November 03, 2009
Jones v. Harris: The Worst Alternative (Except for all the others)
Posted by Brett McDonnell

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.

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