Contract Law - Lewitton v. ITA Software, Incorporated (Seventh Circuit 08-3725)

The Seventh Circuit Holds that An Employer Breached An Employment Contract When It Blocked A Former Employee From Exercising Options To Purchase Stock.

Lewitton was an employee of ITA Software, the Defendant. Three months after he stopped working for ITA Lewitton attempted to exercise options to purchase 138,900 shares of ITA's stock. ITA allowed Lewitton to purchase 34,722 shares, but blocked his effort to exercise the remaining options.

In April 2005, ITA and Lewitton entered into an employment contract under which Lewitton was to serve as ITA's vice president of sales. The contract granted Lewitton the right to purchase up to 200,000 shares of stock. According to the contract the options "'will vest...in equal monthly installments of 4,556 shares each... except that the first twelve months of options will all vest at Lewitton's one-year anniversary.'" The contract also provided that certain of the options were subject to forfeiture depending on whether ITA met certain performance goals. Under the contract, there was to be an assessment period during which sales would be calculated to determine if the company met its revenue goals. However, the contract also specified that the Assessment period would not apply if it were "materially deferred."

Lewitton's job was to supervise the development of the 1U program, a computer program that would apparently allow users to make online reservations for air travel. The software program was not successful and was not accepted by either travel agents or airlines.

The District Court granted summary judgment for Lewitton, holding that the contract unambiguously granted him the right to exercise the options. Under Illinois law, "our primary goal in construing the contract is to give effect to the parties' intent as expressed in the terms of their written agreement." The Court stated: "We first ask if the language of the contract is ambiguous, which is a question we determine as a matter of law...A contract is ambiguous if its terms are indefinite or have a double meaning...If the contract is unambiguous, we must enforce it as written."

ITA argued that the options were subject to forfeiture because the U1 software program did not meet performance goals.

The District Court and the Court of Appeals disagreed. They held that the Assessment Period did not apply (to allow forfeiture) because the U1 program was "materially deferred." "As the district court noted, 'materially deferred' is not a technical term; its ordinary meaning is 'significantly delayed.'" Because the U1 program was not rolled out on time, "the Assessment Period never began and, accordingly, ...the forfeiture provision does not apply."

Accordingly, Lewitton was entitled to exercise the options.

Edward X. Clinton, Jr.
Copyright 2009

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Securities Arbitration - Stern v. Charles Schwab & Co., Inc. (D. Ariz., No. CV-09-1229, October 16, 2009)

COURT REJECTS SECURITIES ARBITRATION WHERE THE BROKER FAILED TO OBTAIN THE CLIENT'S SIGNATURE ON THE ARBITRATION AGREEMENT

Plaintiffs who seek to avoid arbitration and have their claims adjudicated in court are not often successful. There is a recent United States District Court, the District of Arizona, which did not follow the trend. In the case of Stern v. Charles Schwab & Co., Inc. (D. Ariz., No. CV-09-1229-PHX-DGC, 10/16/09), the defendant Schwab filed a Motion To Dismiss and To Compel Arbitration pursuant to the Arizona and Federal Arbitration Acts. In the case, the Sterns invested One Million Nine Hundred Thousand Dollars ($1,900,000.00) with Debra Bennett and Elva Bennett. The Bennetts then transferred the Sterns’ money to a Charles Schwab Brokerage Account and used that account to invest in various investment transactions. The Sterns suffered serious financial losses and alleged that the Bennetts committed fraud, violated various securities law and ran a Ponzi scheme. The case was transferred to the Federal Courts because of diversity of citizenship. The Bennetts opened the Schwab account about one year before the Sterns began investing. The account between the Bennetts and Schwab contained a somewhat standard arbitration clause in which the Schwab account holders agreed to arbitration. The Sterns never signed the Schwab-Bennett contract, but nonetheless Schwab asked the Court to enforce the arbitration provision against them.

