Securities Law - Posner - Easterbrook Debate

A recent decision of the Seventh Circuit represents an interesting conflict between Judges Posner and Easterbrook. In Jones et al v. Harris Associates L.P., 527 F.3d 629 (May, 2008), the Plaintiffs appealed a decision of Judge Kocoras of the District Court for the Northern District of Illinois. Plaintiffs’ shareholders of Oakmark, an open-ended mutual fund managed by Harris Associates, claimed that management fees charged to Oakmark were excessive in violation of Section 32(b) of the Investment Company Act of 1940. There were several other issues but the most important issue was – were the management fees paid by the Oakmark Fund excessive? The District Court granted Summary Judgment in favor of Defendant. The Seventh Circuit affirmed. The Seventh Circuit Panel consisted of Chief Judge Frank Easterbrook and Judges Kanne and Evans.

Plaintiff sought and was granted certiorari by the U. S. Supreme Court.
The District Court followed Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (1982) and ruled that Harris Associates must prevail because its fees are in line with Gartenberg. Gartenberg sets forth two versions of a test to determine whether fees charged a mutual fund violate Section 36(b) of the Investment Company Act of 1940: (1) whether the fee schedule represents a charge that was within the range of what would have been negotiated at arm’s-length in the light of all the surrounding circumstances, and (2) to be guilty of a violation of § 36(b) the advisor 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 was considered the settled law for 25 years.

The Oakmark Fund paid Harris 1% percent on the first two billion of assets and a declining percentage thereafter. Plaintiffs argued that Gartenberg should not be followed because, among other things, the fees were set incestuously. Defendant Harris Associates organized Oakmark and controls it. Plaintiffs pointed out that Harris Associates has institutional clients that pay less in fees. For such clients, the first $15 million under management is paid 0.35% of the amount over $500 million with intermediate breakpoints. Plaintiffs argued that a fiduciary may charge its controlled clients no more than its independent clients.

The Seventh Circuit in Jones v. Harris Associates, 527 F.3d 629 (7th Cir. 2008) on May 19, 2008, in an opinion by Judge Easterbrook stated that the 7th Circuit now disapproves the Gartenberg approach and, among other things, stated that a fiduciary duty differs from rate regulation.

According to Judge Easterbrook, a fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The Trustees of a mutual fund, rather than a judge or jury, determine how much advisory services are worth. The opinion went on to state that a lawyer cannot deceive his client or take strategic advantage of the dependence that develops once representation begins. Hard bargaining and seemingly steep rates are lawful.

The opinion also stated that 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. Plaintiffs do not contend that Harris Associates pulled the wool over the eyes of disinterested trustees or otherwise hindered their ability to negotiate a favorable price for advisory services. The fees are not hidden from investors - and the Oakmark funds net return has attracted new investment rather than driving investors away. According to Judge Easterbrook, Section 36(b) does not make the federal judiciary a rate regulator, similar to the Federal Energy Regulatory Commission. Judgment of the district court granting summary judgment in favor of Harris Associates was affirmed.
There was a Petition For Rehearing. The panel voted unanimously to deny the Petition For Rehearing. A judge called for a vote on the suggestion for rehearing en banc. The majority did not favor such rehearing and it was denied. Judge Posner with Judges Rovner, Wood, Williams and Tinder dissented from the denial of rehearing en banc.

The dissent by Judge Possner (__ F.3d __, 2008 WL 3177282 (7th Cir. 2008) states that the case merits the attention of the full Court. The original panel rejected the approach taken by the Second Circuit in Gartenberg v. Merrill-Lynch Asset Management, Inc., 694 F.2d 923 (1982) in deciding whether a mutual fund adviser has breached his fiduciary duty to the fund. Gartenberg permits the Court to consider as a factor in determining if a breach occurred, whether the fee 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.” The dissent quotes the Oakmark Prospectus and states “Subject to the overall authority of the board of trustees, [Harris Associates] furnishes continuous investment supervision and management to the Funds and also furnishes office space, equipment and management personnel.” The Oakmark Fund, “Prospectus,” Jan. 28, 2008, p. 36. Recall Professor Kuhnen’s observation that “when directors and the management are more connected, advisers capture more rents and are monitored by the board less intensely.”

