On behalf of the Glom, I'd like to thank the Masters for making our first Forum such a success. If you are interested in reading the collected posts on Jones v. Harris, you can find them here. And keep an eye out for future Masters Fora at the Glom!
With Jones v. Harris now submitted to the justices for their consideration,
academics can fill the next few months of silence speculating about the
eventual decision and the responses it may evoke. Some commentators have already considered how trial courts might deal with a pro-plaintiff
Gartenberg-plus standard and whether Congress would revisit a pro-defendant
status quo ruling. But not much time has been spent thinking about how
the executive branch will respond.
In fact, of all the considerable ink spilled reporting Monday’s oral arguments, comparatively little was spent on what may have been the most impressive ten minutes of the session: the appearance of Curtis Gannon, Assistant to the Solicitor General, on behalf of the United States. Gannon was, in my opinion, the most polished, poised, and dynamic oral advocate on the day. But some of the hardest questions he faced raised the issue of the executive branch’s role in this area.
Mr. Gannon: It is aware of that.
Justice Scalia: And yet has brought no suits against this industry?
Mr. Gannon: Since 1980 it hasn’t used section 36(b). It has used less formal mechanisms in the context of examinations and investigations –
Justice Scalia: For disclosure, just for disclosure. But that suggests to me that the SEC may think that this is indeed a self-contained industry and that the comparison with investment advice given to other entities is – is not a fair one.
This exchange demonstrates the occasional awkwardness of one executive office
(the Solicitor General) representing the interests of another (the SEC).
In the SG’s brief, the SG in fact placed a great deal of emphasis on this
fee comparison, and yet the SEC’s action, or rather inaction, of the past
three decades suggests a different attitude toward the industry.
One is left to wonder whether a single SEC investigation of whichever adviser charges the very highest advisory fee might produce a greater deterrent impact at far lower cost than the huge sums spent annually in private litigation. With an SEC stoking its enforcement division to change the topic from how it overlooked Madoff, is that an action we can expect to see?
Thanks to Gordon, Usha, Michelle, Larry, and others who've written here and elsewhere on the fiduciary duty issue. I admit to finding it a good puzzle.
But honestly (and with due respect to Gordon and his brush-off of the same), I am a bit with Justice Kennedy on this one as to his "I don't know why Congress didn't use some other word" remark. (Go ahead and laugh again, Gordon. I can see you doing it now . . . .) I do find his confusion about what a fiduciary duty is quite puzzling, even troubling, given that we depend upon the judiciary to determine the contents of fiduciary duties in individual contexts. (Nod to Gordon on all this.)
Let's face it. Congress had options here in fixing the problem created by the lack of independence of investment advisors from the funds they advise, and it seems to me that it punted. Honestly, I am not sure Congress knew what it meant by a fiduciary duty in this context. Why was it not more specific about the obligation owed by the advisor to the fund? Was it ignorance, laziness, sloppiness, reckless or willful abdication, public interest politics, . . . ? I would be interested if anyone has an answer to that question based on a review of legislative history or involvement in the legislative process. I have neither done that review or have that involvement.
If arm's-length bargaining is what Congress intended (as the Gartenberg case seems to indicate), why did Congress denominate the duty as "fiduciary" in nature? Why did it not just articulate a clear objective and a supportive process--or focus its attention and drafting on a (non-fiduciary) duty of some kind--perhaps good faith and fair dealing? An obligation of good faith and fair dealing is read into contracts anyway, so maybe all Congress had to do was define its contents in this context (to avoid a sloppy and often unsatisfying common law analysis that does not take into account the independence issue present here).
Of course, none of this matters to the Court's decision in Jones. Congress didn't use some other word. It used the word "fiduciary." And so, as to the fiduciary duty question before the Jones Court, I come out with Larry on the duty of candor concept.
This is the question that preoccupied Justice Kennedy in yesterday's oral argument in Jones v. Harris. He asked it over and over again in various ways?
- "Is Harris a fiduciary in the same sense as a corporate officer and a corporate director? Or does his fiduciary duty differ? Is it higher or lower, same with a guardian, same with a trustee?"
