Zehrer v. Harbor Capital Advisors, Inc. et al

Filing 80

MEMORANDUM Opinion and Order, Signed by the Honorable Joan H. Lefkow on 11/18/2014. (ea, )

IN THE UNITED STATES DISTRICT COURT FOR THE
NORTHERN DISTRICT OF ILLINOIS
EASTERN DIVISION
TERRENCE ZEHRER,

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Plaintiff,
v.
HARBOR CAPITAL ADVISORS, INC.
and HARBOR INTERNATIONAL FUND,
Defendants.

Case No. 14 C 789
Judge Joan H. Lefkow

MEMORANDUM OPINION AND ORDER
Plaintiff Terrence Zehrer, a shareholder of Harbor International Fund (“the Fund”), filed
this action on behalf of the Fund under § 36(b) of the Investment Company Act, 15 U.S.C. § 80a1 et seq. (“the ICA”). Zehrer alleges that the Fund’s investment manager and advisor, Harbor
Capital Advisors, Inc. (“Harbor Capital”), charged excessive advisory fees in breach of its
fiduciary duty under § 36(b). Zehrer also named the Fund as a nominal defendant. Both Harbor
Capital and the Fund have moved to dismiss the complaint. The Fund’s motion to dismiss (dkt.
48) is granted and Harbor Capital’s motion to dismiss (dkt. 43) is denied.
BACKGROUND 1
Zehrer holds shares in the Fund, which is one of 29 funds under the “Harbor Funds”
umbrella. 2 (Compl. ¶¶ 7–8.) Each of the 29 funds is overseen by the same eight-member Board
of Trustees (“the Board”). (Id. ¶ 32.)

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Unless otherwise indicated, the following facts are taken from the complaint and are presumed
true for the purpose of resolving the pending motion. Dixon v. Page, 291 F.3d 485, 486 (7th Cir. 2002).
2

Harbor Funds is an open-end management investment company registered under the ICA.

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The Fund opened in 2006 with approximately $15 billion of assets. (Id. ¶ 8.) By October
31, 2013, it had grown to over $48 billion. (Id.) The Fund invests primarily in common and
preferred stocks of foreign companies, including those in emerging markets. (Id.) An
Investment Advisory Agreement dated July 2013 gives Harbor Capital oversight responsibility
for the management of the Fund. (Id. ¶¶ 8–9; dkt. 44, ex. 4.) Harbor Capital delegates the
Fund’s investment management to Northern Cross under a Sub-Advisory Agreement also dated
July 2013. 3 (Compl. ¶ 16; dkt. 44, ex. 5.) Harbor Capital is not liable for the investment
decisions made by Northern Cross but maintains general oversight and supervisory
responsibilities for the Fund, including those related to regulatory filings, legal support, and
board meetings. (Compl. ¶¶ 16–17; dkt. 44, ex. 4 at 2.)
The Board approved the fees paid to Harbor Capital for its services under the Advisory
Agreement. (Compl. ¶ 29.) Harbor Capital receives a fee of 0.75% for the first $12 billion of
the Fund’s assets under management and 0.65% for assets above $12 billion. 4 (Id. ¶ 19.) The
Fund paid Harbor Capital over $225 million in advisory fees for the 2012 fiscal year. (Id.)
Harbor Capital, in turn, paid Northern Cross approximately $125 million under the Sub-Advisory
Agreement for its investment management services to the Fund. (Id. ¶ 20.) Harbor Capital thus
retained approximately $100 million of the fees paid by the Fund in 2012. (Id.) Zehrer alleges

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Zehrer did not attach the Advisory Agreement and the Sub-Advisory Agreement to his
complaint, but Harbor Capital attached them to the declaration of Paul Walsen in support of Harbor
Capital’s motion to dismiss. (See dkt. 44, exs. 4, 5.) Because the agreements are central to Zehrer’s
claim and referenced in the complaint, the court may consider them on a motion to dismiss. See Hecker
v. Deere & Co., 556 F.3d 575, 582 (7th Cir. 2009) (considering agreements attached to motion to dismiss
where they were referenced in complaint, concededly authentic, and central to plaintiff’s claim).
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Harbor Capital contends that it also entered into “voluntary fee waivers” that added two
breakpoints—a reduction to 0.63% for assets between $24 billion and $36 billion and a reduction to
0.58% for assets over $36 billion—which saved the Fund nearly $7 million in 2013. (See dkt. 45-1 at 22.)

