Wednesday, November 04, 2009

Easterbrook, Posner, Buffett, Bogle, Behavioral Finance, the Obama Administration, and Scads of Finance and Business Law Profs -- All in One Case at SCOTUS Yesterday

By Bob Hockett

The Supreme Court heard oral arguments Monday in a fascinating case that DoL readers might find particularly interesting in a time of financial turbulence. The case is Jones v. Harris Associates, LLP, No. 08-586, wherein plaintiff, a mutual fund investor, challenged fees charged by the fund's investment advisor under Section 36(b) of the 1940 Investment Company Act. The case is of interest not only for a number of doctrinal and economic reasons, but also for the two judges it pitted against one another below. For the case finds its way up to SCOTUS after a Seventh Circuit decision not to rehear the case en banc after first finding for the defendant. And that rehearing decision split 5-5 with Chief Judge Easterbrook writing for the winning side in the dispute, and Judge Posner writing for the losing side. (The eleventh judge recused.) Of additional, albeit related interest is the cast of amici who filed briefs with the Court, which constitutes a partial Who's Who of well regarded legal and financial theorists and practitioners, not to mention the SG's office.

Let me first say a brief word about the economic and what I'll call the "structural" significance of the case for the financial services industry, which will be of interest to our nonlawyer readers as well as to lawyers. Then I'll briefly indulge my lawyer's interest in a few of the doctrinal and other legal curios that the case draws out. Then I shall hazard a quick opinion of my own.

Many Americans nowadays invest sizeable portions of their savings in what are known as "investment companies" (ICs). ICs are pooled investment vehicles that enable investors efficiently to diversify investments in broad portfolios of stock- and bond-issuing firms. If you've got $100 spare dollars and Microsoft, Ford, and eight other firms all sell shares at $100 per, alone you will only be able to invest in one. Pool your savings with nine other similarly situated folk and you can each effectively diversify over ten companies, which can be made a good bit safer than putting all of your eggs in only one -- even very good -- basket would be. You might think of ICs as a sort of "upside" counterpart to insurance, inasmuch as they amount to forms of risk-pooling that minimize downside losses that individuals might experience in pursuit of "upside" opportunities.

ICs come in two particularly well-known flavors: so-called "closed end" and "open end" funds. The latter are better known to most Americans as "mutual funds." What distinguishes them -- and the sense in which they are "open" -- is the fact that investors can typically enter and exit at will. As many new shares as might be desired generally are made available to new investors, and these shares are then redeemable at current market value any time the investor wishes to withdraw her investment. The consequent ease of entry and exit renders open end funds attractive even to relatively unsophisticated, small fry investors as higher-yield substitutes for, or complements to, savings and checking accounts held at commercial banks. (Closed end funds, as the name suggests, do not offer this ease of entry and exit. They tend in consequence to cater to wealthier, more sophisticated investors willing to park large sums of money in their funds for the long haul.)

Open end investment companies -- or again, mutual funds, or what I shall now simply call "funds" -- rapidly grew and proliferated commencing in the late 1960s. Several factors accounted for this. One was the combination of a booming stock market, high inflation rates, and mandatorily low bank-offered interest rates of the era, which induced a search by savers for higher-yielding investment that were nonetheless easy to understand and use, and reasonably safe in the way that diversified portfolios often are. Another was the development of financial theory, which increasingly came to afford even non-rocket-scientist investment managers the capacity to diversify away much of the risk of investment while nevertheless realizing respectable returns. Yet another was ERISA and related changes to the tax code commencing in the early 1970s, all of which were meant to encourage more retirement investment on the part of baby-boomers now well ensconced in the work force. The end result was a virtual "explosion" of mutual fund investments, to the point that today it is estimated that over 50 million -- about half of -- American households, numbering to upwards of 90 million adult citizens, directly (in IRAs or related investment categories) or indirectly (through pension funds or similar vehicles) hold upwards of $10 trillion in assets under management in mutual funds.