According to the dissent, the panel opinion states that advisors cannot profit if high fees drive investors to invest elsewhere. The dissent questions whether in fact high fees do drive investors away. The dissent states: “The chief reason for substantial advisory fee level differences between equity pension fund portfolio managers and equity mutual fund portfolio managers is that advisory fees in the pension field are subject to a marketplace where arm’s-length bargaining occurs. As a rule [mutual] fund shareholders neither benefit from arm’s-length bargaining nor from prices that approximate those that arm’s-length bargaining would yield were it the norm.” John P. Freeman & Stewart L. Brown, “Mutual Fund Advisory Fees: The Cost Of Conflicts Of Interest,” 26 J. Corp. L. 609, 634 (2001).

Judge Posner in the dissent also points out that the Jones case is the only appellant opinion disagreeing with Gartenberg and references approximately 20 cases following Gartenberg. Judge Posner stated that in rejecting Gartenberg, the Court relied on economic analysis which should be re-examined on the basis of growing indications that executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation, quoting various sources and authors, including Warren Buffet, Chairman of Berkshire Hathaway. “Letter to the Shareholders of Berkshire Hathaway, Inc.,” Feb. 27, 2004, p. 8.

Judge Posner points out that the advisers charges the captives funds more than twice what it charges independent funds and that the opinion by the panel creates a circuit split, although the panel did not acknowledge such or circulate its opinion to the full court in advance of publication as required when a panel creates a circuit split.
The principles and reasoning in Gartenberg seem to this writer to be more reasonable. Gartenberg was followed for about 25 years. Most practitioners view Judges Posner and Easterbrook to be the intellectual heavy weights of the Seventh Circuit. Judge Posner points out, it is not as if plaintiffs were routinely succeeding under Gartenberg. They were not. However, there were some settlements which resulted in a roll back of rates. In the writer’s opinion, if Judge Easterbrook’s view of fiduciary duty is extended to other factual situations, it could cause the doctrine to be seriously undermined. His analysis is very narrow. He states in his opinion: “A Trustee owes an obligation of candor in negotiation, and honesty in performance, but may negotiate in his own interest and accept what the settlor or governance institution agrees to pay.” Jones et al., 527 F.3d. 632 (7th Cir., 2008)

However, a Trustee is responsible for the interests of others. According to Black’s Law Dictionary: “Fiduciary Duty – A duty of utmost good faith, trust, confidence, and candor owed by a fiduciary (such as a lawyer or corporate officer) to the beneficiary (such as a lawyer’s client or a shareholder); a duty to act with the highest degree of honesty and loyalty toward another person and in the best interests of the other person (such as the duty that one partners owes to another).” Black’s Law Dictionary (8th ed. 2004).

Also, trustees are not in fact independent though the fund meets the rule that 60% are considered to be “independent” by the Investment Company Act. They are selected by the adviser which controls the fund. They are in effect paid by the adviser.
Judge Easterbrook makes reference to lawyers and states: “Lawyers have fiduciary duties to their clients but are free to negotiate for high hourly wages or compensation from any judgment. Jones, 527 F.3d 629, 632 (7th Cir., 2008). See, e.g., In re Synthroid Marketing Litigation, 325 F.3d 974 (7th Cir. 2003), In re Continental Illinois Securities Litigation, 962 F.2d 566 (7th Cir. 1992).

Is the reference to lawyers and legal fees correct? Is a lawyer negotiating a fee a fiduciary? A lawyer becomes a fiduciary only when an attorney-client relationship has been established. “[T]he attorney-client relationship constitutes a fiduciary relationship”. In re Winthrop, 219 Ill 2d at 543). A lawyer negotiating with a prospective client seeks an attorney-client fiduciary relationship. After a fee is settled, the lawyer then has the burden of protecting the client’s interests to the maximum extent possible. Judge Easterbrook says the federal judiciary is not a rate regulator after the fashion of the Federal Energy Regulatory Commission (FERC). FERC is the U.S. agency with jurisdiction over interstate electricity sales, wholesale electric rates, hydroelectric licensing, natural gas pricing, and oil pipeline rates. It seems a stretch to compare a fiduciary’s duty to setting electricity rates.

A fiduciary owes an obligation to those he has agreed to protect. For example, a fiduciary or trustee for minor children must extend his efforts first for the benefit of the children. He or she may seek fees, but his or her interests are secondary. Rate regulation has nothing to do with a fiduciary responsibility.

