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