The Court noted that to compel arbitration the Court needed to find that the party actually signed a written agreement. A non-signatory may be bound to arbitrate based on “ordinary contract and agency principles” such as a corporation by reference, assumption, agency, veil piercing and equitable estoppel. Schwab also argued that the principles of equitable estoppel and agency bind the Sterns to the arbitration clause of the Schwab-Bennett contract. The court noted that when a non-signatory receives a direct benefit from the underlying contract, Arizona courts apply the doctrine of equitable estoppel and enforce the contract, including arbitration. World Group Secs., Inc., v. Allen, 2007 WL 4168572, *3 (D.Ariz. 2007) (quoting Zurich Am. Ins. Co. v. Watts Indus., Inc., 417 F.3d 682, 688 (7th Cir. 2005). Schwab argued that the Sterns received a direct benefit from the Schwab-Bennett Contract because the contract allowed the Sterns to invest the Bennett’s money.

The Court noted that arbitration can be ordered when a party has received a direct benefit from the arbitration contract. However, the Court stated that the Schwab-Bennett contract merely provided a vehicle through which the Bennetts implemented their investment business. It conferred no direct benefit on the Sterns. All the allegations and evidence suggested that the Sterns elected to invest with the Bennetts, not with Schwab and did so because of the Bennetts’ purported investment expertise and the Bennets’ promise of substantial returns. Because the Sterns received no direct benefit from the Schwab-Bennett contract equity does not require that the Sterns be subject to the arbitration provision which they never signed.
Schwab also argued that an agency relationship existed between them and the Bennetts. The response of the Sterns was that no agency relationship existed when the Schwab-Bennett contract was signed, the Bennetts could not be said to have acted on behalf of the Sterns in signing the contract. Therefore, agency principles also do not bind the Sterns to arbitration.

Accordingly, the Court held that the motion of Schwab to dismiss would be denied and the Sterns could proceed with the case in the U.S. District Court.

Edward X. Clinton, Sr.
Copyright 2009

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Securities Law - Proposed Amendments to the Investor Protection Act

The House Financial Services Committee voted strictly along party lines on November 4, 2009 to recommend an amendment to the Investor Protection Act that would double the authorized funding of the SEC and increase its enforcement authority. Further, a fiduciary duty would be imposed on all providers of financial advice, create a whistle-blower “bounty” and protection program and end mandatory arbitration of claims against broker-dealers. If this proposed amendment is adopted it would represent a boom to plaintiffs’ lawyers. This bill will be vigorously opposed by the Republicans in the House and, further, even it passes in one form or another, its passage in the more conservative Senate will be much more difficult.

Edward X. Clinton, Sr.
Copyright 2009

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Attorney Client Privilege - Tenth Circuit Rejects Attorney Work Product Claim

United States v. Textron, Inc. 577 F.3d 21 (August 13, 2009)

A recent case raises an important issue. United States v. Textron, Inc., 577 F.3d, 21 (Aug 13, 2009). In the Textron case, the United States filed a petition to enforce an Internal Revenue Service summons served on Textron, Inc., a public company, in connection with an IRS’s examination to determine tax liability. The United States District Court for the District of Rhode Island denied the petition and the IRS appealed. The question before the 11th Circuit was whether attorney-work product doctrine shields from an IRS summons “tax accrual work papers” prepared by lawyers and others in Textron’s tax department to support its calculation of tax reserves for its
audited corporate financial statements.

As a publicly traded corporation, Textron is required to file financial statements certified by an independent auditor. And, in doing so, it must calculate reserves. The present case began with a 2003 audit. In reviewing Textron’s 2001 returns, IRS determined that a Textron subsidiary had engaged in certain transactions which potentially could be considered abusive tax shelters. Textron had shown the work papers to its accountants, Ernst & Young, but refused to show them to the IRS. The IRS then brought an enforcement action in the Federal District Court of Rhode Island. Textron challenged the summons as lacking a legitimate purpose and it also asserted the attorney-client and taxpayer-practitioner privileges and the qualified privilege available for litigation materials under the work-product doctrine. The IRS contested the privileges claims.

