October 30, 2009
Masters Forum: Jones v. Harris
Posted by Usha Rodrigues

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 economicsAre 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?

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