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that this fee is excessive and a breach of Harbor Capital’s statutory fiduciary duty under § 36(b)
of the ICA. (Id. ¶¶ 36–44.)
LEGAL STANDARD
A motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) challenges a
complaint for failure to state a claim upon which relief may be granted. Fed. R. Civ. P. 12(b)(6).
In ruling on a Rule 12(b)(6) motion, the court accepts as true all well-pleaded facts in the
plaintiff's complaint and draws all reasonable inferences from those facts in the plaintiff's favor.
Dixon v. Page, 291 F.3d 485, 486 (7th Cir. 2002). To survive a Rule 12(b)(6) motion, the
complaint must not only provide the defendant with fair notice of a claim’s basis but must also
establish that the requested relief is plausible on its face. See Ashcroft v. Iqbal, 556 U.S. 662,
678, 129 S. Ct. 1937, 173 L. Ed. 2d 868 (2009); Bell Atl. v. Twombly, 550 U.S. 544, 555, 127 S.
Ct. 1955, 167 L. Ed. 2d 929 (2007). The allegations in the complaint must be “enough to raise a
right of relief above the speculative level.” Twombly, 550 U.S. at 555. At the same time, the
plaintiff need not plead legal theories. Hatmaker v. Mem’l Med. Ctr., 619 F.3d 741, 743 (7th
Cir. 2010); Johnson v. City Shelby, 574 U.S. ---, --- S. Ct. ----, 2014 WL 5798626, at *1 (Nov.
10, 2014) (per curiam) (“Federal pleading rules call for ‘a short and plain statement of the claim
showing the pleader is entitled to relief’ . . . they do not countenance dismissal of a complaint for
imperfect statement of the legal theory supporting the claim asserted.”).
ANALYSIS
A typical mutual fund is set up by an advisor who selects the fund’s directors, manages
its investments, and provides other services to the fund for a fee. See Jones v. Harris Assocs.,
L.P., 559 U.S. 335, 338, 130 S. Ct. 1418, 176 L. Ed. 2d 265 (2010). Because of this relationship,
“the fund often ‘cannot, as a practical matter, sever its relationship with the adviser.’” Id.

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(quoting Burks v. Lasker, 441 U.S. 471, 481, 99 S. Ct. 1831, 60 L. Ed. 2d 404 (1979)). In order
to check the potential for abuse inherent in this structure, the ICA requires that investment
companies, such as mutual funds, be governed by a board of trustees, at least 40 percent of
whom may not be “interested persons” as defined by the ICA. 15 U.S.C. §§ 80a-2(19), 80a-10.
The board is tasked with negotiating advisory fees with the investment advisor on behalf of the
fund and is required to act in the shareholders’ best interest. 15 U.S.C. §§ 80a-15(c), 80a-35(a).
As a further protection against abuse, § 36(b) of the ICA imposes a fiduciary duty on investment
advisors “with respect to the receipt of compensation for services . . . .” 15 U.S.C. § 80a-35(b).
The Securities and Exchange Commission or a fund shareholder may bring an action on behalf
of the fund against the advisor for breach of this fiduciary duty with respect to compensation or
payments. Id. The plaintiff bears the burden of establishing a breach of fiduciary duty. Id.
“[T]o face liability under § 36(b), 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.” Jones, 559 U.S. at 346. To
determine if a fee meets this standard, courts look to all relevant factors, including those set forth
in Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923 (2d Cir. 1982) and adopted by
the Supreme Court in Jones. Id. at 344–46. The Gartenberg factors are, “(1) the nature and
quality of the services provided to fund shareholders; (2) the profitability of the fund to the
adviser-manager; (3) fall-out benefits; (4) economies of scale; (5) comparative fee structures; and
(6) the independence and conscientiousness of the trustees.” Am. Chem. & Equip., Inc. 401(k)
Retirement Plan v. Principal Mgmt. Corp., No. 4:14-CV-00044, 2014 WL 5426908, at *4 (S.D.
Iowa Sept. 10, 2014) (quoting Forsythe v. Sun Life Fin., Inc., 417 F. Supp. 2d 100, 114 (D.
Mass. 2006)).

