To continue my series of posts on Jones v. Harris, in this entry I describe
Chief Judge Easterbrook’s decision, which the Supreme Court has just agreed to
review. Writing for a unanimous Seventh Circuit panel, Easterbrook
advanced a classical law-and-economics analysis that presumed a
well-functioning market for investment advice, dismissed possibly irrational
investor behavior, and concluded with a call for greater deregulation of the
industry.
He began by dramatically clearing out the precedential underbrush from this
area of law with an express disavowal of Gartenberg, of which he was skeptical
because “it relies too little on markets.” (Gartenberg required trustees
and courts to evaluate a set of factors to determine whether an adviser has
breached its fiduciary duty by charging excessive fees to mutual fund
investors.) He held instead that a “fiduciary must make full disclosure
and play no tricks but is not subject to a cap on compensation.”
Easterbrook reached this holding by noting that (a) the investment industry is
very competitive, (b) as in any well-functioning industry, market
competition keeps fees low,
and (c) advisers “can’t
make money” from its funds if “high fees drive investors away.” The
existence of a competitive market in investment advice is therefore critical to
his holding.
But what of the Senate report in the legislative history suggesting that
Congress, when enacting the Section 36(b) fiduciary duty, concluded that this
market is highly incestuous and not competitive at all? To that contention, Easterbrook replied that "a lot has happened in the last 38 years,” and therefore arguments
cannot be made today merely on the strength of “suppositions about the market
conditions of 1970.”
So what proof is there that the market is competitive now?
“Today,” Easterbrook noted, “thousands of mutual funds compete. The pages
of the Wall Street Journal teem with listings.” Moreover, there is
scholarly support for this conclusion: a “recent, careful study” of the
industry by Professors John Coates and Glenn Hubbard “concludes that thousands
of mutual funds are plenty, that investors can and do protect their interests
by shopping, and that regulating advisory fees through litigation is unlikely
to do more good than harm.”
But what about all those regular investors who don’t know much about investing?
“It won’t do,” insisted Easterbrook, “to reply that most investors are
unsophisticated and don’t compare prices. The sophisticated investors who
do shop create a competitive pressure that protects the rest.”
Easterbrook perorated with a reminder of the
first principles of law, economics, and regulation: “Federal securities laws,
of which the Investment Company Act is one component, work largely by requiring
disclosure and then allowing price to be set by competition in which investors
make their own choices.” He then concluded that the less involvement by
government, the better: “As § 36(b) does not make the federal judiciary a rate
regulator, after the fashion of the Federal Energy Regulatory Commission, the
judgment of the district court is affirmed.”
In sum, Easterbrook’s opinion was a tour-de-force of classical law and
economics.
Next, Judge Posner’s economic rebuttal to Easterbrook’s economic analysis.
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1. Posted by Lawrence Cunningham on March 11, 2009 @ 16:56 | Permalink
It could be interesting to compare this approach with the approach that Judge Easterbrook took in his discredited 1990 opinion in DiLeo v. Ernst & Young,* limiting auditors' liability for attesting to misrepresented financial statements largely on the ground that it would be "irrational" for an auditor to attest to misleading financial statements because doing so would jeopardize a firm's reputation! That 1990 opinion did not stand the test of the decade, which culminated in the demise of Arthur Andersen, and black eyes for all large auditing firms.
* 901 F.2d 624, 629 (7th Cir. 1990) (Easterbrook, J.).
2. Posted by Jake on March 11, 2009 @ 20:25 | Permalink
More important, without regard to competing law-and-economics views, Easterbrook's opinion is a tour-de-force of judicial restraint. Not all perceived ills ought to have judicial remedies. A healthy society lets the chips fall where they may at times.
3. Posted by Thomas on March 12, 2009 @ 7:51 | Permalink
I think that Lawrence is overstating when he says that Easterbrook's opinion in DiLeo was "largely on the ground" cited. For those who don't wish to read the opinion again, I'd note that the discussion of the irrationality begins with the word "moreover". That's an odd way to introduce the central grounds for a decision. In any case, I think that the example of AA demonstrates that Easterbrook was correct. When AA's reputation was destroyed, the firm collapsed.
4. Posted by steve on March 14, 2009 @ 5:40 | Permalink
While AA indeed was destroyed by it's "irrational" behavior, plenty of people were hurt and plenty of money was lost while awaiting these so called market forces.
5. Posted by John on September 8, 2009 @ 11:44 | Permalink
This statement: "[Easterbrook] presumed a well-functioning market for investment advice, dismissed possibly irrational investor behavior..." is really quite slanted, and it doesn't line up with the stated opinion in the case.
Easterbrook does not presume a well-functioning market, and he acknowledges the shortcomings thereof. However, he contends that the imperfect market still performs better than a putative judicial review of reasonability in compensation ever would.
I find that to be refreshingly honest in terms of both deference to competitive forces and frank analysis of their shortcomings.
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