Section 36: Fiduciary Duty on Investment Adviser Fees

Section 36(b) excessive fee claims let a mutual fund shareholder sue the fund’s investment adviser when the compensation the adviser collects from the fund is so out of line with the services provided that it could not have come from fair bargaining. The right is real, but the standard is steep: no plaintiff has ever won a verdict at trial under Section 36(b) of the Investment Company Act of 1940. Understanding why starts with what the statute actually requires you to prove.

What Section 36(b) Covers

Section 36(b) imposes a fiduciary duty on investment advisers with respect to the compensation they receive from the funds they manage. The duty reaches any payment of a material nature that comes from the fund or its shareholders.¹ Congress wrote this provision because mutual fund advisory contracts are not negotiated the way ordinary business deals are. The adviser typically creates the fund, picks the initial board, and sets the fee structure before any shares are sold. There is no genuine arm’s-length bargaining at the start, and once an advisory relationship is in place, it tends to stay in place.

You do not have to prove personal misconduct to win. The question is not whether the adviser cheated or lied. It is whether the fee itself is so high that it could not have resulted from a fair negotiation.¹ An adviser can act in good faith, deliver competent management, and still violate the statute if the price is unreasonable for the services delivered.

A note on the neighboring provision: Section 36(a) covers personal misconduct by fund officers, directors, and advisers, but only the SEC can bring those claims. Shareholders have no standing under 36(a). If you are a fund investor thinking about litigation, 36(b) is the only door open to you.

The Legal Standard You Have to Meet

The test comes from a 1982 Second Circuit decision, Gartenberg v. Merrill Lynch Asset Management. To prevail, a shareholder must show that the adviser charged a fee “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.”² The threshold is deliberately high. Courts are not in the business of setting advisory fees or second-guessing reasonable business decisions. They step in only when a fee sits so far outside the range of fairness that no rational board bargaining at arm’s length would have agreed to it.

In 2010, the Supreme Court unanimously adopted the Gartenberg standard in Jones v. Harris Associates. The Court confirmed that the inquiry looks at both the process the board used to approve the fee and the substance of the fee itself. It also made clear that Section 36(b) does not turn judges into rate-setters. Congress specifically rejected a general “reasonableness” standard that would have asked courts to calculate the right fee.³

Factors Courts Weigh

No single factor decides a Section 36(b) case. Courts look at the arrangement as a whole.

Nature and Quality of Services

The analysis starts with what the adviser actually does: portfolio management, research, compliance, administrative support, shareholder services. A fund that consistently underperforms its benchmark while charging above-average fees creates a gap between cost and quality that becomes relevant. But poor performance alone does not prove a breach. Investment results fluctuate, and an adviser providing substantial operational support may justify fees that look high when measured only against returns.²

Profitability to the Adviser

A court will look at how much profit the adviser earns from the fund after its own costs. Unusually high margins can suggest the adviser is extracting more value than the services warrant. Measurement is messy, though. Advisers manage multiple funds and business lines, and overhead allocation choices can swing the profitability picture for any single fund. A plaintiff typically needs access to the adviser’s internal financial records to build a credible profitability case.

Economies of Scale

As a fund’s assets grow, the cost of managing each dollar tends to fall. An adviser running a $50 billion fund does not need fifty times the staff of one running a $1 billion fund. A fair arrangement passes some of those savings to shareholders through breakpoints, where the percentage fee drops at higher asset thresholds. When the adviser keeps all the efficiency gains and the percentage stays flat, that fact cuts against the fee.²

Fall-Out Benefits

Advisers often collect indirect economic benefits beyond the stated advisory fee. Soft-dollar arrangements where brokerage commissions pay for research the adviser uses across its business. Revenue from affiliated service providers handling custody, transfer agency, or distribution. Courts add these collateral benefits to the total compensation picture.² A 0.75% management fee combined with substantial revenue from affiliated services has an effective cost higher than 0.75%.

Comparative Fee Data

What other advisers charge for similar funds is a reference point, but courts treat it cautiously. The Supreme Court warned in Jones v. Harris that fees charged by other mutual fund advisers may themselves not reflect genuine arm’s-length bargaining, so leaning on industry averages can be circular.³ Comparisons to what the same adviser charges institutional clients like pension funds are common in plaintiffs’ briefs, but the Court said those comparisons deserve only the weight warranted by the actual similarities and differences in the services involved. Mutual fund contracts usually bundle far more than portfolio management, so a raw fee comparison can mislead.