So much for the broad economic backdrop. Now to the "structural." The Jones case is rooted in the way that mutual funds generally are organized and run. Typically what happens is this: A so-called "Investment Advisor" (IA, or "advisor") organizes a fund either as a trust or as a stripped-down corporation under a particular state's corporate code or business trust statute. The fund is then treated as a simple legal entity that is effectively nothing more than a pot of money -- the pooled funds of investors. The advisor also names a board to oversee this fund, and to decide what fees to pay those who manage the fund's investments. Who does that managing? Easy: in most cases, the advisor her-, him- or itself, or persons retained for the task. So the advisor acts much as the management of any business corporation, while the board acts much as do boards of such corporations. Investment advisors also, quite often, establish multiple distinct funds or "families" of funds, and name board members to each distinct fund or family. In addition to playing this role, many investment advisors engage in another activity more clearly indicated by the term for them -- they advise, in this case even for funds that they have not organized or named the boards for. In light of this dual role, funds with which IAs are affiliated often are categorized in the industry as "captive" and "independent." Captive funds are those organized by, and whose boards are named by, their investment advisors. Independent funds -- often pension funds sponsored by employers -- are those that are simply advised by their investment advisors.

Now to the specifically legal aspects of the Jones case. As the term "captive" suggests, the relation between IAs and their "captive" funds occasions some legal concern. The reason is fairly clear -- and indeed is richer even than the litigants in Jones appear to have emphasized. Advisors to captive funds name the boards of those funds, and it is these boards that in turn vote in favor of or against the fee arrangements that advisors make with the funds. The fact that the board members are in effect indebted to the advisors whose compensation they are to decide is of course thought to render them less than optimally vigilant. That much the litigants in Jones have noted. What has received less attention in Jones is that often the boards of funds are indebted to advisors for more than their positions with particular funds whose shareholders bring suit in particular cases: Often they are indebted to those advisors for naming them to *other* funds as well. Indeed it's quite common that one board member might sit on the boards of ten or more funds managed by the same advisor. The conflict of interest can be very stark in such cases.

The law of course reflects cognizance of this danger, and the forms that this reflection takes give rise to doctrinal puzzles that I believe ought to fascinate lawyers a bit more than they seem in general to do.

The first means by which the law addresses the conflict is via the fiduciary doctrine of the state in which any fund is organized. State law fiduciary doctrine typically divides into discrete duties of care, loyalty, and obedience, and the relations between mutual fund boards and investment advisors ought in theory to implicate some manner of "hybrid" between traditionally relaxed care review and traditionally more exacting loyalty review. (Perhaps something like the apparently middling new "duty of good faith" that some commentators attribute to the Delaware Supreme Court in its recent fiduciary duty jurisprudence.) The reason I say this is that fund directors are in one, formal sense simply making non-conflicted business judgments in deciding what to pay funds' investment advisors, while they are in another, more pragmatic sense at least "vicariously" conflicted in deciding how to pay those to whom they owe their very positions with the funds they direct.

The second means by which the law addresses the conflict is via Section 36(b) of the Investment Company Act of 1940 (ICA, or "the Act"), which is actually the section under which the Jones case has been litigated. Section 36(b), added to the Act in 1970 in response to perceived abuses in the fee arrangements between funds and advisors, is somewhat puzzlingly worded -- so much so that Justices Breyer and Kennedy yesterday wondered aloud about the provision's import, while Justice Scalia predictably labeled the statutory language "utterly meaningless." What the Section does is impose upon investment advisors "a fiduciary duty with respect to the receipt of compensation for services." It also directs courts to give "such consideration as [they] consider[s] due under the circumstances" to the fact that a fund's board has approved a challenged advisory fee.