After a hearing, the District Court denied the petition for enforcement on the basis that the papers were protected by the work-product privilege. 507 F.Supp. 2d 138. The District Court stated that the privilege derived from a case Hickman v. Taylor, 329 U.S. 495 (1947) and is now embodied in Rule 26(b)(3) of the Federal Rules of Civil Procedure. The District Court pointed out that there would be no need regarding the adequacy if the reserve amount of Textron had not anticipated a dispute with the IRS that was likely to result in litigation or some other adversarial proceeding.

On appeal to the 11th Circuit, a divided panel upheld the District Court’s decision. A petition for an en banc review was granted. Then the panel decision was vacated and additional briefs were submitted. The En Banc Bank panel pointed out that the U.S. Supreme Court has not ruled on the issue, namely, one in which a document is not in any way prepared for “litigation but relates to a subject that might or might not occasion litigation.” In Hickman v. Taylor, 329 U.S. 510, there was ongoing litigation in which one side filed interrogatories seeking from opposing counsel memorandum recording witness interviews the latter had conducted after receiving notice of possible claims. In Hickman the Court declared that the interrogatories conducted by opposing counsel in preparation for litigation was protected by a qualified privilege.

The En Banc panel concluded that the work-product privilege is aimed at protecting work done for litigation – not in preparing financial statements. Textron’s work papers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they would be carefully prepared in their present form. And, IRS access serves the legitimate and important function of detecting and disallowing abusive tax shelters.
The En Banc Panel vacated the initial decision of the District Court and remanded the case. Thus, the IRS prevailed and will obtain access to the withheld materials.

Two of the five Circuit judges on the en banc panel dissented. The dissent made reference to Rule 26(b)(3) and stated that the text of the Rule does not limit its protection to materials prepared to assist at trial. To the contrary, the text of the Rule clearly sweeps more broadly. It expressly states that work-product privilege applies not only to documents “prepared … for trial” but also to those prepared “in anticipation of litigation.” If the drafters of the Rule intended to limit its protection to documents made to assist in preparation for litigation, this would have been adequately conveyed by the phrase “prepared … for trial.” The fact that documents prepared “in anticipation of litigation” were also included confirms that the drafters considered this to be a different, and broader category. Nothing in the Rule states or suggests that documents prepared “in anticipation of litigation” with the purpose of assisting in the making of a business decision does not fall within its scope.

The dissent made reference to United States v. Adlman, 134 F.3d 1194 (2d Cir. 1998) where Judge Leval stated a “prepared for” requirement is not consistent with the plain language of Federal Rule of Civil Procedure 26, which provides protection for documents “prepared in anticipation of litigation or for trial.” Fed.R.Civ.P.26(b)(3)(A).

In short, the dissent agreed with the District Court and took strong exception to the findings of the majority on the en banc panel.
* * *

The case has created uncertainty. Could its rational be extended beyond work product issues? Perhaps the Supreme Court will accept the Textron case in order to put certainty into the area. It is time for SEC reporting companies and other companies to set up standards for handling work-product materials. It would be prudent to mark documents as “work-product being prepared in anticipation of litigation.” Auditors routinely request comment by corporate counsel on the issues of significant litigation and request a view as to the ultimate conclusion. No responding lawyer wants to disclose information that might enlighten a potential or actual adversary.

Edward X. Clinton, Sr.
Copyright 2009

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Securities Law - The SEC Uses Sarbanes-Oxley To Attack A CEO's Bonus

Apparently the SEC filed its first action under Section 304 of the 2002 Sarbanes-Oxley Act. It appears to represent the start of a more watchful and aggressive approach to regulation by the SEC.

Section 304 provides in part:

If there is material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the CEO and CFO of the issuer shall reimburse the issuer for (1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever occurs first) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

The Chief Executive Officer of CSK Auto Corp., Maynard L. Jenkins, has been asked to return $4,000,000 he received in bonuses and stock sales while the company was allegedly committing accounting fraud. The action was filed in the United States District Court for Arizona. According to the Complaint, Jenkins, formerly the Chairman and CEO of CSK was engaged in accounting fraud which also involved many of its senior officers for the years 2002, 2003 and 2004.

