March 11, 2009
Chief Judge Easterbrook and Classical Law & Economics.
Posted by William Birdthistle

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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