Jerry Jones v. Harris Associates ( 2008 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 07-1624
JERRY N. JONES, MARY F. JONES,
and ARLINE WINERMAN,
Plaintiffs-Appellants,
v.
HARRIS ASSOCIATES L.P.,
Defendant-Appellee.
____________
On Petition for Rehearing and
Rehearing En Banc
____________
DECIDED AUGUST 8, 2008
____________
Before EASTERBROOK, Chief Judge, and KANNE and EVANS,
Circuit Judges.
PER CURIAM. The panel has voted unanimously to deny
the petition for rehearing. A judge in active service
called for a vote on the suggestion for rehearing en banc.
A majority did not favor rehearing en banc, and the
petition therefore is denied. Circuit Judge Ripple did not
participate in the consideration or decision of this case.
2 No. 07-1624
POSNER, Circuit Judge, with whom Circuit Judges
ROVNER, WOOD, WILLIAMS, and TINDER join, dissenting
from denial of rehearing en banc.
This case merits the attention of the full court. The panel
rejected the approach taken by the Second Circuit in
Gartenberg v. Merrill Lynch Asset Management, Inc., 694
F.2d 923 (2d Cir. 1982), to deciding whether a mutual
fund adviser has breached his fiduciary duty to the fund,
the duty created by section 36(b) of the Investment Com-
pany Act, 15 U.S.C. §§ 80a-1 et seq. Gartenberg permits a
court to consider, as a factor in determining such a breach,
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.” 694 F.2d at 928. The panel opinion states that
it “now disapprove[s] the Gartenberg approach. . . . A
fiduciary must make full disclosure and play no tricks but
is not subject to a cap on compensation.” Jones v. Harris
Associates L.P., 527 F.3d 627, 632 (7th Cir. 2008).
The opinion says that this court had previously sug-
gested that the Gartenberg approach “is wanting.” Id. It cites
Green v. Nuveen Advisory Corp., 295 F.3d 738, 743 n. 8 (7th
Cir. 2002), for this proposition, but neither in footnote 8
nor elsewhere in that opinion is there any suggestion that
Gartenberg’s treatment of the issue of excessive fees is
incorrect; Green was not an excessive-fee case. The panel
cites another Green opinion, Green v. Fund Asset Manage-
ment, L.P., 286 F.3d 682 (3d Cir. 2002), as suggesting
disagreement with Gartenberg, but again the amount of
compensation was not at issue.
Jones is the only appellate opinion noted in Westlaw as
disagreeing with Gartenberg; there is a slew of positive
citations. See, e.g., Migdal v. Rowe Price-Fleming Int’l, Inc.,
No. 07-1624 3
248 F.3d 321, 326-27 (4th Cir. 2001); In re Salomon Smith
Barney Mutual Fund Fees Litigation, 528 F. Supp. 2d 332, 336-
37 (S.D.N.Y. 2007); Gallus v. Ameriprise Financial, Inc., 497 F.
Supp. 2d 974, 979 (D. Minn. 2007); Sins v. Janus Capital
Management, LLC, 2006 WL 3746130, at *2 (D. Colo. Dec. 15,
2006); Siemers v. Wells Fargo & Co., 2006 WL 2355411, at *15-
16 (N.D. Cal. Aug. 14, 2006); Hunt v. Invesco Funds Group,
Inc., 2006 WL 1581846, at *2 (S.D. Tex. June 5, 2006); Stegall
v. Ladner, 394 F. Supp. 2d 358, 373-74 (D. Mass. 2005);
Becherer v. Burt, 2003 WL 24260305, at *2 (S.D. Ill. Mar. 6,
2003); Millenco L.P. v. MEVC Advisors, Inc., 2002 WL
31051604, at *3 (D. Del. Aug. 21, 2002). The Coates
and Hubbard article that the panel cites, John C. Coates &
R. Glenn Hubbard, “Competition in the Mutual Fund
Industry: Evidence and Implications for Policy,” 33 J.
Corp. L. 151 (2007), expressly approves Gartenberg, while
seeking to fine tune judicial interpretations of some
Gartenberg dicta. In the section of the article captioned
“Refinements to Gartenberg,” the authors state that “radical
shifts in existing law, or for sweeping new laws and
regulations, are unwise on the ground that the case has
not been made that the existing framework for regulation
of funds and advisory fees is intrinsically flawed.” Id. at
213. It’s not as if Gartenberg has proved to be too hard on
fund advisers. “Subsequent litigation [after Gartenberg]
in excessive fee cases has resulted almost uniformly in
judgments for the defendants . . . although there have
been some notable settlements wherein defendants have
agreed to prospective reduction in the fee schedule.” James
D. Cox et al., Securities Regulation: Cases and Materials
1211 (3d ed. 2001); see also James D. Cox & John W. Payne,
“Mutual Fund Expense Disclosures: A Behavioral Perspec-
tive,” 83 Wash. U. L.Q. 907, 923 (2005).
