March 12, 2009
Judge Posner and Behavioral Law & Economics.
Posted by William Birdthistle

For this third and penultimate entry in my series of posts on Jones v. Harris, I review the opinion of Judge Posner, who dissented from the Seventh Circuit’s denial of rehearing the case en banc.  In his dissent, Posner vigorously rebutted the arguments of Chief Judge Easterbrook, not by rejecting economic analysis but by calling for a more nuanced, subtle, and sophisticated version of that economic analysis.  Posner’s opinion was also a wonderful model of how to cry for certiorari within the polite confines of the Federal Reporter.

Posner’s dissent 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.”

But what about the Coates-Hubbard study that Easterbrook cited as evidence of how competitive the investment advisory industry is? 

Posner dismissed it as already outdated and cited multiple studies to the contrary, such as one by the SEC’s Office of Economic Analysis and another by a Kellogg School of Management scholar.

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. 

The panel’s opinion focused primarily on the comparison of the fees that one adviser charges its funds with the fees that other advisers charge funds with similar investment strategies.  But, argued Posner, such a comparison is useful only if one has reason to believe that the market is competitive.  If the market is not competitive, then the fact that many advisers are charging similar fees may prove nothing more than that investors in all the funds are being overcharged: “The governance structure that enables mutual fund advisers to charge exorbitant fees is industry-wide, so the panel’s comparability approach would if widely followed allow those fees to become the industry’s floor.”

Posner concluded his opinion with a remarkable summation of dissatisfaction with Easterbrook’s opinion: “[T]he creation of a circuit split, the importance of the issue to the mutual fund industry, and the one-sided character of the panel’s analysis warrant our hearing the case en banc.”  Since Posner knew at the time he wrote those words that such a rehearing was not going to happen owing to a lack of votes, one may reasonably suppose that he was directing his petition to a higher authority.  And we now know that the higher authorities were listening.

This dissent, which is almost certain to receive very close attention and perhaps even approval from the justices, is a fascinating early glimpse into Posner’s turn toward a more behavioralist and skeptical strain of economic analysis.  That evolution is evidently reaching its apotheosis in his forthcoming book, A Failure of Capitalism.

Next, a few predictions and implications of a possible Supreme Court ruling.

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