One puzzle that Section 36(b) introduces, of course, is just what fiduciary duty the Congress had in mind, given the traditional divvying up of fiduciary duty into discrete duties. A second puzzle that it introduces is whether and how this fiduciary duty, what ever it is, should interact with the state fiduciary doctrine in which ever state a particular fund is organized. Does anyone hear the phrase "federal common law" Eriely echoing here? (In one sense, you shouldn't, since we're talking federal question under 36(b), and state law question under state trust and corporate law.  But in the absence of a well developed federal common law of fiduciary duties under the ICA or associated Roosevelt-era finance-regulatory statutes, the fiduciary doctrine of the state where a fund is organized is sometimes apt to tempt.)  Finally, a third puzzle raised by Section 36(b) -- and the only one, as it happens, that had actually been discussed prior to oral argument yesterday before SCOTUS -- is how, precisely, a court is to determine whether a particular investment advisor's fee arrangement with a fund falls afoul of the fiduciary standard "articulated" in Section 36(b). But though this third puzzle is the only one substantially argued over below, the way the Seventh Circuit went about addressing it has occasioned plenty of procedural interest in its own right!

Until the Seventh Circuit's decision last year, the practical answer, such as it is, to our third puzzle long had been that supplied by the Second Circuit in its 1982 decision, Gartenberg v. Merrill Lynch Asset Management (cert. denied, 1983). Under the Gartenberg standard, an Investment Advisor falls afoul of ICA Section 36(b) only by "charg[ing] 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." The general rule under Gartenberg is that fees are to fall "within the range of what would have been negotiated at arm's length in the light of all of the surrounding circumstances."

Perhaps needless to say, few plaintiffs have tended to prevail under this standard, notwithstanding its broad conferral of discretion upon district courts in considering "surrounding circumstances." The principal reason is that federal courts, rather like state courts in garden variety corporate law fiduciary duty cases, have as a practical matter proved reluctant to impugn the independence of directors even of "captive" funds, at least provided that one or more such directors were not beholden to their funds' advisors for multiple additional directorships. I'm often forced to issue a crooked-smiled apology to my Financial Institutions students when we cover the leading cases here.

The plaintiffs in Jones, however, sought to prevail under Gartenberg by adducing a novel ground for discrediting directorial approval of investment advisory fees: They argued that Harris Associates, as investment advisor for the Oakmark group of funds in which plaintiffs invested, could clearly be seen to have acted in violation of the standard in virtue of having charged much higher fees to its "captive" funds than it did to its independent ones. That disparity, they argued, indicated that the directors of the "captive" Oakmark funds must indeed have been captive, and the fees accordingly not those that would have been negotiated in true arms-length negotiations between bona fide representatives of shareholders on the one hand and an investment advisor on the other hand.

Now, you might have thought that this argument would invite a more or less careful judicial inquiry, of an at least partly empirical character, into whether the disparity in fees charged Harris Associates' captive funds and its independent ones could be innocently explained. But that isn't quite what happened. Indeed oral argument yesterday afforded some indication that the SCOTUS and the litigants alike remain a bit puzzled as to how best to characterize what *did* happen.

Here is what happened. First, the district court in Jones v. Harris granted Harris's motion for summary judgment under the Gartenberg standard, on grounds of representations by Harris Associates that the services rendered its captive funds, which held many more dollars' worth of assets under management than did its independent funds, simply were more costly to render even on a pro rata basis. And while it is not clear on the basis of prior precedent under Gartenberg that this decision was incorrect, it also is not clear that it is correct. Perhaps seeing this, the Seventh Circuit, per Judge Easterbrook, took a surprising step on appeal: It not only affirmed the district court's decision on the grounds given by that court, but also while at it went out of its way expressly, and it seems unnecessarily, to disavow Gartenberg, in the act introducing a pronounced circuit split. (Two other Circuits additional to the Second follow Gartenberg.) And it is here that things grow particularly interesting, particularly against the backdrop of renewed public discussion about the allocative efficiency of capital markets and the reliable rationality of their participants.

