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Advisory Contract Renewal

One of the most important responsibilities of the independent directors is to annually review and approve the advisory contract, including the advisory fees. This process is known as the 15(c) process, after the section of the 1940 Act that requires a majority of a fund’s independent directors to annually approve the fund’s advisory contract at an in-person meeting called for that purpose. Section 15(c) requires the board to “request and evaluate,” and the adviser to furnish, “such information as may reasonably be necessary” for the board “to evaluate the terms” of the advisory contract.

While the statute requires one annual meeting for the purpose of approving the contract, the process of preparing for that meeting takes several months, and often the entire year. Independent directors spend a significant amount of time preparing for, and participating in, numerous other meetings at which they develop questions for the adviser probing the appropriateness of the fee, review the answers provided by the adviser, and solicit additional information when the information provided by the adviser is deemed insufficient. In the process, independent directors consider and review hundreds if not thousands of pages of detailed information, some of which is provided by third-party consultants. 

Boards consider a number of factors when reviewing an advisory contract, including those considered by federal courts in “excessive fee” cases (also known as 36(b) cases after the section of the 1940 Act that allows the SEC or a shareholder to sue a fund’s adviser for breach of fiduciary duty with respect to the receipt of compensation). The factors, which, for many years, have been referred to as the “Gartenberg factors” after the court decision that first articulated them, have been incorporated into an SEC disclosure rule requiring funds to discuss the basis for the board’s approval of the advisory contract. Thus, at a minimum, boards typically consider:

  • the nature, extent, and quality of the services to be provided by the investment adviser;
  • the investment performance of the fund and the investment adviser;
  • the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates;
  • the extent to which economies of scale would be realized as the fund grows; and
  • whether fee levels reflect these economies of scale for the benefit of fund investors.

Boards also often consider comparative fees and services information, such as those under contracts between another fund and its adviser or the same adviser and other types of clients (e.g., pension funds and other institutional clients). The SEC requires funds to disclose whether the board relied upon such comparisons.

key terms
Breakpoints. The dollar amounts at which many mutual funds offer reduced fees to investors. There are two kinds of breakpoints. One kind is a reduction in sales charges (load fees) to investors when they initially purchase fund shares. The amount of the discount varies, depending upon the amount of the investment: the more invested, the greater the likelihood of surpassing a breakpoint and thus receiving a discount. The other kind of breakpoint is a reduction in management fees that fund advisers may charge their associated funds as fund assets surpass a given level.

In the Jones v. Harris Associates case, the Supreme Court in 2010 endorsed the Gartenberg court’s approach to reviewing excessive fee claims against an adviser, but provided a few cautionary notes about fee comparisons. First, the Court noted that courts may give comparisons of the fees charged by different types of clients “the weight they merit in light of the similarities and differences between the services that the clients in question require” and that “there may be significant differences between the services provided by an investment adviser to a mutual fund and those it provides to a pension fund.” The Court also cautioned that undue reliance should not be given to comparisons with fees charged to funds by other advisers. In discussing the advisory contract renewal process, the Jones Court recognized the critical role of fund boards and made clear that the standard for court review does not call for “judicial second-guessing of informed board decisions.”

The adviser’s fees are part of the advisory contract that directors review and approve every year. Directors are not required to negotiate for the absolute lowest rate with the adviser. Instead, regulators and the courts recognize that directors must balance a number of considerations, including the factors noted above. In the fee approval process, of course, directors may work with the adviser to take steps to bring fees down, such as instituting breakpoints at specified asset levels, waiving fees, reducing fees outright, or enhancing services.