- "The word 'fiduciary' -- does fiduciary imply different standards, depending on what kind of fiduciary you are?"
- "Is the fiduciary standard the same, without getting into how its applied?"
- "Is the fiduciary standard the same for [Harris], for a guardian, for a trustee, for a corporate officer or a corporate director, always the same?"
- "Do you think Congress used the term 'fiduciary' in a very special sense here?"
Why is he so preoccupied with this question? After asking all those questions, he tells us:
I will just tell you the problem I'm having with the case. If I look at a standard that the fees must be reasonable and I compare that with what a fiduciary would do, I thought a fiduciary has the highest possible duty. But apparently the submission is the fiduciary has a lower duty, a lesser duty than to charge a reasonable fee. I just find that quite a puzzling use of the word "fiduciary.... I don't know why Congress didn't use some other word." (emphasis added)
I laughed out loud at that last sentence. I wonder if he had another word in mind?
In my experience, many business people and judges who do not specialize in fiduciary law (like Justice Kennedy) have a vague notion that the law imposes a standard set of (demanding) obligations on those who are called "fiduciaries." As I observe at the beginning of my article, The Critical Resource Theory of Fiduciary Duty, this is half right: "courts require fiduciaries to adhere to a general obligation of loyalty, but countless variations on that theme tailor the general obligation to the specific context." So it seems to me that Larry Ribstein is on the right track when he asks, "What fiduciary duties are appropriate to this particular standard form?" (If you are in the mood for a more extensive treatment of this issue in the context of this case, check out William Birdthistle's article, Investment Indiscipline: A Behavioral Approach to Mutual Fund Jurisprudence, where he writes, among other things, "As every law student knows, the term 'fiduciary duty' describes a broad range of obligations, from the most minimal requirements of a bailee to the far more onerous responsibilities of an executor.")
Of course, in this case, the term "fiduciary" was used by Congress in §36(b) of the Investment Company Act of 1940: "the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services." Thus, we could just view this as an exercise statutory interpretation, though "fiduciary" is not a defined term in the statute, so it's not clear how this change in perspective helps things. In the end, it appears that Congress was leaning on the common law to give content to the term.
Where do we start? William Birdthistle surely is correct in asserting, "Any argument that market forces are and ought to be the only restraints on the fees that investment advisors charge fund shareholders – and that courts are ill-suited to this task – must first acknowledge that Congress has already decided otherwise in its enactment of Section 36(b)." Of course, this is a bit of straw man because even Judge Easterbrook did not hold that "market forces are and ought to be the only restraints on the fees." Instead, he held that investment advisors are subject to a fiduciary duty of candor. That is a fairly minimalist understanding of fiduciary duty.
The Gartenberg case has a more expansive understanding of the duty, variously framed as a duty to avoid a fee “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” and a duty to charge a fee “within the
range of what would have been negotiated at arm’s length in light of all the surrounding circumstances.” Lyman Johnson, in A Fresh Look at Director “Independence”: Mutual Fund Fee Litigation and Gartenberg at 25, says that the first formulation looks substantive while the second looks procedural, but I disagree. They both look substantive to me. The focus is on the size of the fee, and the process is mentioned only as a guide to determining a reasonable size. Substantive tests for breach of fiduciary duty are extremely difficult for courts to assess, and courts rarely pull the trigger under a substantive test ... go read Chancellor Allen's Gagliardi case if you need more convincing on that point. Nevertheless, if the process is compromised -- and the process here looks very compromised -- courts don't have much choice but to look at substance. By the way, Judge Posner seems to embrace the substantive standard in his dissent from denial of rehearing en banc: "unreasonable compensation can be evidence of a breach of fiduciary duty."
Usha noted another option from the oral argument that made me laugh. This one came from David Frederick, who was representing the petitioners. Going back to Justice Kennedy's questions, Frederick announced:
What Judge Cardozo, when he was on the New York Court of Appeals, said [is that] a fiduciary represents the punctilio of honor, and that is contrasted with the morals of the marketplace operating at arm's-length. It surely cannot be the case that, where you are dealing with a fiduciary duty -- which is a higher standard recognized in the law -- that you can charge twice as much as what you are obtaining at arm's-length for services that you are providing.