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Because a claim under § 36(b) need only meet the liberal pleading standards set forth in
Rule 8, it is not necessary for a plaintiff to make a conclusive showing of each Gartenberg factor
to survive a motion to dismiss. Am. Chem., 2014 WL 5426908, at *4; see also Reso ex rel.
Artisan Int’l Fund v. Artisan Partners Ltd. Partnership, No. 11-CV-873, 2011 WL 5826034, at
**5–6 (E.D. Wisc. Nov. 18, 2011); In re Scudder Mut. Funds Fee Litig., No. 04 Civ. 1921, 2007
WL 2325862, at *18 (S.D.N.Y. Aug. 14, 2007) (citing In re Evergreen Mut. Funds Fee Litig.,
423 F. Supp. 2d 249, 258 (S.D.N.Y. Mar. 24, 2006)); Millenco, L.P. v. MEVC Advisors, Inc., No.
CIV. 02-142, 2002 WL 31051604, at *3 (D. Del. Aug. 21, 2002). But “a § 36(b) complaint is
not sufficient if it rests solely on general and conclusory legal assertions that the fees charged
were excessive.” Forsythe, 417 F. Supp. 2d at 115. A plaintiff must allege sufficient facts to
plausibly support an inference that the advisory fee is so disproportionately large as to bear no
reasonable relationship to the services rendered in exchange for the fee. Am. Chem., 2014 WL
5426908, at **4–5 (“At the heart of a 36(b) claim is the relationship between the fees charged to
the fund and the services rendered to the fund.”) (citations omitted).
I.

The Fund’s Motion to Dismiss
The Fund argues that the language of § 36(b) precludes an action against the Fund as a

nominal defendant. Section 36(b) of the ICA is neither a purely direct nor a purely derivative
action: “[W]hile section 36(b) claims are not derivative for the purposes of Rule 23.1 of the
Federal Rules of Civil Procedure, which requires pre-suit demand on the board of directors, they
are derivative, in the general sense of the word, because they are asserted on behalf of all
shareholders and result in no direct benefit to the individual plaintiff shareholders.” In re
Dreyfus Mut. Fund Fee Litig., 428 F. Supp. 2d 357, 359 (W.D. Pa. 2006). Because § 36(b)
straddles the line between direct and derivative, courts have looked to the language of the statute

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to resolve procedural issues. See, e.g., Daily Income Fund v. Fox, 464 U.S. 523, 542, 104 S. Ct.
831, 78 L. Ed. 2d 645 (1984) (§ 36(b) plaintiff not required to satisfy Rule 23.1 prerequisites for
derivative suits).
Zehrer argues that because the action is derivative, he must name the Fund as a nominal
defendant. But § 36(b)(3) specifically provides, “No such action shall be brought or maintained
against any person other than the recipient of such compensation or payments, and no damages
or other relief shall be granted against any person other than the recipient of such compensation
or payments.” 5 15 U.S.C. § 80a-35(b)(3). Zehrer does not cite any authority to justify ignoring
this clear statutory directive. Although a corporation may be a necessary party in most derivative
litigation, the court finds that it is not necessary in the instance of a § 36(b) claim under the ICA.
See, e.g., Millenco, 2002 WL 31051604, at *1 n.2 (dismissing fund “[b]ecause § 36(b) of the
ICA prohibits an action against the Fund because it has not received compensation or payments
from a registered investment company, and because all parties have agreed to dismiss the fund as
a nominal defendant”). The Fund is dismissed from this case.
II.

Harbor Capital’s Motion to Dismiss
Harbor Capital argues that Zehrer has failed to allege sufficient facts to state a plausible

claim under § 36(b). Zehrer responds that his allegations that Harbor Capital delegates
investment management responsibilities to Northern Cross but retains almost half of the fees
(about $100 million) are adequate by themselves to survive a Rule 12(b)(6) challenge, and that
they are bolstered by allegations relating to economies of scale and a conflicted and overworked
Board.

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Zehrer concedes that he only asserts a § 36(b) claim (see dkt. 59 at 19 n.12), and thus his entire
case is subject to the limitation set forth in § 36(b)(3).