4 No. 07-1624
The panel bases its rejection of Gartenberg mainly on an
economic analysis that is ripe for reexamination on the
basis of growing indications that executive compensa-
tion in large publicly traded firms often is excessive
because of the feeble incentives of boards of directors to
police compensation. See, e.g., Lucian Bebchuk & Jesse
Fried, Pay without Performance: The Unfilfilled Promise of
Executive Compensation 23-44 (2004); Charles A. O’Reilly III
& Brian G.M. Main, “It’s More Than Simple Economics,” 36
Organizational Dynamics 1 (2007); Ivan E. Brick, Oded
Palmon & John K. Wald, “CEO Compensation, Director
Compensation, and Firm Performance: Evidence of
Cronyism?,” 12 J. Corp. Finance 403 (2006); Arthur
Levitt, Jr., “Corporate Culture and the Problem of Execu-
tive Compensation,” 30 J. Corp. Law 749, 750 (2005); Gary
Wilson, “How to Rein in the Imperial CEO,” Wall St. J., July
9, 2008, p. A15; Joann S. Lublin, “Boards Flex Their
Pay Muscles: Directors Are Increasingly Exercising More
Clout in Setting CEO Compensation; and in Some Cases,
the Boss Is Actually Feeling a Little Pain,” Wall St. J., Apr.
14, 2008, p. R1; Ben Stein, “In the Boardroom, Every Back
Gets Scratched,” N.Y. Times, Apr. 6, 2008, p. B9. Directors
are often CEOs of other companies and naturally think
that CEOs should be well paid. And often they are picked
by the CEO. Compensation consulting firms, which
provide cover for generous compensation packages
voted by boards of directors, have a conflict of interest
because they are paid not only for their compensation
advice but for other services to the firm—services for which
they are hired by the officers whose compensation they
advised on. Bebchuk & Fried, supra, at 37-39; Gretchen
Morgenson, “How Big a Payday for the Pay Consultants?,”
N.Y. Times, June 22, 2008, p. B1; Neil Weinberg, Michael
Maiello & David K. Randall, “Paying for Failure,” Forbes,
May 19, 2008, p. 114; Joann S. Lublin, “Conflict Concerns
No. 07-1624 5
Benefit Independent Pay Advisors,” Wall St. J., Dec. 10,
2007, p. B3; Warren E. Buffet, “Letter to the Shareholders
of Berkshire Hathaway, Inc.,” Feb. 27, 2004, p. 8,
www.berkshirehathaway.com/letters/2003ltr.pdf (visited
July 28, 2008).
Competition in product and capital markets can’t be
counted on to solve the problem because the same struc-
ture of incentives operates on all large corporations and
similar entities, including mutual funds. Mutual funds
are a component of the financial services industry,
where abuses have been rampant, as is more evident now
than it was when Coates and Hubbard wrote their article.
A business school professor at Northwestern University
recently observed that “business connections can mitigate
agency conflicts by facilitating efficient information
transfers, but can also be channels for inefficient favorit-
ism.” She found “evidence that connections among
agents in [the mutual fund industry] foster favoritism, to
the detriment of investors. Fund directors and advisory
firms that manage the funds hire each other preferentially
based on past interactions. When directors and the man-
agement are more connected, advisors capture more
rents and are monitored by the board less intensely. These
findings support recent calls for more disclosure re-
garding the negotiation of advisory contracts by fund
boards.” Camelia M. Kuhnen, “Social Networks, Corporate
Governance and Contracting in the Mutual Fund Industry”
(Mar. 1, 2007), http://ssrn.com/abstract=849705 (visited
July 28, 2008). The SEC’s Office of Economic Analysis (the
principal adviser to the SEC on the economic aspects of
regulatory issues) believes that mutual fund “boards
with a greater proportion of independent directors are
more likely to negotiate and approve lower fees, merge
6 No. 07-1624
poorly performing funds more quickly or provide greater
investor protection from late-trading and market timing,”
although “broad cross-sectional analysis reveals little
consistent evidence that board composition is related to
lower fees and higher returns for fund shareholders.”
“OEA Memorandum: Literature Review on Independent
Mutual Fund Chairs and Directors,” Dec. 29, 2006,
www.404.gov/rules/proposed/s70304/oeamemo122906-
litreview.pdf (visited July 28, 2008).
A particular concern in this case is the adviser’s charging
its captive funds more than twice what it charges inde-
pendent funds. According to the figures in the panel
opinion, the captives are charged one percent of the first
$2 billion in assets while the independents are charged
roughly one-half of one percent for the first $500 million
and roughly one-third of one percent for everything above.
