The teacher’s manual to Klein, Ramseyer, & Bainbridge opens discussion of Jones v. Harris in typically Ramseyeresque fashion:
This case deviates from our usual practice. In general, we pick cases for the facts. This case has no facts of interest. We include it instead for the reasoning – for Frank Easterbrook’s in-your-face explanation for why compensation is best left for the market.
Judging from the outpouring of interest in the case, many law professors appear to disagree with Ramseyer that Jones v. Harris has no interesting facts. (Or, alternatively, we share Klein, Ramseyer, and Baindridge’s fascination with Easterbrook’s “in your face” market defense). But Ramseyer is certainly correct that executive compensation (and compensation issues more generally) is “hot” at the moment.
I expected, prior to reading Easterbrook's opinion (Download Easterbrook), to disagree with the 7th Circuit ruling. In the end, however, I did not. Easterbrook’s basic argument that the appropriate reference point for the court’s decision should be the fees that other funds of similar size and investment goals pay their advisers, rather than the fees charged to unaffiliated institutional clients seems correct to me, at least based on the information we currently have available. And, according to the 7th Circuit, it is undisputed in Jones v. Harris that the fees Oakmark paid Harris Associates are roughly equal in both level and breakpoints to those paid by similar funds. (I’ll leave aside, for present purposes, the extent to which Easterbrook’s opinion abandons Gartenberg and replaces it with a disclosure standard, as that question is addressed at length elsewhere, including in today’s oral argument).
Why did I expect to disagree with the 7th Circuit ruling? Posner’s dissent from rehearing en banc (Download Posner dissent) resonates in some fairly basic ways. Chief among them is his discussion of the incentuousness of the mutual fund industry. As Posner notes on page 5:
“connections among agents in [the mutual fund industry] foster favoritism, to the detriment of investors. Fund directors and advisory firms that manage the funds hire each other preferentially based on past interactions. When directors and the management are more connected, advisors capture more rents and are monitored by the board less intensely.”
Quoting Camelia M. Kuhnen, “Social Networks, Corporate Governance and Contracting in the Mutual Fund Industry” (Mar. 1, 2007), https://ssrn.com/abstract=849705 (visited July 28, 2008).
This is a reality that should resound with even casual students of board life. In my own research on boards of directors (designed to study questions of race and gender diversity on boards but, in fact, revealing a trove of information about the daily workings of boards, management, and their corporate constituent relations) narratives of board interconnectedness and “it’s all about who you know” recur.
Yet Easterbrook anticipates such objections well. As he notes, there are thousands of mutual funds, and investors can (and apparently do) shift money at will, creating competition. True, funds may not explicitly compete on management fees, but mutual funds’ total expenses as a percentage of assets are a widely publicized benchmark and even lazy investors seek maximum returns net of expenses.
Very few observers of today’s financial and corporate landscape believe that the market perfectly sets compensation to align management incentives with shareholder welfare. Concluding that courts can systematically do better, however, requires more evidence than what I’ve seen so far in Jones v. Harris.
Elaborating on Easterbrook’s university president hypothetical, my boss, Duke University president Richard Brodhead, may be overpaid (for the record, I do not believe this to be the case, but you get the picture). If Brodhead receives “$50 million a year, when no other president of a comparable institution receives more than $2 million,” then a court might reasonably conclude that the compensation is so unreasonable that deceit must have occurred or the trustees abdicated their responsibilities in approving the compensation. But should the court inquire whether a salary normal among similar institutions is, nonetheless, excessive, because all university trustee-president relationships are insular? Absent a clearer statutory mandate than §36(b), or more evidence of market failure than was presented in Jones v. Harris, I think not. In Easterbrook’s words, “a fiduciary duty differs from rate regulation.”
Thanks to Usha and the other Glommers for hosting me, and feel free to visit me at my regular home over at The Faculty Lounge.
Cross-posted at The Faculty Lounge
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