Two points here. First, Frederick is stuck in a world in which "fiduciary" has meaning independent of context. The reason I laughed at his invocation of Meinhard v. Salmon is that this articulation of fiduciary duty stands for the proposition that the fiduciary loses. Seriously, can you live up to the "punctilio of an honor the most sensitive"? Can anyone? The standard is largely vacuous, a fun rhetorical flourish without any meaningful content. If you tried to derive content from this standard, you would be led astray because the talk is too tough.
Second, Cardozo's standard is clearly procedural. It's about how the fiduciary behaves in exercising discretion. Frederick slides from that straight into Gartenberg's substantive standard. Apples and oranges.
So where does this leave us? I think Brett McDonnell got it right: "Gartenberg [is] the worst alternative available, except for all of the others."
I don't think I buy the crucial arguments for either side in Jones v. Harris. Judge Easterbrook thinks the market for mutual funds is working just dandy, and needs little help from the law. I know the empirical arguments are complex and indeterminate (they always are), but this strikes me as highly unlikely. There are too many unsophisticated retail investors out there, and those gaps between captured and independent funds sure do look suspiciously large. The conflicts and backscratching in this area are ubiquitous. Market competition does set some outer bounds, but it leaves a lot of room for skimming nice pools of money off the top. In part, that's a consequence of the huge amounts of money that get thrown around in American financial markets today. You don't have to divert very much at all in percentage terms into your own pockets in order to make out very well indeed.
So markets are probably not working so well. Still, to make their case, those who want active regulatory intervention need to show that either courts, the SEC, some other agency, or Congress can make things better. Maybe the market level isn't right, but then what is? I haven't seen any really good answer to that question.
Which rather leaves us stuck, I'm afraid. In a forthcoming paper on Executive Compensation and the Optimal Penumbra of Delaware Law, Claire Hill and I suggest using case law to reinforce norm-setting mechanisms that may limit excessive compensation. The idea is that case law often has a low probability of leading to actual liability, but nonetheless sets standards of conduct that agents may follow for reasons other than, or in addition to, avoiding the risk of liability.
Does that approach favor the Gartenberg factors or Easterbrook's position? I'm not sure. I suspect that Easterbrook's position is so hands off that it dictates no norms of conduct whatsoever, beyond that of open disclosure. The Gartenberg factors risk creating too much intervention by courts. But at p. 3 of his dissent, Judge Posner notes, quoting James Cox, that "Subsequent litigation [after Gartenberg] in excessive fee cases has resulted almost uniformly in judgments for the defendants. . . although there have been some notable settlements wherein defendants have agreed to prospective reduction in the fee schedule." If that is right, it suggests to me that in practice Gartenberg is getting it roughly right, and is worth preserving.
So count this as one cheer for Gartenberg. It's the worst alternative available, except for all of the others.
Here's my Jones v. Harris analogy: say on the University of Georgia's campus each Coke machine was set up by Coke as its own private corporation. Coke picked a board of directors for each Coke machine, and told that board to negotiate supply fees with Coke. Congress imposed on Coke a "fiduciary duty with respect to the receipt of compensation." Petitioners argue that fiduciary duty means a fair fee, which means a fee that would be obtained in an arm's length transaction. And they further argue that there's no arm's length bargaining here; although the Coke machine directors are not interested in the transaction, neither are they really independent--if they reject Coke's offer and ask Coke to lower its fee, then they'll basically be out of a job next year. And that Coke charges "non-captive" machines--i.e., machines in a rest stop or shopping mall--half the price of fees they charge on Georgia's campus. Easterbrook thinks that the fact that there's a soda machine market solves everything: consumers know how much they're paying for a can of Coke, and if they think the campus Cokes are too expensive, they can walk somewhere else. Petitioners disagree. I actually know very little about the Investment Company Act or mutual funds, so this analogy may be seriously flawed, and I invite people to tell me so.
