Jones v. Harris Associates: Let 8,000 Lawsuits Bloom, Part 1

“I suggest you consign 8,000 mutual funds to a trial,” declared Attorney John Donovan during oral argument at the U.S. Supreme Court on Monday. Before the Court was Jones v. Harris Associates on appeal from the 7^th Circuit. Plaintiffs Jerry N. Jones, Mary F. Jones and Arline Winerman were investors in three Oakmark mutual funds managed by Harris Associates L.P. (“Harris Associates”).

Lawsuit Filed in August 2004

In August 2004, the trio sued in federal court in Illinois, claiming that Harris Associates violated its fiduciary duty to the funds under Section 36(b) of the Investment Company Act of 1940 (the “1940 Act”) by charging excessive fees. Plaintiffs contended that Harris Associates charged outside institutional clients half as much as captive mutual funds for the same services. As one example:

• “Harris charged the Oakmark Fund an effective rate of 0.88% on assets of $6.3billion, and it charged an independent client with a comparable investment objective . .  0.45% on assets of $160 million. . .  Thus, the Oakmark Fund paid approximately $55 million in fees, while the independent client paid only $720,000 for essentially the same services.” Petitioner’s brief

Case Dismissed by District Court in February 2007

In February 2007, the district court granted Harris Associate’s motion for summary judgment, dismissing the case, reasoning that since there was nothing preventing the board of directors from negotiating a fee at arm’s length, and because the fee was comparable to what other fund advisers charged mutual funds, there was no breach of fiduciary duty. It was irrelevant to the court that independent institutional clients paid half as much.

Court of Appeals Affirms in May 2008

In May 2008, the 7^th Circuit affirmed the district court’s decision, but  employed a new legal standard. In the opinion, Judge Easterbrook rejected the long-followed approach articulated in 1982 by the 2^nd Circuit in Gartenberg v. Merrill Lynch Asset Mgmt. Under Gartenberg, an Adviser violates 36(b) by charging the mutual fund a fee that exceeds “the range of what would have been negotiated at arm’s-length in the light of all of the surrounding circumstances.”

Instead, Easterbrook supported a market-based, director-centric model of corporate governance. He determined that “[a] fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.” Short of “pulling the wool over the eyes” of the fund board members, the board’s approval of the fee “is conclusive.” Easterbrook did admit that  it was “possible to imagine compensation so unusual that a court will infer that deceit must have occurred, or that the persons responsible for decision have abdicated.” Nevertheless, this could not, as a matter of law, be inferred if  fees were similar to what other Advisers charged  mutual funds. In other words, evidence of lower fees paid to institutional clients was not considered.

Denial of En Banc Rehearing in August 2008

Displeased with Easterbrook’s opinion, Judge Posner and four others on the 7^th Circuit supported a rehearing en banc, however, the decision was split 5-5 and rehearing was thus denied in August 2008. However, Posner wrote a dissent to the denial of rehearing. In this dissent, he challenged Easterbrook’s departure from the Gartenberg standard and also questioned the effectiveness of boards and market forces. He referred to “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.” Regarding the Jones v. Harris litigation specifically, he insisted that “there is no doubt that the captive funds are indeed captive . . . [and noted that Harris had a practice of] “charging its captive funds . . . more than twice what it charges independent” clients.