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Courts have required that § 36(b) plaintiffs allege facts supporting the disproportionality
of the fees at issue in the suit rather than general facts about the potential for abuse inherent in
the system. See, e.g., Amron v. Morgan Stanley Inv. Advisors Inc., 464 F.3d 338, 343–44 (2d
Cir. 2006) (affirming dismissal of § 36(b) claim where the allegations relied on information
about the industry rather than allegations “pertinent to th[e] relationship between fees and
services”) (quoting Migdal v. Rowe Price-Fleming Int’l, 248 F.3d 321, 327 (4th Cir. 2001))
(internal quotation marks omitted). If a plaintiff alleges specific facts about the fees paid to the
defendant and their relationship to the services rendered, courts have allowed the complaint to
survive a motion to dismiss. For example, in Kasilag v. Hartford Investment Financial Services,
LLC, No. 11-1083, 2012 WL 6568409 (D.N.J. Dec. 17, 2012), the plaintiff alleged that the
defendant advisor paid subadvisors to do substantially all of the investment management services
for a third or less of the fee paid by the mutual fund. Id. at *3. Although the defendant advisor
countered that it performed extensive services that were not delegated to the subadvisor, the
court found that the defendant’s argument was more appropriately addressed at summary
judgment and that the plaintiff had adequately alleged that the fee was excessive. Id.; see also
Am. Chem., 2014 WL 5426908, at *7 (finding specific allegations about defendants’ practices
regarding subadvisors, nature of services, economies of scale, and independence of the board
sufficient to survive motion to dismiss); Millenco, 2002 WL 31051604, at *3 (finding allegations
that advisor had “very little to do” because it subcontracted with another advisor along with other
allegations sufficient to survive motion to dismiss).
Although it is far from clear that Zehrer will be able to meet the high standard for liability
under § 36(b), he has alleged sufficient facts specific to the fees paid to Harbor Capital to survive
a motion to dismiss. First, Zehrer alleges that a substantial portion of the tasks assigned to

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Harbor Capital in the Advisory Agreement are actually performed by the Fund’s subadvisor,
Northern Cross and that Harbor Capital’s services “are minimal compared to the day-to-day
responsibilities of managing [the Fund’s] portfolio” performed by Northern Cross. (Compl.
¶ 21.) Harbor Capital’s contention that it retains significant responsibility for the Fund’s
management is better suited for summary judgment. 6 In addition, Zehrer alleges that Harbor
Capital received “economies of scale” benefits as the Fund grew that were not passed on to the
Fund. Although these allegations alone may not be sufficient to survive a motion to dismiss,
they support Zehrer’s claim that the fees are disproportionate to the services rendered and are not
the product of arm’s length bargaining. 7 Compare Scudder, 2007 WL 2325862, at **16, 18
(finding breakpoint allegations regarding economies of scale insufficient to survive motion to
dismiss), with Reso, 2011 WL 5826034, at *9 (denying motion to dismiss and observing, “Reso’s
strongest allegations relate to the economies of scale factor of Gartenberg”); Sins v. Janus Cap.
Mgmt., LLC, Nos. 04-CV-1647, 04-CV-2395, 2006 WL 3746130, at *3 (D. Col. Dec. 15, 2006)
(allegations regarding increase in assets without fee breakpoints could show disproportionality).
In all, Zehrer has pleaded adequate facts for the court to conclude he has a plausible
claim that Harbor Capital’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.” Jones, 559 U.S. at 346; see also Dumond v. Mass. Fin. Servs. Co., No. CIV. A. 046

Harbor Capital argues that Zehrer’s allegation is clearly rebutted by the advisory agreements
and thus its argument is properly considered at this stage. The court has reviewed the agreements and
believes that Zehrer’s allegation that Northern Cross is responsible for almost all the investment
management of the fund is not clearly rebutted by the agreements. Cf. Kasilag, 2012 WL 6568409, at *3
(comparing services provided by advisor and subadvisor).
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Harbor Capital makes much of the fact that Zehrer failed to include reference to two additional
“breakpoints” that were contained in later-signed waivers. See supra n.3. Although information about
the breakpoints (and the Board’s negotiation of the breakpoints) is relevant to the ultimate disposition of
Zehrer’s claim, Harbor Capital does not claim that Zehrer miscalculated the total amount of fees paid to
Harbor Capital, and the additional breakpoints do not vitiate Zehrer’s allegations about economies of
scale.