As an independence maven, what interests me is the lack of traction this "can't be fired" argument seems to be have found with the Court. David Frederick (for the plaintiffs) tried to make the point to Justice Sotomayor, who appeared to ignore it. Justice Scalia asked Frederick questions indicated he didn't believe in the disparity of power between board and adviser:
JUSTICE SCALIA: Mr. Frederick, I don't understand your statement that they can't fire the investment adviser. Maybe they can't fire him, but they can insist that he accept a lower fee, right? Surely they can do that, can't they?
MR. FREDERICK: They --
JUSTICE SCALIA: Can they insist that he accept a lower fee? Can they do that.
MR. FREDERICK: In practical terms, no.
JUSTICE SCALIA: Why?
MR. FREDERICK: Because the adviser picks the board of directors.
JUSTICE SCALIA: Oh, no, that's something different. Let's assume you have a disinterested board of directors, which is what the statute requires. You tell me even though they are disinterested, they can't fire the adviser. It seems to me, while they can't fire him, they can say: We are going to cut your fee in half. Whereupon they don't have to fire him. He will pack up and leave, and they will get a new adviser. Doesn't that work?
MR. FREDERICK: There is actually no evidence in any record I am aware of where that has actually happened. The directors have no leverage.
And then Frederick ran out of time.
I was reminded of these acidic lines on independence from Aronson v. Lewis: "it is not enough to charge that a director was nominated by or elected at the behest of those controlling the outcome of a corporate election. That is the usual way a person becomes a corporate director." How much work is the concept of independence doing here? Does independence mean the power to act free from outside influence? Or the absence of conflict? Or something else?
As an aside, I was getting kind of anxious as I neared the end of the 50 page oral argument transcript. Could we possibly have a conversation about fiduciary duty and not mention Meinhard v. Salmon? But there on page 49 was the Cardozo shoutout, courtesy of Fredrick: "what Judge Cardozo, when he was on the New York Court of Appeals, said, a fiduciary represents the punctilio of honor, and that is contrasted with the morals of the marketplace operating at arm's-length."
As those of you familiar with Glom history know, this phrase resonates.
Have investment advisers chosen a strategic withdrawal to the relative safety of trial courts, where they have never lost a case? Perhaps the most surprising development at today’s oral argument was not the decision of the respondent to abandon Chief Judge Easterbrook’s opinion in the Seventh Circuit, which it had already done on the briefs, but instead to acknowledge the propriety of comparisons between institutional and retail fees. Heretofore, Harris Associates – and the industry generally – had consistently maintained that such comparisons are inapt, unworkable, and unwise.
In the face of this morning’s pointed questioning from Justices Ginsburg, Sotomayor, and especially Breyer, however, oral advocate John Donovan of Ropes & Gray conceded that comparing the fees that advisers charge to different clients “is a factor . . . likely to be relevant.” For years, defendants in these lawsuits have consistently resisted efforts by plaintiffs to petition courts to include and indeed to privilege such a comparison among the Gartenberg series of factors. Unlike comparisons to other mutual fund fees, comparisons between clients reveal that some investors pay twice as much as others for similar investments. So why then would the defendant accede to such a new standard today?
Perhaps Harris Associates calculated that appearing conciliatory before the Court by agreeing to the inclusion of this factor in the overall test would ward off harsher and more dramatic responses either from the Supreme Court in an adverse decision in this case or subsequently from Congress in a revised statute. The adviser might be gambling that the addition of one more factor – even one that most directly highlights large disparities in fees – to an already fact-intensive legal standard can effectively be combated and neutralized on remand with the same force of experts, data, and attorneys that have won advisers every previous excessive fees case at trial for the past forty years.
If, as some of today’s questions seem to indicate, the eventual decision from the Court in Jones v. Harris will read like Gartenberg with just one additional factor included in an already long and nebulous evaluation, we might have to wait for the next wave of litigation in trial courts to see whether the new Jones standard makes any practical difference on fees. If, on the other hand, the justices highlight and strongly emphasize the institutional/individual fee comparison in an opinion that reads like Posner’s dissent or Ameriprise v. Gallus, the pressure upon the industry to lower fees could be more acute and immediate.