Plaintiff does not expect rate regulation but rather asks the question did the adviser breach its fiduciary responsibility? If it did, the summary judgment in favor of the defendant would be reversed. On remand, the parties at the district court would seek a rate that was not “excessive.” A settlement would be likely.

The Supreme Court will hear arguments in the coming weeks.

The briefs have been filed in the appeal by Oakmark of Jones v. Harris Associates, L.P., 527 F.3d 629 to the U.S. Supreme Court and can be viewed at 2007 WL 1833245 (C.A. 7).

Note: the Supreme Court unanimously reversed the Seventh Circuit in this case. See Jones et al. v. Harris Associates, L.P., 08-586 (March 30, 2010). The unanimous opinion was written by Justice Alito.

Edward X. Clinton, Sr.
Copyright 2009

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Stoneridge Investment Partners v. Scientific Atlanta, Inc. 552 U.S. 148 (2008)

Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008)

This article, by Edward X. Clinton, Sr., appeared in the Chicago Daily Law Bulletin In September 2007.

"The U.S. Supreme Court will hear argument on October 9, 2007 on whether to limit the scope of SEC Rule 10b-5 or expand the reach of the Rule.

It is the most important case in Securities Regulation in years and goes to the core of President Bush’s conservative base. The President personally intervened and overruled the Republican controlled SEC. Doubtless, the President was asked by a business supporter to intervene.

The case is controversial as the plaintiffs seek to impose liability not on Scientific-Atlanta, which allegedly made the false statements, but on its customers and suppliers who allegedly agreed to contracts which concealed fraudulent activity from investors in Scientific Atlanta.

The case is Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al., No. 06-43. The case involves a claim of securities fraud by Scientific American, Inc. and Motorola, Inc. The facts as alleged in the complaint are as follows:

Respondents supplied digital set-top boxes to Charter Communications, one of the largest cable-television operators. In 2000, Charter learned that it was unlikely to meet its annual target for operating cash flow and decided to ask respondents to enter into “wash” transactions, whereby Charter would pay respondents additional amounts for the set-top boxes and respondents would use those amounts to “purchase” advertising on Charter’s cable channels. In effect, those transactions would entitle respondents to receive free advertising.

In order for Charter to improve its cash flow as a result of those transactions, it needed to capitalize the payments to respondents (on the theory that they were for the purchase of equipment) while treating the return of payments from respondents as revenue (on the theory that they were for the purchase of advertising). Before entering into the transactions, Charter discussed them with Arthur Andersen, its outside accountant. Andersen advised Charter that it could not recognize the advertising payments as revenue if they were integrally related to the payments to respondents, but that it could do so if the two sets of payments were unrelated to each other, negotiated at least one month apart, and made at fair market value. Charter informed Andersen that it would satisfy those conditions. In September 2000, Charter and each respondent entered into separate agreements for the price increase in the set-top boxes and for the advertising; the agreements concerning the set-top boxes, however, were backdated to August 2000.

A proposed second amended complaint contains more detailed allegations. It alleges that Charter instructed Scientific-Atlanta to notify Charter that it was raising the price of set-top boxes that Charter had already agreed to purchase, and further instructed Scientific-Atlanta to cite higher manufacturing costs as the reason for the increase. Scientific-Atlanta followed Charter’s instructions, even though it knew that the stated reason for the increase was false. The parties later entered into an agreement under which Charter would pay an extra $20 for each set-top box it had already agreed to purchase (totaling $6.73 million in excess payments). The parties simultaneously entered into a separate agreement in which Scientific-Atlanta agreed to purchase $6.73 million in advertising from Charter (at rates four to five times higher than those paid by other advertisers).

The proposed complaint also alleged that Charter entered into an agreement with Motorola to purchase 540,000 set-top boxes by December 31, 2000, even though Charter had no present need for the Motorola boxes (and thus no intention of buying them). The agreement contained a provision requiring Charter to pay Motorola $20 per box in liquidated damages (totaling $10.8 million) if it did not purchase the boxes by the specified date. The parties entered into a separate agreement in which Motorola agreed to purchase $10.8 million in advertising from Charter (again at rates four to five times higher than those paid by other advertisers).

The proposed second amended complaint alleges that respondents knew that Charter intended to use the transactions artificially to inflate its operating cash flow.

