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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