Given the skepticism of Chief Justice Roberts and Justice Scalia for judicial involvement in this issue, combined with the lack of engagement in the particulars of this case by Justices Stevens and Kennedy (who asked only general and theoretical questions about the concept of fiduciary duties), and even the relatively modest concern by Justices Ginsburg, Breyer, and Sotomayor (who seemed supportive of the petitioners but not terribly impressed that the institutional fee comparison would be definitive), it’s hard to foresee a passionate opinion arising out of this case. Joining Justice Thomas in silence today was Justice Alito, which was a great shame given his personal involvement on the SEC's brief in the last major mutual fund case before the Supreme Court (Daily Income Fund v. Fox) and significant expertise on this topic.
I'll leave the heavy lifting to the experts, but I found one fact about the oral argument to be amusing: due to the apparently confusing end of daylight savings time, the argument began at 6:20 by the Court's own clock, flashed forward to 10, and hit 11:00 before everything was said and done. The WSJ roundup suggests that affirmed with revisions may be a likely outcome; that looks like a pretty big hedge to me.
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
The Jones v. Harris case is attracting some popular media attention, most of which focuses on the higher rates that mutual fund advisers generally charge their captive funds versus their institutional investor clients. For example, NPR covered the case this morning and tried to present both perspectives on this particular rate issue, with comments from David Frederick, counsel for mutual fund investors, and Karrie McMillan, general counsel for the trade association for mutual funds. You can listen to the story here. Judge Posner also acknowledged this issue in his dissent, stating that “[a] particular concern in this case is the adviser’s charging its captive funds more than twice what it charges independent funds.”
An adviser’s rate structure obviously is an important factor to consider, but I think we also need to analyze factors like any difference in services provided captive funds versus institutional investor clients, the actual services provided to captive funds in exchange for the negotiated fees and the independence of the fund’s directors or trustees who negotiated the adviser’s contract. For an excellent discussion of the difference between “interestedness” and “independence” in the context of mutual fund directors/trustees, see Professor Lyman Johnson’s article titled A Fresh Look at Director “Independence”: Mutual Fund Fee Litigation and Gartenberg at 25. And yes, I think courts should have the flexibility to consider market standards and competition.
That being said, what troubles me about Judge Easterbrook’s majority opinion in Jones v. Harris is not his reference to market standards and competition, but his level of deference to those factors. Perhaps his strong opinion was necessary to call attention to an arguable imbalance in the courts’ weighing of the Gartenberg factors. Based on Gartenberg’s dicta, many courts do not consider market standards and competition; according to Professor Lyman’s article, many courts do not consider director/trustee independence. I have not conducted a review of all court decisions applying the Gartenberg test, but I suspect other factors might get more or less attention than they deserve.
At the end of the day, the mutual fund’s advisory contract needs to reflect terms negotiated in good faith and at arm’s length. If a mutual fund goes beyond the definition of interestedness and retains truly independent directors/trustees, a court might grant more deference to the actual terms of the negotiated contract. If director/trustee independence is lacking, a court might place greater emphasis on evidence regarding disclosure of conflicts and terms of fee structures, market standards, competition in the markets, profitability of the fund and the like. Although such judicial discretion and flexibility may make some uncomfortable, I think it is an appropriate standard given that markets, investors and fund practices can change and are not static concepts. It will be interesting to see the Supreme Court’s decision and whether it has any impact on the larger executive compensation debate.
In addition, I want to say how much I appreciate Professor Larry Ribstein’s post yesterday on Jones v. Harris. It highlights the utility of the case beyond the basic fee dispute and reminds us of the importance of entity form selection both as we teach the concepts to our students and as they ultimately advise their clients in practice. I also think Professor Ribstein raises an important issue regarding the use of the term “fiduciary” in the business context—again, an issue that extends beyond the case and Section 36(b) of the Investment Company Act.
Jones raises both legal and policy questions. The legal question is: what is the nature of the “fiduciary duty” that Congress imposed on investment advisors in Section 36(b) the Investment Company Act, specifically regarding the fee the advisor charges? The policy question is: What duty should the advisor have? Since it’s rather unclear what Congress wanted to do in 1970 when it adopted Section 36(b), policy can inform the applicable legal standard. Legal and policy questions accordingly converge.