Charter subsequently informed Andersen that the agreements had been negotiated a month apart from each other, and Andersen duly advised Charter that it could recognize the advertising payments as revenue. Charter did so in its financial statements for the fourth quarter of 2000, thereby increasing its operating cash flow by at least $17 million. But for its accounting of the transactions with respondents, Charter would not have met analysts’ projections for its operating cash flow. Charter continued to report an increase in cash flow throughout 2001 and the first quarter of 2002. On April 1, 2003, however, Charter issued a restatement of its financial reports in which it reduced its operating cash flow for 2000 by $195 million and its operating cash flow for 2001 by $292 million.

Respondents filed motions to dismiss, contending, that the complaint failed to allege actionable misstatements or omissions by respondents, and also failed to allege that petitioner had relied on respondents’ alleged deceptions. The district court granted the motions. The court held that “the claims amount to claims for aiding and abetting liability under § 10(b) and Rule 10b-5,” and were therefore barred by Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), which held that a private party may not pursue a Section 10(b) action on a theory of aiding and abetting liability. The district court reasoned that petitioner does not assert that respondents made any statement, omission or action at issue or that petitioner relied on any statement, omission or action made by either of them. Instead, the court noted, “petitioner contends that respondents are liable to Charter’s investors on the basis that they engaged in a business transaction that Charter purportedly improperly accounted for.”

The court of appeals affirmed and noted that, in Central Bank, the Supreme Court held that “Rule 10b-5 does not reach those who only aid or abet a violation of § 10(b).”

The court of appeals rejected petitioner’s contention that it had “properly alleged a primary violation of the securities laws within the meaning of Central Bank because respondents violated Rule 10b-5(a) and (c),” which prohibit “employing a device, scheme, or artifice to defraud” or “engaging in an act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.”

The court of appeals determined that petitioner’s complaint failed to state a claim. The court reasoned that “the focus of [petitioner’s] § 10(b) and Rule 10b-5 claims was deception” by Charter, and that “neither Motorola nor Scientific-Atlanta was alleged to have engaged in any * * * deceptive act.” In addition, the court held that respondents “did not issue any misstatement relied upon by the investing public, nor were they under a duty to Charter investors and analysts to disclose information useful in evaluating Charter’s true financial condition.” The court thus concluded that the district court properly dismissed the claims, barred by Central Bank, that respondents knowingly aided and abetted the Charter defendants in deceiving the investor class.

The court of appeals stated that is was aware of no case imposing § 10(b) or Rule 10b-5 liability on a business that entered into an arm’s length non-securities transaction with an entity that then used the transaction to publish false and misleading statements to its investors and analysts. Imposing liability in those circumstances, the court concluded, “would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings,” and “decisions of this type should be made by Congress.”

The Supreme Court accepted certiorari with the Chief Justice and Justice Breyer not participating. At least 30 amicus briefs have been filed by a wide array of persons and entities, including: North American Securities Administrators Association, Inc.; AARP; Ohio, Texas, and 30 other States and Commonwealths; Former SEC Commissioners and Officials and Law and Finance Professors; Defense Research Institute; American Bankers Association; Chamber of Commerce of the United States of America; John Conyers, Jr., Chairman of the House of Representatives Committee on the Judiciary, and Barney Frank, Chairman of the House Committee on Financial Services.

The Securities and Exchange Commission, by a vote of 3 to 2, asked the Solicitor General to submit an amicus brief on behalf of Petitioner (in other words, to support reversal). According to the amicus brief of representatives Conyers and Frank, President Bush personally intervened and instructed Paul D. Clement, the Solicitor General, to file an amicus brief supporting affirmation, which he did. You have the unusual conflict of a Republican SEC voting to ask the Solicitor General to seek reversal and the President asking the Solicitor General to submit a brief in favor of affirming. Of course, the Solicitor General followed the President’s direction.

The amicus brief of the Solicitor General argues that the district court’s dismissal of petitioner’s complaint was correct was because petitioner did not sufficiently plead reliance on respondents’ deceptive conduct. Petitioner does not allege that it was even aware of the transactions that respondents executed with Charter; at most, petitioner relied on Charter’s misstatements in purchasing Charter stock. Petitioner does not dispute that Charter independently decided to make the misrepresentations in its financial statements, and does not contend that respondents drafted or otherwise created those misstatements.

The brief also argued that allowing liability for a primary violation under the circumstances would constitute a sweeping expansion of the judicially inferred private right of action in Section 10(b) and Rule 10b-5, potentially exposing customers, vendors, and other actors far removed from the market to billions of dollars in liability when issuers of securities make misstatements to the market.