Judge Easterbrook disavowed Gartenberg because, in his words, it relied "too little on markets." Where there is no evidence that an investment advisor "pulls the wool over the eyes" of a fund's shareholders, he argued, and where there are literally thousands of mutual funds among which investors can shop, investment advisory fees are presumptively fair and "judicial price-setting" will be out of place. Any advisory fee is effectively within the law, Easterbrook argued, so long as advisors "make full disclosure and play no tricks." For again, in a market where there are thousands of funds, including low fee index funds, among which investors can shop, there simply is no reason to suspect that competition is insufficient to keep fees down to their socially optimal level. Even less is there reason, Easterbrook opined, to think that courts could do better.

Plaintiffs' appeal for rehearing en banc brought yet another interesting wrinkle to the case. The full court split 5-5, with Judge Posner writing the dissent to what defaulted to being an effective denial of the appeal for rehearing. The clash between Posner and Easterbrook makes for fascinating reading. Posner first noted that Easterbrook's claims that the 7th and other Circuits had earlier found Gartenberg wanting were simply not supported by the prior decisions to which he cited in footnotes, in that those were not excessive fee cases. Posner next noted that an influential 2007 article by John Coates and Glenn Hubbard upon which the court relied actually came down in favor of the Gartenberg standard, even while recommending some "fine tuning." Then Posner observed, notably, that the panel had based its rejection of Gartenberg "mainly on an economic analysis that is ripe for reexamination..." Zounds! Why? Because 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." Here Posner cited Bebchuk and Fried's widely cited "Pay without Performance" article of 2004, along with, characteristically, a slew of others. He then went on to point out how abuses were particularly rampant in the financial services industry in particular, and in the mutual fund industry more particularly still, once again citing impressively.

Posner had particularly harsh words for the casual speculations that the panel offered putatively to account for the differential fees Harris Associates charged its captive and its independent funds. "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." Posner also noted that the governance structure that characterizes advisors' relation to their captive funds is industry-wide, meaning that the panel's agreement with defendants that it was better to compare Harris's fees with those charged to other captive mutual funds rather than to independent funds was ill-considered. It would virtually guarantee that what might be exorbitant fees will come to constitute an industry floor, all while too hastily rejecting what might be a better baseline of comparison -- the fees charged independent funds, as proposed by plaintiffs -- on the basis of no more than "airy speculation." Finally, Posner noted that the panel's opinion created a circuit split, and that the panel had not acknowledged this or circulated its opinion to the full court in advance of publication, as the court requires when a circuit split is created by a panel decision.

The procedural oddities attending the Jones case below in the Seventh Circuit made for some fascinating moments of confusion in oral argument before the SCOTUS yesterday. Asked by Justice Sotomayer whether he wished to disavow Judge Easterbrook's ground for ruling in favor of the defendants, John Donovan, counsel for Harris Associates said "I do not defend that." Instead, he argued that the Justices should affirm the district court decision, ignoring the Seventh Circuit panel's decision. Nevertheless, Chief Justice Roberts and Justice Scalia appeared sympathetic to the Easterbrook line of thinking. Roberts observed that one could ascertain the management fees charged mutual fund investors, and pull out of funds whose fees are unattractive, within 30 seconds on Morningstar. Scalia questioned the competence of courts to second-guess boards of directors. Breyer and Sotomayer, by contrast, were openly skeptical about the reliability of the market to police mutual fund fees. Thomas, for his part, was silent as ever. So was Alito. Stevens posed only one question. Breyer was less vocal than usual, with laryngitis. Kennedy, as mentioned, puzzled over what Section 36(b) could mean by "fiduciary." Ginsburg, like Breyer and Sotomayer, appeared to be inclined to remand to the district court for explicit factual findings. There were also some indications that some Justices, as well as counsel for both parties to the litigation, were puzzled over whether Judge Easterbrook's proposed new standard really was incompatible with Gartenberg.  Finally, all parties, it is reported, were uncharacteristically subdued throughout yesterday's proceedings, with defendant's counsel, Mr. Donovan, using only 25 of his alloted 30 minutes in argument.