In theory, as I discussed in Are Partners Fiduciaries, a “fiduciary duty” is one of unselfishness by one who has substantial discretion to manage another’s property. An investment advisor arguably would fit this description. But this is only a default rule that can be waived, particularly as to the fiduciary’s compensation. So the real question is what limits did Congress intend to impose on the fund’s power to contract for compensation?
In answering this question, I will emphasize the importance of viewing the mutual fund as a type of standard form contract. What fiduciary duties are appropriate to this particular standard form? I see three possible approaches here. First, we could view mutual funds as products. There is significant evidence of vigorous competition in the market for mutual funds, as discussed extensively by Coates & Hubbard and in the Jones amicus brief that I joined . This arguably supports a minimalist approach to regulation. On the other hand, Congress’s imposition of a “fiduciary duty” must have been intended to accomplish something. These considerations lead me to accept Judge Easterbrook’s conclusion in Jones that the fiduciary duty is one of candor.
The second analogy is to a corporation. There is plenty of competition in the corporate governance market too. However, the corporate analogy highlights the fact that although investors can choose which fund to enter, the market doesn’t fully protect them from fiduciary abuse once they’ve invested. This arguably leads us to Judge Posner’s conclusion that there should be some limit on compensation, perhaps meaning that Harris can’t charge its controlled funds more than it charges independent funds. As Judge Posner argues, this duty is supported by “evidence that connections among agents [in the mutual fund industry] foster favoritism, to the detriment of investors.”
The corporate analogy is imperfect because, unlike shareholders, mutual fund investors can cash out at any time at the asset value of the fund. As a result, investors’ sale price is not freighted with managerial agency costs as it may be in closed end funds. This suggests that maybe investors in open end mutual funds don’t need as much fiduciary duty protection as corporate shareholders. On the other hand, exit is not costless, and even if it were fund managers could still inflict high fees and other possible harm on investors for whatever period they remain in the fund. Competition in the industry evidently has reduced agency costs, but not to zero. Of course we can’t expect zero agency costs. But what level of agency costs did Congress want to achieve?
If we accept the corporate analogy, then the panoply of corporate protections would apply, including independent directors and fairness standards where directors are not independent. The question is whether the corporate analogy is appropriate given investors’ ability to exit.
Fortunately we don’t have to choose between the product and the corporate analogies. There is a third possible analogy, what I’ve called the “uncorporation” – that is, partnerships, limited partnerships, LLCs and other unincorporated entities. I’ve argued, most recently in my Rise of the Uncorporation, that a critical difference between the corporation and the uncorporation is investors’ ability in the latter to get their money out of the firm. This ability supports a lower level of monitoring managers than in the corporation.
The uncorporation analogy is not perfect either. On the one hand, mutual fund investors have greater access to their cash than uncorporate investors, arguably supporting less need for fiduciary duties. Uncorporation statutes and agreements generally limit investor exit. This enables the firms to engage in long and intermediate-term business and investment strategies. On the other hand, the mutual fund industry has less sophisticated investors than many uncorporations such as private equity and hedge funds. Congress accordingly has imposed “fiduciary duties” on investment companies regulated by the ICA without a clear power to fully opt out of duties as there is for uncorporations under state (i.e., Delaware) law.
So where does that leave us? I would stick with Easterbrook's fiduciary duty of candor. A lower duty would ignore Congress’s intent to impose some duty, while a higher duty would ignore the fundamental distinctions between mutual funds on the one hand and corporations on the other particularly regarding exit.
More generally, I think the above analysis illustrates the usefulness of analyzing the array of governance structures available in distinct standard business forms.
Welcome to our first Conglomerate Masters Forum! The Supreme Court will hear oral arguments in Jones v. Harris tomorrow, but I think one or two of our Masters might weigh in today to share some opening thoughts. Try these links if you need to get up to speed (the lead for the WSJ article: "The money-management fees that drive the mutual-fund industry are at stake Monday when the Supreme Court hears a case that asks how much is too much."). Check back in to read our man-on-the-scene William Birdthistle's take on the oral argument. And get ready for some lively analysis!
