Conglomerate

In Berle's Footsteps

2009-11-07T18:29:42-07:00

Chuck O'Kelley has assembled a fascinating group of scholars to examine the legacy of Adolf A. Berle, Jr. at a conference called "In Berle's Footsteps." The conference prompted me to revisit The Modern Corporation and Private Property, which I first read in the mid-1990s upon entering legal academe. The book is full of profound insights, but one that jumped off the page on this reading is that the conventional account of the separation of ownership and control in the legal literature is misleading. Modern legal academics tend to think of the separation of ownership and control as a cause of problems (i.e., agency costs) in search of a solution. But Berle clearly viewed the separation of ownership and control as a solution to problems of non-liquidity that (according to Berle) burdened traditional forms of property ownership. Here are a couple of passages:

To divide [non-liquid] properties into participations involves the creation of a mechanism, by which their management and integral quality is undisturbed, despite the transfer from hand to hand of relatively low-priced participations in them. This has been accomplished by the aid of the corporate device and, at least in part, accounts for the popularity of the so-called 'share of stock.'

...

The owner of a non-liquid property is, in a sense, married to it.... To some extent, non-liquid property immobilizes the owner by its own immobility.

...

The separation of ownership from management and control in the corporate system has performed [an] essential step in securing liquidity. It is the management and 'control' which is now wedded to the physical property. The owner has no direct personal relation to it and no responsibility toward it. The management is more or less permanent, directing the physical property which remains intact while the participation privileges of ownership are split into innumerable parts – ‘shares of stock’ – which glide from hand to hand, irresponsible and impersonal.

Berle concludes in a later chapter, the shareholder “has exchanged control for liquidity.”

So the big point here is that the separation of ownership and control is an adaptation that enables liquidity and, in the process, generates greater productivity. That point acknowledged, the separation admittedly creates new problems. In addition to the familiar problem of agency costs, there is the problem of the concentration of power that the corporate form enables: "The rise of the modern corporation has brought a concentration of economic power which can compete on equal terms with the modern state – economic power versus political power, each strong in its own field."

I will attempt to flesh all of this out in a paper to be published next year with the other papers from the conference. In the meantime, if you haven't read The Modern Corporation and Private Property, consider this a plug.

Will Sarbanes-Oxley Be A Casualty of the Financial Crisis?

2009-11-06T11:10:17-07:00

Floyd Norris says yes, and I must say I'm surprised. Despite the raft of academic criticism about Sarbanes-Oxley, it is hard to believe that a deregulatory measure would be a popular sell in Congress, though the column is worth a read on that score. Prediction: if the momentum to revisit the statute is strong enough, it is unlikely that it would not be paired with some financial reform directed at this crisis. In that sense, Sarbanes-Oxley has made a Consumer Financial Products Agency that much more likely.

Thank you, Masters!

2009-11-05T23:00:00-07:00

On behalf of the Glom, I'd like to thank the Masters for making our first Forum such a success. If you are interested in reading the collected posts on Jones v. Harris, you can find them here. And keep an eye out for future Masters Fora at the Glom!

Judicial, Legislative, and Executive Responses to Jones v. Harris

2009-11-05T11:05:51-07:00

With Jones v. Harris now submitted to the justices for their consideration, academics can fill the next few months of silence speculating about the eventual decision and the responses it may evoke. Some commentators have already considered how trial courts might deal with a pro-plaintiff Gartenberg-plus standard and whether Congress would revisit a pro-defendant status quo ruling. But not much time has been spent thinking about how the executive branch will respond.

In fact, of all the considerable ink spilled reporting Monday’s oral arguments, comparatively little was spent on what may have been the most impressive ten minutes of the session: the appearance of Curtis Gannon, Assistant to the Solicitor General, on behalf of the United States. Gannon was, in my opinion, the most polished, poised, and dynamic oral advocate on the day. But some of the hardest questions he faced raised the issue of the executive branch’s role in this area.

Justice Scalia: Well, [the SEC] must be aware of the divergence between the fees that investment advisers charge to these [mutual funds] and what they charge to other clients. Isn’t the SEC aware of that?

Mr. Gannon: It is aware of that.

Justice Scalia: And yet has brought no suits against this industry?

Mr. Gannon: Since 1980 it hasn’t used section 36(b). It has used less formal mechanisms in the context of examinations and investigations –

Justice Scalia: For disclosure, just for disclosure. But that suggests to me that the SEC may think that this is indeed a self-contained industry and that the comparison with investment advice given to other entities is – is not a fair one.

This exchange demonstrates the occasional awkwardness of one executive office (the Solicitor General) representing the interests of another (the SEC). In the SG’s brief, the SG in fact placed a great deal of emphasis on this fee comparison, and yet the SEC’s action, or rather inaction, of the past three decades suggests a different attitude toward the industry.

One is left to wonder whether a single SEC investigation of whichever adviser charges the very highest advisory fee might produce a greater deterrent impact at far lower cost than the huge sums spent annually in private litigation. With an SEC stoking its enforcement division to change the topic from how it overlooked Madoff, is that an action we can expect to see?