Nearly as interesting as the doctrinal puzzles and procedural idiosyncrasies attending Jones is its array of amicas briefs. Submitting briefs on behalf of plaintiffs were an array of legal and "behavioral finance" luminaries including Ian Ayres, Robert Litan, and a large passel of law professors. Many of the arguments proffered by these parties highlighted the market failures apt to be found in the financial markets owing to behavioral-psychological dispositions figuring large in much empirical legal scholarship these days. (Indeed the briefs read almost as "primers" of the still burgeoning field.) Also submitting briefs for the plaintiffs were John Bogle, renowned financier and founder of the innovative Vanguard group of low fee index funds, and the Solicitor General's office under Solicitor General and recent Harvard Law School Dean Elena Kagan. Warren Buffet, though he did not file an amicus brief, also had spoken out on behalf of the plaintiffs in Jones. Arrayed against these parties in the amicus sweepstakes were a number of investment companies and industry groups, including the most influential in this context, the ICI.

What to make of all of this, and what to recommend? Well, I've got three quick thoughts and a recommendation.

First, as a matter of appellate procedure, one thing that SCOTUS might do is simply affirm the Seventh Circuit under some perhaps fine-tuned or further clarified version of the Gartenberg standard that has come to prevail in other Circuits over the past quater-century, noting that the disctrict court itself had done so and that the Seventh Circuit panel had unnecessarily muddied the waters in going out of its way unnecessarily to slap together a new standard, unteathered in either the language of or Congressional intent prompting Section 36(b), out of whole cloth. And in light of prior precedent under Gartenberg even in the Seventh Circuit itself, there would be no glaring doctrinal error in a decision to this effect. But I'm not going to recommend this, and I'll say why in a moment.

Second, as a "big picture" doctrinal matter, one might imagine SCOTUS acting in some way to clarify that status of federal "fiduciary" law under the ICA and other statutes from the same era, with an eye in particular to how, if at all, it should interact with state fiduciary duty doctrines applicable in the states in which firms subject to both federal and state fiduciary doctrine are organized. There appears to be a large Erie-reminiscent (though as noted above, not Erie-doctrinal) "federal common law" question lurking here that's at bottom of Justice Kennedy's puzzling yesterday, and that at some point might have to be resolved. And there is the related, and still hotly contested, larger backdrop question of the appropriate federal role in traditionally state-determined matters of corporate governance.  There are quite a few ways one might imagine the Court embarking upon any such attempt at clarification, but I won't elaborate these here basically because I doubt that the Court is in any mood to address any such "big picture" questions in connection with this case, and am not sure that I'd be in such a mood either. So I won't recommend -- or predict -- this course either for Jones.

Finally third, as a matter both of "judicial minimalism" and of sensible policy prudence, one might imagine -- and I'm going to hope -- that the Court will go the route that Justices Breyer, Ginsburg, and Sotomayer seem to be leaning, and that is effectively entailed by Judge Posner's apt observations in his dissent below. In a word, defendants in Jones *might* very well be right that to compare fees charged captive funds to those charged independent ones is illicitly to compare "apples and oranges," and hence not to go correctly about the task of determining whether the first set of fees can plausibly be characterized as arms-length. But defendants might *also* be *incorrect* in suggesting this, and this is precisely the point. The district court erred, in my judgment, in not subjecting the dispute over appropriate bases of comparison in captive fund fee cases to at least moderately careful empirical scrutiny. And that is the case partly because such inquiry is not difficult to manage, and partly because there is very good reason to be skeptical about (a) captive boards' capacities to act independently even when acting in good faith, (b) captive funds' capacity, therefore, meaningfully to compete with one another on fees, and (c) small fry investors' capacities actually to shop carefully among captive funds. Against this combined low-cost-of-court-inquiry, high-likelihood-of-market-failure backdrop, surely the best course of action for SCOTUS to take is to remand to the district court under some version of the Gartenberg standard, which is capacious enough as it is to take due account of a competitive market if it is found empirically to be there.