.e., “that the fees are so disproportionately large that they bear no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.”
To determine whether an advisory fee is excessive, courts consider the fee in light of the factors initially set forth in the 1982 decision of the U.S. Court of Appeals for the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc., which were cited with approval by the U.S. Supreme Court in its 2010 decision Jones v. Harris Associates, LP.
The Court’s Analysis of Deference Given to Board Decisions
In Jones, the Supreme Court said that a court should not “supplant the judgement of disinterested directors apprised of all relevant information, without additional evidence that the fee exceeds the arm’s-length range.” In this instance, the Court considered, in detail, evidence that the Board was independent, noting the qualifications of the Trustees, the quality of the Board’s counsel, the volume of information considered by the Board in approving the Funds’ investment advisory agreement and the Board’s efforts to negotiate fees.
The Court concluded that the plaintiffs failed to point to admissible evidence to contest the process or independence of the Board and failed to show that the Board was uninformed or that the review process was tainted by the withholding of necessary information. Ultimately, the Court concluded that the plaintiffs’ disagreement with the Board did not create a genuine issue of material fact as to whether the Board failed in its role as an “independent watchdog.”
The Court’s Application of the Gartenberg Factors
Applying the Gartenberg factors, the Court concluded the following:
- Nature and Quality of Services: In reviewing the nature and quality of services provided under an advisory agreement, all services provided under the agreement should be considered, including both services provided directly by the Adviser and services provided through a sub-contractual relationship (i.e., by a subadviser). Additionally, the plaintiffs failed to provide evidence “from which a reasonable jury could conclude”6 that the Funds had not performed at least as well as, if not better than, comparable funds.
- Comparative Fee Structures: “[N]o reasonable trier of fact, viewing the undisputed facts in the light most favorable to plaintiffs, could find that [the Adviser’s] fees fell outside the range of fees paid by comparable funds.” On this point, the plaintiffs raised issues with respect to the reports from independent financial services firms that were reviewed by the Board, including (1) the use of the total expense ratio as a proper fee comparison measurement, (2) the sample sizes in the comparative expense groups, and (3) the comparability of the expense group constituent funds, among other things. The Court found that the plaintiffs’ first argument was “well-taken,” noting that the total expense ratio takes into account fees that are not part of the advisory fee and, as such, “may not provide a clear picture of what the actual bargaining range is for advisory fees alone.” However, the Court pointed out that the data sets reviewed by the Board were not limited to total expense ratios. As to the size of the peer group, the Court said that plaintiffs failed to cite case law mandating larger data sets, noting that “the Seventh Circuit has affirmed a district court’s finding that sample sizes of 10 or 11 peer funds is sufficient for a finding of comparable fees.”
- Profitability: The plaintiffs failed to identify any case law supporting their contention that the Adviser should treat the fees it pays to the Funds’ sub-advisers as “pass-through payments” and thus excluded from the Adviser’s expenses in calculating profitability. In fact, the Court noted evidence in the record that the Board considered both profitability metrics—i.e., profitability both with and without the sub-adviser fees—and “rejected plaintiffs’ preferred method as unhelpful or inappropriate.”
- Economies of Scale: The Court agreed with the Adviser that the plaintiffs failed to raise any triable issues of fact regarding economies of scale. In this regard, the Adviser argued that the plaintiffs provided no “evidence that the total per-unit cost of servicing the Funds declined as the Funds grew in size” and thus did not carry their burden of proof to show whether economies of scale existed. Moreover, the Adviser asserted that the contractual breakpoints and fee waivers in place were adequate to share any realized economies of scale.
- Fall-Out Benefits: The plaintiffs failed to identify any evidence or articulate an argument for why the fees received by the Adviser’s affiliates for distribution and transfer agent services, “which were known to and approved annually by, the Board, and paid directly by the Funds, militate towards a finding that the advisory fee charged by [the Adviser] is excessive.” Consequently, “plaintiffs failed to raise a triable issue of fact as to this factor.”
The order granting the motion to dismiss was issued under the captions Zehrer v. Harbor Capital Advisors, Inc., Case No. 14 C 00789, and Tumpowsky v. Harbor Capital Advisors, Inc., Case No. 14 C 07210.