Jones v. Harris Associates, L.P.; Posner v. Easterbrook

Judges Posner and Easterbrook are two of our eminent jurists. Both are long-time members of the Seventh Circuit Court of Appeals, having been appointed by President Reagan. Both are closely associated with the Chicago School of Law and Economics, Judge Posner being one of its founders. See his textbook, Economic Analysis of the Law, now in its seventh edition. Judge Easterbrook has also made numerous contributions to the teachings of this school, see, e.g., Easterbrook and Fischel, The Economic Structure of Corporate Law (1991). Judge Posner has authored too many books to count, on virtually every subject touched by the law (and then some), his most recent being How Judges Think (2008). He was even the subject of a lengthy profile in The New Yorker (December 10, 2001) (“The Bench Burner”), and, in celebration of his 25th year on the Seventh Circuit, was the subject last year of commemorations in the Harvard Law Review (Volume 120 March 2007) (where Judge Posner attended law school and was President of the Law Review) and the University of Chicago Law Review (Volume 74, Special Issue (2007) (where Judge Posner taught and lectures). Each is a gifted opinion writer, albeit often acerbic and bordering on contemptuous of parties (often plaintiffs) whose arguments they find wanting.

It is therefore always of intense interest when they lock horns over a matter touching upon their core expertise. Such was the case most notably in Jordan v. Duff and Phelps, 815 F.2d 429 (7th Cir. 1987) (Easterbrook writing the opinion for the majority, Posner dissenting) in which the issue joined was the obligation of a closely-held corporation to disclose material information to an at-will employee when purchasing his stock on termination pursuant to a pre-set formula, Judge Easterbrook concluding the corporation had such a duty and therefore summary judgment for the corporation was improperly granted, Judge Posner concluding that summary judgment in favor of the corporation was proper. The ground still shakes from that contest. See Ramseyer “Not-So-Ordinary Judges In Ordinary Courts: Teaching Jordan v. Duff & Phelps, Inc.,” 120 Harv. L. Rev. 1199 (2007).

While the clash between Judges Posner and Easterbrook in Jones v. Harris Associates is not over a M&A transaction, because of their prominence in the field of law and economics and as jurists, I believe their clash deserves a post on this blog.

A. Panel Opinion

Echoes of their dispute in Jordan can be found in their most recent one, in Jones v. Harris Associates, L.P., 527 F.3d 627 (7th Cir. 2008), petition for rehearing and rehearing en banc denied, 2008 WL 3177282 (August 8, 2008) (Posner, with Judges Rovner, Wood, Williams, and Tinder, dissenting).

In this case, owners of shares in mutual funds brought an action against their common investment advisor (Harris Associates) under Section 36(b) of the Investment Company Act of 1940 alleging that the advisor’s compensation was excessive. The lower court granted summary judgment for the advisor, and the panel of the Seventh Circuit, in an opinion by Chief Judge Easterbrook, affirmed the judgment. In his opinion for the panel, Judge Easterbrook takes the occasion to disapprove the standard of review of advisor compensation established by the Second Circuit in its 1982 decision in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2nd Cir 1982). The Gartenberg court established, as the test for applying Section 36(b) to an advisor’s fee, the following:

“[T]he test is essentially whether the fee schedule represents a charge within the range of what would have been negotiated at arm’s-length in the light of all the surrounding circumstances.
. . .
[to] be guilty of a violation of § 36(b) . . . the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.”

Gartenberg, quoted in Jones at 527 F.3d at 631.

Judge Easterbrook found Gartenberg wanting because it relied too little on markets. Investors have thousands of mutual funds to choose among, and administrative expenses (which include advisor management fees) as a percent of assets under management is a commonly used and widely distributed measure to assess mutual fund performance. High fees drive investors away. Judge Easterbrook is not shy about expressing his and the panel’s preference for the discipline of markets over that of judges or juries:

“A fiduciary duty differs from rate regulation. A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trustees [of the mutual fund] (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth.”