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. And there is
no doubt that the captive funds are indeed captive. The
Oakmark-Harris relationship matches the arrangement
described in the Senate Report accompanying § 36(b): a
fund “organized by its investment adviser which pro-
vides it with almost all management services.” S. Rep. No.
184, 91st Cong., 1st Sess. 41 (1969), quoted in Green v. Fund
Asset Management, L.P., supra, 286 F.3d at 685. Financial
managers from Harris founded the Oakmark family of
funds in 1991, and each year since then the Oakmark Board
of Trustees has reselected Harris as the fund’s adviser.
Harris manages the entire Oakmark portfolio, which
consists of seven funds. The Oakmark prospectus describes
the relationship this way: “Subject to the overall authority
No. 07-1624 7
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 Funds, “Prospec-
tus,” Jan. 28, 2008, p. 36, www.oakmark.com/fundlit/
literature.asp?selected=Prospectus# (visited July 28, 2008).
Recall Professor Kuhnen’s observation that “when directors
and the management are more connected, advisors
capture more rents and are monitored by the board less
intensely.”
The panel opinion says that the fact “that mutual funds
are ‘captives’ of investment advisers does not curtail this
competition. An adviser can’t make money from its captive
fund if high fees drive investors away.” 527 F.3d at 632.
That’s true; but will high fees drive investors away? “[T]he
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).
The panel opinion acknowledges that the level of com-
pensation of trustees could be “so unusual that a court
will infer that deceit must have occurred, or that the
persons responsible for [the] decision have abdicated.” 527
F.3d at 632. Compensation that is “so unusual” might not
seem to differ materially from compensation that is “so
disproportionately large.” But although one industry
8 No. 07-1624
commentator has suggested that “courts may . . . conclude
that in fact what the Court of Appeals has done [in Jones] is
merely articulate the Gartenberg standard in a different
way,” “Seventh Circuit ‘Disapproves’ Gartenberg, But
Is This New Approach Fundamentally Different?,” May 27,
2008, www.bingham.com/Media.aspx?MediaID=7004
(visited July 28, 2008), this misses an important difference
between the Gartenberg approach and the panel’s approach.
The panel’s “so unusual” standard is to be applied solely
by comparing the adviser’s fee with the fees charged
by other mutual fund advisers. Gartenberg’s “so dispropor-
tionately large” standard is rightly not so limited. The
governance structure that enables mutual fund advisers
to charge exorbitant fees is industry-wide, so the panel’s
comparability approach would if widely followed allow
those fees to become the industry’s floor. And in this case
there was an alternative comparison, rejected by the panel
on the basis of airy speculation—comparison of the fees
that Harris charges independent funds with the much
higher fees that it charges the funds it controls.
The panel opinion points out that courts do not
review corporate salaries for excessiveness. That misses
the point, which is that unreasonable compensation can
be evidence of a breach of fiduciary duty.
The opinion is recognized to have created a circuit split,
although the panel did not acknowledge this or circulate its
opinion to the full court in advance of publication, as is
required when a panel creates a circuit split. See, e.g.,
“Fund Alert: Seventh Circuit Rejects Gartenberg Approach
to Determining the Appropriateness of Mutual Fund
Management Fees,” May 2008, www.stradley.com/
newsletters.php?action=view&id=347; “Investment
Management Alert: Seventh Circuit Court of Appeals
No. 07-1624 9
Rejects Gartenberg,” June 2, 2008, www.drinkerbiddle.com/
files/Publication/f74b9bc2-9376-4b60-b732-
0242868a873c/Presentation/PublicationAttachment/be9
e677f-8b35-440a-8b53-022caedb13e0/Gartenberg.pdf;
“Email Alerts: It’s Too Early to Disregard the Gartenberg
Factors During Advisory Fee Renewals,” May 27, 2008,
www.wilmerhale.com/publications/whPubsDetail.aspx
?publication=8329; “Appeals Court Rejects Mutual Fund
Excessive Fee Claims, Adopting New Standard for Evalua-
tion of Fees,” May 20, 2008, www.ropesgray.com/
litigationalert/?PublicationTypes=0c16874b-f94e-4696-
b607-de259b87a13f; “The Future of Gartenberg: A New
Approach in Evaluating Investment Advisor Fees,” May
2008, www.paulhastings.com/assets/publications/
919.pdf?wt.mc_ID=919.pdf. (All these web sites were
visited on July 28, 2008.)
The outcome of this case may be correct. The panel
opinion gives some reasons why, though one of them is
weak in its unelaborated form: that the funds managed by
Harris have grown faster than the industry norm. One
would need to know over what period they had grown
faster to know whether other than random factors were
at work. But the creation of a circuit split, the importance
of the issue to the mutual fund industry, and the one-sided
character of the panel’s analysis warrant our hearing
the case en banc.
8-8-08