The amicus brief of Messrs. Conyers and Frank argued that the interpretation of Section 10(b) and Rule 10b-5 adopted by the Court of Appeals and urged by Respondents ultimately rests on policy considerations at odds with the statutory text that should more appropriately be addressed to Congress than to the Supreme Court. The brief stated that the conduct at issue is prohibited by the plain language of Section 10(b) of the Exchange Act and its companion regulation, Rule 10b-5, and urges that any change to the substantive law should be made by legislative action and not by the courts.

The amicus brief also stated that the Supreme Court has stated repeatedly that Section 10(b) should be construed “ ‘not technically and restrictively, but flexibly to effectuate its remedial purposes.’” SEC v. Zandford, 535 U.S. 813, 819 (2002) (quoting Affiliated Ute Citizens v. United States, 406 U.S. 128, 151 (1972), quoting SEC v. Capital Gains Research Bureau, 375 U.S. 180, 195 (1963)); accord Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 12-13 (1971); see also Santa Fe Indus. v. Green, 430 U.S. 462, 477 (1977) (“No doubt Congress meant to prohibit the full range of ingenious devices that might be used to manipulate securities prices.”).

The brief also stated that the Supreme Court previously has stated that “§ 10(b) and Rule 10b-5 prohibit all fraudulent schemes in connection with the purchase or sale of securities, whether the artifices employed involve a garden type variety of fraud, or present a unique form of deception. Novel or atypical methods should not provide immunity from the securities laws.” Bankers Life, 404 U.S. at 11 n.7 (quoting A.T. Brod & Co. v. Perlow, 375 F.2d 393, 397 (2nd Cir. 1967)); also see Ernst & Ernst v. Hochfelder, 425 U.S. 185, 203 (1976) (stating that Section 10(b) is “a ‘catchall’ clause to enable the Commission ‘to deal with new manipulative (or cunning) devices.’”).

Taking into account the current make-up of the U.S. Supreme Court, the odds are in favor of affirmation."

P.S. As I predicted the U.S. Supreme Court did in fact affirm.

THE SUPREME COURT OPINION

The opinion can be found at 128 S.Ct. 761 552 U.S. 148. Writing for the majority, Justice Kennedy wrote: In this suit investors alleged losses after purchasing common stock. They sought to impose liability on entities who, acting both as customers and suppliers, agreed to arrangements that allowed the investors’ company to mislead its auditor and issue a misleading financial statement affecting the stock price. We conclude the implied right of action does not reach the customer/supplier com-panies because the investors did not rely upon their statements or representations. We affirm the judgment of the Court of Appeals."

The majority opinion further reasons as follows: "Respondents had no duty to disclose; and their deceptive acts were not communicated to the public. No member of the investing public had knowledge, either actual or presumed, of respondents’ deceptive acts during the relevant times. Petitioner, as a result, cannot show reliance upon any of respondents’ actions except in an indirect chain that we find too remote for liability."

THE DISSENT

Justice Stevens, joined by Justice Ginsburg and Justice Souter, dissented.

The Dissent argued that the majority opinion had construed the concept of "reliance" far too narrowly.

Justice Stevens wrote: "The sham transactions described in the complaint in this case had the same effect on Charter’s profit and loss statement as a false entry directly on its books that included $17 million of gross revenues that had not been received. And respondents are alleged to have known that the outcome of their fraudulent transactions would be communicated to investors. The Court’s view of reliance is unduly stringent and unmoored from authority."

The Dissent further argued that, without the fraudulent acts of the respondents, Charter would not have been able to defraud investors.

"Charter Communications, Inc., inflated its revenues by $17 million in order to cover up a $15 to $20 million expected cash flow shortfall. It could not have done so absent the knowingly fraudulent actions of Scientific-Atlanta, Inc., and Motorola, Inc. Investors relied on Charter’s revenue statements in deciding whether to invest in Charter and in doing so relied on respondents’ fraud, which was itself a “deceptive device” prohibited by §10(b) of the Securities Exchange Act of 1934. 15 U. S. C. §78j(b)."

The SEC, which voted 3 to 2 in support of the view announced in the Dissent, no doubt viewed the sham transactions and the alleged conspiracy as a serious threat to investors and the markets.


Edward X. Clinton, Sr.
Copyright 2009

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