CSK, a large distributor of automotive parts and accessories, was a retailer which purchased products from vendors that manufactured various parts. A portion of CSK’s income was obtained from allowances it received from its vendors. Vendor allowances are used to provide financial support to market the vendor’s product. Generally, CSK accounted for the allowances by reducing its costs of goods sold. The more vendor allowances earned, the lower the costs and correspondingly greater pre-tax income. There were millions in uncollectible vendor allowances recognized but were actually uncollectible. According to the SEC Complaint, CSK engaged in a scheme to hide the uncollectible receivables. Instead of writing off the uncollectible receivables and taking a reduction in pre-tax income, CSK concealed its uncollectible receivables by applying millions of dollars allowances earned and collected for later program years to prior program years. For this and similar schemes, CSK avoided writing off tens of millions of dollars of uncollectible receivables. As a result of the failure to properly account for the vendor failures, CSK filed its Form 10-K overstating 2003 pre-tax income by about $11,000,000. The SEC charged that CSK knew or was reckless in not knowing that it failed to write off uncollectible allowances. There were similar charges for later years.

As a result of this fraud, the SEC charged that CSK violated the Anti-Fraud Provisions of the Securities Laws, namely Section 17(a) of the Securities Act. Section 10(b) of the Exchange Act and Rule 10(b)-5 thereunder.

The SEC alleges in its complaint that during the 12 month period following the filing of the fraudulent Form 10-K’s, Jenkins received bonuses and other incentive-based and equity-based compensation from CSK. Jenkins never reimbursed CSK for any portion of the bonuses or other incentive-based and equity-based compensations or his stock sales profits.

The SEC seeks a judgment ordering Jenkins to reimburse CSK for any bonuses and other incentive-based and equity-based compensation and the profits of CSK stock sales pursuant to Section 304 of Sarbanes-Oxley. Section 304 of Sarbanes-Oxley does not permit the remedy of attaching salary, so it is possible that in the future corporate officers may want more of their compensation in terms of salary which cannot be affected by Section 304.

Doubtless, the action of the SEC is one further step in the promise by the new Chairman of the SEC, Mary Schapiro, to be more aggressive. The Maddoff Fraud was a serous blow to the agency which has over the years been considered responsive to investor protection. It appears. Schapiro will try to reverse at least some of the SEC’s prestige in failing to detect Maddoff’s massive fraud.

Edward X. Clinton, Sr.
Copyright 2009

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United States v. Ruehle, 09-50161 (9th Cir. 2009)

CONFLICT
THE TREACHEROUS PATH

William Ruehle, the Chief Financial Officer of Broadcom, a California corporation, and Henry Nichols, a co-founder of Broadcom, were indicted by a Federal grand jury for conspiracy, securities fraud, false certification of financial statements, wire fraud and other crimes in the United States District Court for California. These charges arose from the alleged backdating of options granted to officers of Broadcom.
The story started from events commencing in May of 2006 when Irell & Manella, LLP, a prestigious California law firm, with about 220 lawyers, ranked 60th in a nationwide survey by Vault’s 2009 Guide To The Top 100 Law Firms, was retained by the Audit Committee of Broadcom to conduct an internal investigation concerning the backdating of stock options by Broadcom. It was also decided that the Board would not appoint a panel of independent outside directors to oversee the review. At the time Irell was personally representing Ruehle in civil litigation concerning the backdating of stock options by Broadcom. In June 2006, Irell lawyers, at the request of the Audit Committee, met with Ruehle who told them about the option practices of Broadcom. The Irell firm did not state to Ruehle that they were only representing Broadcom. Word of the backdating problem leaked out and civil suits were filed.

Irell lawyers claimed that they gave an oral Upjohn (Miranda) warning to Ruehle prior to or at the meeting. However, Ruehle does not remember receiving such a warning and the notes of the Irell lawyers do not reflect that a warning was given.
Ruehle, at the request of Irell, met with Broadcom executives and board members to discuss Irell’s internal review and it was agreed that the information would be turned over to the outside auditors, Ernst & Young.