Why the Board’s Approval Matters So Much

Section 15(c) of the Investment Company Act requires a majority of the fund’s independent directors to approve the advisory contract each year at a meeting called for that purpose, and it obligates the adviser to furnish the information the directors need to evaluate it.⁴ That annual review is designed as the first line of defense against excessive fees, before any lawsuit starts.

When a Section 36(b) case reaches court, the quality of that review process is often decisive. Jones v. Harris held that where the board’s process for negotiating and reviewing compensation is robust, courts should give considerable weight to the board’s decision to approve the fee. A judge who would have weighed the Gartenberg factors differently still cannot override an informed board on that basis alone. The reverse also holds: if the process was sloppy or the adviser withheld material information, the court scrutinizes the fee far more aggressively.³

Advisers know this and build careful paper trails. A well-documented board process with detailed fee comparisons, profitability analyses, and service quality assessments creates a record that is very hard for plaintiffs to overcome. As a practical matter, a shareholder bringing a Section 36(b) claim is challenging not only the adviser’s fee but the independent directors’ judgment in approving it.

Who Can Sue and Who Can Be Sued

Only two plaintiffs can bring a Section 36(b) claim: a shareholder of the specific fund in question, or the SEC. A shareholder sues on behalf of the fund, and any recovery goes back to the fund’s assets rather than to the individual plaintiff.¹ Investors in other funds managed by the same adviser have no standing. Most courts also require continuous ownership of shares throughout the litigation. Sell your shares mid-case and you lose standing to continue.

On the defense side, the statute reaches the investment adviser, any affiliated person of the adviser, and any officer, director, or advisory board member who has a fiduciary duty regarding the compensation at issue.¹ In practice, the advisory firm itself is almost always the primary defendant.

Burden of Proof

The plaintiff bears the burden of proving the adviser breached its fiduciary duty. The statute says so explicitly.¹ You have to show affirmatively that the fee was so disproportionate to the services that it could not have resulted from fair bargaining. The adviser does not need to justify the fee. You need to prove it was unjustifiable.

The statute also tells courts to give board and shareholder approval “such consideration as is deemed appropriate under all the circumstances.”¹ Combined with the Supreme Court’s instruction to defer to robust board processes, this means a plaintiff is fighting uphill from the opening. You typically have to show either that the board process was flawed or that the fee is extreme enough to overwhelm even a well-conducted review.

What You Can Recover

Even a winning shareholder faces a tight cap on damages. The statute limits recovery to the compensation the defendant actually received from the fund during the twelve months before the lawsuit was filed.¹ Fees paid before that one-year window are unrecoverable, no matter how excessive. Total recovery cannot exceed the actual payments received. No punitive damages, no multipliers. If the adviser collected $8 million in the lookback period, $8 million is the ceiling.

The money flows back to the fund, not to the shareholder who brought the case. Courts also lack authority under Section 36(b) to rewrite the advisory contract or order future fee reductions. The remedy is purely backward-looking. That makes timing critical: if you wait years to sue, you cannot recapture earlier overcharges.

Why These Cases Rarely Succeed

The track record is lopsided. No plaintiff has ever won a verdict at trial in an excessive fee case under Section 36(b). The reasons follow directly from everything above. The Gartenberg standard is intentionally high. The plaintiff carries the burden. Courts defer substantially to board approval when the process looks thorough. And the comparison data that might support a claim is inherently unreliable, since industry-wide averages may reflect the same absence of arm’s-length bargaining the statute was written to address.

Most Section 36(b) cases settle or get dismissed. Advisers with documented board processes, breakpoints tied to asset growth, and fees within the broad industry range are hard targets. The cases that generate real pressure tend to involve advisers charging meaningfully more than peers for comparable services, retaining all economies of scale, or working with a board that appeared to rubber-stamp the fee without meaningful review. Even then, clearing the “so disproportionately large” threshold is the central obstacle for any shareholder willing to shoulder the cost and complexity of federal litigation.

1
Office of the Law Revision Counsel. 15 U.S. Code 80a-35 – Breach of Fiduciary Duty
2
Justia Law. Gartenberg v. Merrill Lynch Asset Management, Inc., 573 F. Supp. 1293
3
Justia U.S. Supreme Court Center. Jones v. Harris Associates L. P., 559 U.S. 335 (2010)
4
Office of the Law Revision Counsel. 15 U.S. Code 80a-15 – Contracts of Advisers and Underwriters