527 F.3d at 632.

Betraying his background as a professor, Judge Easterbrook turns pedantic on the workings of the capital and products markets:

“Publicly traded corporations use the same basic procedures as mutual funds: a committee of independent directors sets the top managers’ compensation. No court has held that this procedure implies judicial review for ‘reasonableness’ of the resulting salary, bonus, and stock options. These are constrained by competition in several markets – firms that pay too much to managers have trouble raising money, because net profits available for distribution to investors are lower, and these firms also suffer in product markets because they must charge more and consumers turn elsewhere. Competitive processes are imperfect but remain superior to a ‘just price’ system administered by the judiciary. However weak competition may be at weeding out errors, the judicial process is worse – for judges can’t be turned out of office or have their salaries cut if they display poor business judgment.”

Id., at 632-633.

Let the market decide, concludes Judge Easterbrook:

“Mutual funds come much closer to the model of atomistic competition than do most other markets. Judges would not dream of regulating the price of automobiles, which are produced by roughly a dozen large firms; why then should 8,000 mutual funds seems ‘too few’ to put competitive pressure on advisory fees?”

Id., at 634.

B. Judge Posner’s Dissent

And so it ended, almost. Apparently the rules of the Seventh Circuit permit a single judge to call for a vote on a request for a rehearing en banc. After Judge Easterbrook’s panel voted “unanimously” to deny the plaintiffs’ petition for a rehearing by the panel, “a” judge, not identified (we can guess who) requested a vote on the request for rehearing en banc. A majority of the Circuit did not favor such a rehearing, and so the petition was denied. That led to Judge Posner’s dissent from the denial.

One would not expect judges of the stature and intellectual firepower of Judges Posner and Easterbrook to be shy or to pull punches. And they don’t. Judge Posner, in concluding his dissent, notes that the panel decision creates a “circuit split” between the Seventh and Second Circuits, “although the panel did not acknowledge this or circulate its opinion to the full court in advance of publication as is required when a panel creates a circuit split.” 2008 WL 31772, at *4. Ouch!

Judge Posner challenges the scholarship of the panel opinion in its claim that the Gartenberg approach has been found “wanting” in previous Seventh Circuit opinions. Not so, noted Judge Posner, and he cites a “slew” of positive citations to Gartenberg, and cites studies concluding that the excessive fee cases brought since Gartenberg have “resulted almost uniformly in judgments for the defendants …” Id. at *1.

It is most remarkable for a free market advocate such as Judge Posner to cite recent scholarship showing that “executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation,” id., at *2, most notably Lucian Bebchuk’s and Jesse Fried’s studies of executive compensation. For a judge and scholar strongly disposed to granting markets wide latitude, Judge Posner’s reliance upon the findings of this literature is striking:

“Directors are often CEOs of other companies and naturally think that CEOs should be well paid. And often they are picked by the CEO. Compensation consulting firms, which provide cover for generous compensation packages voted by boards of directors, have a conflict of interest because they are paid not only for their compensation advice but for other services to the firm – services for which they are hired by the officers whose compensation they advised on.”

Id. at *2.

Responding to the panel’s reliance upon the capital and products markets to regulate managers’ compensation, Judge Posner observes that competition in these markets “can’t be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds.” Id. Judge Posner also cites “rampant” abuses in the financial services industry, of which mutual funds are a component.

Of significance to Judge Posner is the difference in what Harris Associates charges its “captive” funds (those funds it organized and manages) and what it charges independent funds: “A particular concern in this case is the adviser’s charging its captive funds more than twice what it charges independent funds.” Id. at *3. Judge Posner is not impressed by the panel’s explanation of why this difference may be justified:

“The panel opinion throws out some suggestions on why this difference may be justified, but the suggestions are offered purely as speculation, rather than anything having an evidentiary or empirical basis.” Id., at *3. Nasty!

Concluding that the outcome of the panel decision “may” be correct, Judge Posner concludes that, because of the 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,” the case warrants a rehearing en banc.

It’s a fair bet that much of Judge Posner’s analysis will appear in any petition for certiorari filed by the plaintiffs with the Supreme Court.