Easterbrook v. Posner and Losing Faith in the Market: Jones v. Harris Associates

The Supreme Court recently scheduled oral arguments in Jones v. Harris Associates, 527 F.3d 627 (7th Cir. 2008), for November 2^nd.  The Seventh Circuit’s decision has been widely discussed, including a series of posts by Professor Birdthistle on The Conglomerate.  In granting certiorari, the Supreme Court will address the issue of excessive compensation for mutual fund advisors.  Chief Judge Easterbrook wrote for the majority opinion while Judge Posner dissented from the petition for rehearing en banc.  See Jones v. Harris Assocs., 537 F.3d 728 (7th Cir. 2008) (Posner, J., dissenting). 

The case centers around the alleged excessiveness of fees paid to an advisor of mutual funds.  Judge Easterbrook viewed the case as an effort to shift to the courts the determination of the reasonableness of the fees.  He preferred that the decision be left to the market.  Judge Posner, in contrast, has apparently lost some of his faith in the market.  His dissent suggests that he no longer sees economics and the market as an automatic solution. 

In 1991, the financial managers of Harris Associates (“Harris”) founded Oakmark funds.  Every year thereafter, Oakmark’s trustees reinstated Harris as the fund’s advisor.  Under the control of Harris, the fund’s growth outpaced the market, attracting large institutional investors.  The institutions received discounted management fees compared to the fund’s smaller investors. 

The plaintiffs are shareholders of several of the Oakmark funds claiming the fund paid Harris excessive fees.  They argued that the Trustees of the funds violated their fiduciary obligations in approving the compensation. The trial court dismissed the claim, finding that the fees were similar to others and therefore failed the test articulated in Gartenberg v. Merrill Lynch Asset Mgmt, 694 F.2d 923 (2d Cir. 1982)("[t]o be guilty of a violation of §36(b) . . . the advisor-manager 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."). 

Plaintiffs disputed the standard set out in Gartenberg, asserting that the court had relied excessively on market prices as a benchmark for reasonableness.  Judge Easterbrook agreed that the case should no longer control the standard for excessive fees in mutual funds.  Contrary to the plaintiff’s argument that Gartenberg was too dependent on market forces, however, the Chief Judge dismissed it as not dependent enough.

Providing a tutorial on economics, Judge Easterbrook objected strenuously to the role of the courts in assessing the reasonableness of advisor compensation.  He asserted that market forces were the appropriate place to regulate advisor compensation.  The sheer number of mutual funds and the ease of entrance into the market put pressure on every fund to control fees as investors have thousands of alternative locations to invest. With high fees, returns go down.  With a decrease in returns, investors go elsewhere.  Even though funds may retain the same advisor for years, these market forces prevented the advisor from extracting excessive fees from the fund.  Based on this argument, Judge Easterbrook dismissed the claim that mutual funds were somehow the captives of their advisors. 

Judge Easterbrook acknoweldged that fiduciaries, like trustees, had an obligation to communicate candidly with the beneficiaries.  With proper communication, the trustee and the fiduciary earned the right to seek a high fee as compensation.  The beneficiary could agree or disagree with the fee. 

He conceded that the amount of the fees could sometimes be so unusual so as to infer abdication by the relevant decision makers.  A college president who received fifty million dollars in compensation compared to others who received two million was an example.  No such suspicion would exist, however, where the compensation or, in this case, the fees, were typical. 

Judge Easterbrook also likened the process for approving mutual fund fees to compensation approved by business corporations.  Courts did not review the reasonableness of the amount paid in compensation.  Instead, the amount was a matter for the board within its fiduciary obligations.  

• Publicly traded corporations use the same basic procedures as mutual funds: a committee of independent directors sets the top managers’ compensation. No court has held that this procedure implies judicial review for “reasonableness” of the resulting salary, bonus, and stock options. These are constrained by competition in several markets—firms that pay too much to managers have trouble raising money, because net profits available for distribution to investors are lower, and these firms also suffer in product markets because they must charge more and consumers turn elsewhere. Competitive processes are imperfect but remain superior to a “just price” system administered by the judiciary. 

Finally, Judge Easterbrook dispensed with the argument the advisors breached a fiduciary duty by charging different rates to the fund’s investors.  Labor costs control compensation in a mutual fund.  Institutional investors received a discount because they required less labor to manage.  Charging different rates based on effort did not violate fiduciary obligations. 

In his conclusion, the Chief Judge focused on securities laws as a mechanism that promoted disclosure.  Once a member of the public received proper disclosure, however, it was their decision to invest or go elsewhere.  It was not the responsibility of the court to dictate where they invested based on rate regulation.

In dissenting from the circuit's decision not to hear the case en banc, Judge Posner was unimpressed by the majority’s abandonment of the Gartenberg standard.  He also challenged the economic analysis provided by the Chief Judge. 

• The panel bases its rejection of Gartenberg mainly on an economic analysis that is ripe for reexamination on the basis of growing indications that executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation.

Judge Posner disputed the independence of boards and contended that their advisors were not necessarily neutral in the advice provided.   

• Directors are often CEOs of other companies and naturally think that CEOs should be well paid. And often they are picked by the CEO. Compensation consulting firms, which provide cover for generous compensation packages voted by boards of directors, have a conflict of interest because they are paid not only for their compensation advice but for other services to the firm—services for which they are hired by the officers whose compensation they advised on.

Judge Posner was concerned the market could not overcome adviser control over the fund.  The Judge cited an article asserting that "[w]hen directors and the management are more connected, advisors capture more rents and are monitored by the board less intensely." Camelia M. Kuhen, “Social Networks, Corporate Governance and Contracting in the Mutual Fund Industry” (Mar. 1, 2007), http://ssrn.com/abstract=849705 (visited September 14, 2009). 

He was particularly concerned with the higher fees paid to the advisor in connection with the captive funds when compared with the independent funds.  "The panel opinion throws out some suggestions on why this difference may be justified, but the suggestions are offered purely as speculation, rather than anything having an evidentiary or empirical basis."  

Judge Posner likewise disagreed with the majority’s use of a "so unusual" standard for determining excessive fees.  The standard limited the analysis to fees paid by other mutual funds. The approach would do little good given the industry wide "governance structure that enables mutual fund advisers to charge exorbitant fees."  As a result, the "comparability approach would if widely followed allowthose fees to become the industry’s floor." 

Ultimately, Judge Posner noted that the opinion "may be correct."  Nonetheless, the case deserved the attention of the full court. "But the creation of a circuit split, the importance of the issue to the mutual fund industry, and the one-sided character of the panel’s analysis warrant our hearing the case en banc." 

He didn't get a hearing by the en banc court but in early November there will be a hearing by the US Supreme Court.

The primary materials for this post are available on the DU Corporate Governance Website.

Directors
are often CEOs of other companies and naturally think
that CEOs should be well paid. And often they are picked
by the CEO. Compensation consulting firms, which
provide cover for generous compensation packages
voted by boards of directors, have a conflict of interest
because they are paid not only for their compensation
advice but for other services to the firm—services for which
they are hired by the officers whose compensation they
advised on.

Comments

[Charlene]

Very well-written post. Sounds like Judge Posner has been reading this Blog, and particularly Professor Brown's comments regarding the lack of independence of boards. This will be a fascinating case to watch.