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11458, 2006 WL 149038, at **2–3 (D. Mass. Jan. 19, 2006) (reading complaint as a whole and
denying motion to dismiss where plaintiff made “allowably summary” allegations regarding
economies of scale, kickbacks, third party clients, and board independence).
Harbor Capital raises a few additional issues. First, Harbor Capital asks that the court
strike Zehrer’s alternate request for rescission of the Advisory Agreement under § 47(b) of the
ICA, arguing that it is not an appropriate remedy for a § 36(b) claim and, even if it were, Zehrer
must first meet the demand prerequisites for filing a derivative suit under Rule 23.1. 8 Section
47(b) of the ICA provides that “contracts that violate provisions of the ICA and accompanying
regulations, or whose performance involves such violation, are unenforceable.” Smith v.
Oppenheimer Funds Distrib., Inc., 824 F. Supp. 2d 511, 517 (S.D.N.Y. 2011) (citing 15 U.S.C.
§ 80a-46(b)(1)). Courts have held that § 47(b) contains a remedy rather than a “distinct cause of
action or basis of liability.” Oppenheimer Funds, 824 F. Supp. 2d at 519–21 (noting that § 36(b)
includes a private right of action that could predicate a remedy of rescission under § 47(b))
(citing Smith v. Franklin/Templeton Distribs., No. C09-4775, 2010 WL 2348644, at *7 (N.D.
Cal. June 8, 2010); Stegall v. Ladner, 394 F. Supp. 2d 358, 378 (D. Mass. 2006); Mutchka v.
Harris, 373 F. Supp. 2d 1021, 1027 (C.D. Cal. 2005)). Although at least one appellate court has
determined that § 36(b)’s limitation on damages also forecloses relief under § 47(b), see
Steinberg v. Janus Capital Mgmt., LLC, 457 F. App’x 261, 267–68 (4th Cir. 2011), it is not
binding on this court. And at least one court has allowed a plaintiff to proceed with its request
for rescission under § 47(b) if a violation of § 36(b) is established. See Tarlov v. Paine Webber
Cashfund, Inc., 559 F. Supp. 429, 438 (D. Conn. 1983); see also Oppenheimer Funds, 824 F.
Supp. 2d at 521(indicating that § 47(b) could be rendered a nullity if its remedy is not available
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The Fund also requests that the court dismiss Zehrer’s request for relief under § 47(b) because
Zehrer has not fulfilled the Rule 23.1 demand prerequisites. The court will not separately address the
Fund’s request because it grants the Fund’s motion to dismiss on other grounds.

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in the event of a violation of § 36(b)); Laborers’ Local 265 Pension Fund v. iShares Trust, No.
3:13-CV-00046, 2013 WL 4604183, at **6–7 (M.D. Tenn. Aug. 28, 2013) (denying § 47(b)
remedy because § 36(b) claim could not survive). Section 36(b) is an equitable action that
specifically limits money damages to restitution. See Kamen v. Kemper Financial Services, Inc.,
908 F.2d 1338, 1350-51 (7th Cir. 1990), rev’d on other grounds, 500 U.S. 90, 111 S. Ct. 1711,
114 L. Ed. 2d 152 (1991) (§ 36(b) is equitable because it “creates a fiduciary duty and recovery
‘shall in no event exceed the amount of compensation or payments received from [the]
investment company’”) (quoting 15 U.S.C. § 80a-35(b)(3)). It does not, however, explicitly
foreclose other equitable remedies, such as injunctive relief or rescission. Because it is unsettled
whether rescission under § 47(b) is an appropriate remedy if Zehrer is able to make out a
violation of § 36(b), the court will not strike Zehrer’s alternate request for rescission at this stage.
Second, Harbor Capital complains that Zehrer’s complaint cites the fee data for the 2012
fiscal year and disputes Zehrer’s assertion that this was the most recent data available at the time
the complaint was filed. It is not necessary, and is often impossible, for § 36(b) plaintiffs to file
suit with the fee data that relates to the entire damages period. See, e.g., Am. Chem., 2014 WL
5426908, at *1 n.1 (noting plaintiff filed complaint to preserve its claim for damages in the year
between plaintiff’s original filing and its second complaint filed after publicly available
information was updated). Although Harbor Capital faults Zehrer for not using 2013 fee data, it
does not make any claim that the fees for 2013 are not in line with the fees from 2012.
Finally, Harbor Capital asks that the court strike Zehrer’s jury trial demand pursuant to
the Seventh Circuit’s direction in Kamen, 908 F.2d at 1351. The court grants the request and
strikes the jury demand.

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CONCLUSION
Based on the foregoing discussion, the Fund’s motion to dismiss (dkt. 48) is granted and
Harbor Capital’s motion to dismiss (dkt. 43) is denied.

Date: November 18, 2014

________________________________
U.S. District Judge Joan H. Lefkow

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