Ruehle and Nichols were indicted in a 65 page indictment. Later, Broadcom told Irell to disclose Ruehle’s conversations about backdating options to the auditors of Broadcom, the SEC and the United States Attorney. Irell did not seek or get the advance consent of Ruehle.

The U.S. Attorney now argues that it can use Ruehle’s statements to Irell at Ruehle’s criminal trial. Ruehle objected at that point on the grounds of the attorney-client privilege because Irell was representing Ruehle in connection with certain civil cases involving those same options. In fact, Ruehle had a long relationship with Irell.
Apparently no one asked the Irell lawyers to get Ruehle’s consent to the dual representation, nor did they recommend that Ruehle get separate independent counsel.
Because of Ruehle’s objection, a couple of months later the District Court at the request of the U.S. Attorney, ordered an evidentiary hearing to determine whether, in fact, the attorney-client privilege, asserted by Ruehle at this point, should be recognized. The U.S. attorneys said that they can use the statements to Irell because an Upjohn (“Miranda”) warning was given by Irell to Ruehle. The District Court stated that it doubts that, in fact, an Upjohn warning was given. The Irell attorneys had no notes of such a warning and Ruehle said he did not remember receiving such a warning.

There was then an evidentiary hearing – some of it outside the presence of the U.S. Attorneys. At the conclusion of the hearing, the Court held that Ruehle reasonably believed that Irell was gathering facts for his defense. The Court went on to say that even if there was an oral Upjohn warning, it was not enough, because such a warning should have been in writing and acknowledged by Ruehle. The Court further stated that the subject of the attorney-client privilege and whether an Upjohn warning was given was very important because Ruehle faces a significant prison sentence if convicted in the criminal case. The Court found Irell breached its duties to Ruehle in disclosing information he told them. The District Court in its decision suppressed the statements of Ruehle to the Irell lawyers and referred the Irell Firm to the State Bar Disciplinary authorities.

The government sought, and was granted, an interlocutory appeal to the Ninth Circuit seeking to overturn the decision to suppress the Ruehle disclosures.

At the outset the Ninth Circuit acknowledged the “’treacherous’ path which Corporate Counsel must tread under the attorney-client privilege when conducting an internal investigation to advise a publicly traded company of its financial disclosure obligations.” Broadcom’s outside counsel recommended that Broadcom restate its earnings to account for 2.2 billion in additional stock-based compensation expenses.
The statements of Ruehle were not made in confidence but were for the disclosure to the corporate auditors. Ruehle never attempted to segregate what he considered what was privileged and what was not privileged with regard to the information furnished in his conversations with Irell.

The Ninth Circuit stated that the overwhelming evidence demonstrates that Ruehle’s statements to Irell lawyers were not made in confidence but rather for the purpose of outside disclosure.

The interlocutory appeal of the government was successful. The Order of the District Court suppressing Ruehle’s statements was overturned. The Ninth Circuit stated that the reference to the Bar authorities was not before it on appeal and therefore it did not enter into that area of whether that referral was appropriate. The case represents a series of questionable acts.

Why did an experienced corporate officer, Ruehle, proceed without clear written assurances from Broadcom, his employer, and Irell, his lawyer, in the option backdating cases that disclosures he might make were subject to the attorney-client privilege? Or, why did Ruehle not ask for separate counsel? Ruehle’s lapse is difficult to understand. The Indemnification By-laws of Broadcom undoubtedly provided that Ruehle could have retained separate counsel at least initially at the expense of Broadcom.

Why did Irell proceed with a dual representation without written acknowledgement by Broadcom and Ruehle that it was representing both, that a conflict might well develop and that such a conflict might involve Broadcom blaming Ruehle of the wrongful backdating. However, even if Irell had such acknowledgment, would its disclosures have breached Irell’s duty of loyalty to Ruehle? A lawyer cannot furnish adverse information about a client.

Why didn’t the General Counsel of Broadcom intervene and insist on a full disclosure of the conflict in the interests of his corporate employer, Broadcom?
Should Ruehle be found guilty following a trial, it seems to be a prime case for review by the United States Supreme Court.

Edward X. Clinton, Sr.
Copyright 2009

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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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