Glom readers, get ready our first Masters Forum: Jones v. Harris. Supreme Court (that's U.S., not Delaware) oral arguments are set for Nov. 2, and we'll have a correspondent, William Birdthistle, live on the scene. The Forum will begin Nov. 1 and continue throughout next week.
What's all the fuss about? For those of you who haven't been following the story, here's a brief recap, shamelessly borrowing from William's prior posts:
Jones, et al., were investors in mutual funds managed by Harris Associates, an investment adviser. Those investors are now suing Harris for charging excessive fees to manage the funds in violation of the adviser's fiduciary duty under Section 36(b) of the Investment Company Act of 1940. Congress added that fiduciary duty -- and a private right of action to enforce it -- in 1970, legislating that "the investment adviser of a registered investment company shall be deemed to be a fiduciary with respect to the receipt of compensation for services." What exactly does that mean?
The Second Circuit attempted to answer that question in 1982 with its ruling in Gartenberg v. Merrill Lynch Asset Management. The Second Circuit held that the Section 36(b) fiduciary duty is violated if the adviser charges a fee that "bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining." Fund trustees -- and courts -- can make this substantive determination, according to Gartenberg, by evaluating a set of factors, including the nature of the services rendered by the adviser, the profitability of the fund to the adviser, economies of scale, the fees of similarly situated mutual funds, &c. Since 1982, mutual fund trustees everywhere have conducted an annual review of advisory contracts following these "Gartenberg factors."
In the Seventh Circuit, Jones v. Harris featured a notable disagreement between Judges Easterbrook and Posner. Easterbrook, relying on the market, noted 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.”
Posner dissented from rehearing en banc, and incorporated a behavioralist economic approach characterized by vigilance for market failures, attention to recurring and predictable distortions of the incentives of market participants, and the contemplation of roles for regulatory or private interventions in poorly functioning economic systems. And, for Posner, the investment industry is a perfect exemplar of precisely these kinds of disordered markets.
Posner began his dissent by attacking the central pillar of Easterbrook’s opinion: namely, that this industry enjoys healthy competition. Easterbrook’s faith in the disciplining effect of market forces is misplaced here, Posner argued, because “mutual funds are a component of the financial services industry, where abuses have been rampant.”
For Posner, as for the plaintiffs, the most troubling indicium of a lack of competitiveness in the industry generally, and this case specifically, is the wide pricing disparity between the fees that advisers charge to their own mutual funds and the fees that they charge to unaffiliated institutional investors. And Posner was particularly distressed by Easterbrook’s failure to consider this discrepancy seriously.
Prawfs who were amici of the petitioner included (Glommers or Masters in bold): Barbara Aldave, William Birdthistle, Barbara Black, Douglas Branson, Jim Cox, Steven Davidoff, Lisa Fairfax, Jim Fanto, Jesse Fried, Theresa Gabaldon, Joan MacLeod Heminway, Don Langevoort, David Millon, Larry Mitchell, Bud Murdock, Donna Nagy, Liz Nowicki, Alan Palmiter, Frank Partnoy, Margaret V. Sachs, Bill Sjostrom, Marc Steinberg, Ahmed Taha, Steven Thel, Randall Thomas, and Manning Warren. Amici for the defendants included William Baumol, Michael Bradley, William Carney, Stephen Choi, Robert Clark, John Coates, Allen Ferrell, Joseph Grundfest, Ehud Kamar, Steven Kaplan, Edmund Kitch, Kate Litvak, Thomas Lys, Jonathan Macey, Fred McChesney, Adam Pritchard, Mark Ramseyer, Larry Ribstein, Eric Roiter, Steven Schwarcz, Kenneth Scott, J.W. Verret, Sunil Wahal, and Roman Weil.
Rational choice vs. behavioral economics? Are mutual fund directors like the directors of corporations? And, if the WSJ's Jason Zweig is right and "[b]eing a fund director carries nice benefits, like earning as much as $200,000 a year for showing up at a handful of meetings, sometimes at fancy golf resorts"--where do I sign up?