Jones v. Harris: Misreading the Dynamics Inside the Boardroom

The Supreme Court in Jones v. Harris soundly rejected the opinion of Chief Judge Easterbrook and his conclusion that full disclosure and the market was enough to remedy any wrong in the compensation area.  Judge Easterbrook is still relying on the mantra that the market can correct all evils, a position that would seem hard to justify given the ubiquitous examples of market failure.

Nonetheless, we take a moment to examine some of the reasoning used by Justice Alito.  While it was refreshing to see the rejection of the discredited market approach used by Judge Easterbrook ("By focusing almost entirely on the element of disclosure, the Seventh Circuit panel erred."), it was unfortunate that Justice Alito fell back on the old saw that process in general was enough and that approval by disinterested directors will be sufficient to protect shareholders.  If anything has been made clear by the current financial crisis, it is that a system of executive compensation in which courts are lavishly deferential to process does not work. 

Thus, for example, he notes that in reviewing compensation decisions, considerable deference should be given to process.  As he states:

• Thus, if the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently. . .  .

Perhaps.  But this assumes a process with integrity. 

Certainly, in Delaware, there is no guarantee that the process of approving executive compensation has sufficient integrity to protect shareholders.  As we have noted, Delaware does not have in place a system that ensures independent directors are independent.  Delaware has done little or nothing to screen for conflicts of interest with respect to compensation consultants (an issue only relevant if shareholders can get past the presumption of independence for directors). Nor does Delaware restrict the interested directors from participating in the decision making process. 

Similarly, with respect to mutual funds, there is likewise no guarantee that the process will protect shareholders.  It is true that mutual fund boards must consist of at least 40% of disinterested directors, see  15 USCS § 80a-10(a) (a percentage that increases to 75% if the fund relies on certain exemptive rules), and that these directors get to approve the agreement with the investment advisor, see 15 USCS § 80a-15(c), this is not enough. 

First, like Delaware, the concept of disinterested is not broad enough.  The definition of interested person doesn't screen for friendship (including structural bias) or fees paid to directors.  Second, while disinterested directors must approve the agreement, there is nothing in the statute that excludes the interested directors from participating in the process.  Third, mutual funds usually have no employees.  Administrative staff is typically provided by the advisor.  Any information or support needed by the directors in reviewing advisory fees would need to be arranged through the advisor.  Finally, the process takes place in an environment where the advisor likely founded the mutual fund and would be logistically difficult to fire.

As with the approach used by Delaware, there is no reason to believe that process will protect shareholders. 

The Court did note that compensation approved through proper process could still be challenged, relying on language from Gartenberg.  Yet the standard, while not the clearest, seems something akin to the waste standard used in Delaware.  As Justice Alito states:

• This is not to deny that a fee may be excessive even if it was negotiated by a board in possession of all relevant information, but such a determination must be based on evidence that the 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."

The language suggests a tough standard.  In Delaware, waste applies to compensation "so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration."  Brehm v. Eisner, 746 A.2d 244, 263 (Del. 2000).  The standard in Delaware is so high that it imposes no meaningful limits on compensation. 

Nonetheless, the decision contains hints that the standard for challenging fees may be less deferential than he sometimes suggests.  

First, despite the admonishment that courts should not engage in "judicial second-guessing of informed board decisions," he did emphasize that deficiencies in process justified a harder look by the courts.  

• In contrast, where the board's process was deficient or the adviser withheld important information, the court must take a more rigorous look at the outcome. When an investment adviser fails to disclose material information to the board, greater scrutiny is justified because the withheld information might have hampered the board's ability to function as "an independent check upon the management." . . . . "Section 36(b) is sharply focused on the question of whether the fees themselves were excessive."

He left to lower courts to determine what would be a deficient process.  Lower courts, therefore, have room to make the process used by boards of mutual funds meaningful, a hopeful trend. 

Second, the disproportionate standard apparently can be determined through reference to comparable payments by comparable funds.  The disproportionate standard doesn't guarantee that fees approved by boards are fair, but it does reduce the likelihood of fees that are substantially different than the industry norm.  Waste under Delaware law has no comparable reference.  As a result, amounts of compensation disproportionate to what is normal within the industry are common enough and not subject to reasonable challenge.

Jones v. Harris provides a path, not present in Delaware, for approving compensation in a way that may actually protect shareholders.  The only question is whether the lower courts will take it.