Jones v. Harris and the Role of Government in Business

2009-11-05T09:42:41-07:00

One interesting aspect of the Jones v. Harris is how this case and the controversy surrounding it reflect an apparent shift in how judges and government officials are thinking about the role of government in business, and in particular the appropriateness of government input on questions of compensation.

As Usha has observed, for years courts have clung blithely to notions of director independence and arms-length bargaining to eschew difficult judgment calls about when compensation is excessive. Although fairness is the standard for assessing conflict transactions, by invoking director “independence” these questions magically become issues of “business judgment” and judges typically allow a board’s decision to stand.

Just as judges are reluctant to weigh in on the question of how much is too much when it comes to compensation, Congress and the SEC have relied to a large extent on “incentive compensation” requirements and disclosure obligations in vain attempts to constrain executive pay.

With the financial bailout and other unfortunate economic events that seem to belie the “pay for performance” construct, government officials begun to take a more hands-on approach in dealing with compensation issues. The TARP limits, the role of the pay “czar” and new proposals for overseeing bank compensation practices are just a few examples of this kind of intervention.

The Supreme Court’s decision to review Jones v. Harris, and the debate between Judges Easterbrook and Posner on the ability of markets to ensure fair pay practices is also a sign that the “independence” and “market efficiency” rationales for deference on pay decisions are beginning to lose force. I make no predictions on the outcome of the case, but only note that judges and regulators seem to be asking questions and taking actions in compensation matters that they had assiduously avoided in the past.

A fiduciary by any other name . . . .

2009-11-05T09:10:56-07:00

Thanks to Gordon, Usha, Michelle, Larry, and others who've written here and elsewhere on the fiduciary duty issue. I admit to finding it a good puzzle.

But honestly (and with due respect to Gordon and his brush-off of the same), I am a bit with Justice Kennedy on this one as to his "I don't know why Congress didn't use some other word" remark. (Go ahead and laugh again, Gordon. I can see you doing it now . . . .) I do find his confusion about what a fiduciary duty is quite puzzling, even troubling, given that we depend upon the judiciary to determine the contents of fiduciary duties in individual contexts. (Nod to Gordon on all this.)

Let's face it. Congress had options here in fixing the problem created by the lack of independence of investment advisors from the funds they advise, and it seems to me that it punted. Honestly, I am not sure Congress knew what it meant by a fiduciary duty in this context. Why was it not more specific about the obligation owed by the advisor to the fund? Was it ignorance, laziness, sloppiness, reckless or willful abdication, public interest politics, . . . ? I would be interested if anyone has an answer to that question based on a review of legislative history or involvement in the legislative process. I have neither done that review or have that involvement.

If arm's-length bargaining is what Congress intended (as the Gartenberg case seems to indicate), why did Congress denominate the duty as "fiduciary" in nature? Why did it not just articulate a clear objective and a supportive process--or focus its attention and drafting on a (non-fiduciary) duty of some kind--perhaps good faith and fair dealing? An obligation of good faith and fair dealing is read into contracts anyway, so maybe all Congress had to do was define its contents in this context (to avoid a sloppy and often unsatisfying common law analysis that does not take into account the independence issue present here).

Of course, none of this matters to the Court's decision in Jones. Congress didn't use some other word. It used the word "fiduciary." And so, as to the fiduciary duty question before the Jones Court, I come out with Larry on the duty of candor concept.

Regulating Derivatives, as a Question of Defining Them

2009-11-04T10:14:25-07:00

A brief break from the Jones v. Harris dialogue to point you to this letter from Barney Frank updating everyone on where the derivatives regulation legislation stands. The broader angle, I suppose, is that there is a question as to who should be defining exactly what financial products should/must be cleared on an exchange.

Congress could define what should be included, it could delegate that task to the CFTC, SEC, or both, or it could leave that task to the exchanges/clearinghouses themselves. Frank's letter suggests that Congress will be doing a bit more defining than it has in the past, but will also leave much of the rest of the definition to the agencies, rather than the exchanges - even though one of those agencies, the CFTC, doesn't appear to want the responsibility.

Making legislation is complicated, like sausage, and the blow by blow is interesting mostly to the shadow enforcement world of private regulators who can assure their clients about what Congress meant, even though appellate courts would be unlikely to bother with every jot and tittle of every letter. Perhaps that is reason enough for the rest of us to give things at least a passing glance.

"Is the fiduciary standard the same?"

2009-11-03T21:41:38-07:00

This is the question that preoccupied Justice Kennedy in yesterday's oral argument in Jones v. Harris. He asked it over and over again in various ways?

"Is Harris a fiduciary in the same sense as a corporate officer and a corporate director? Or does his fiduciary duty differ? Is it higher or lower, same with a guardian, same with a trustee?"
"The word 'fiduciary' -- does fiduciary imply different standards, depending on what kind of fiduciary you are?"
"Is the fiduciary standard the same, without getting into how its applied?"
"Is the fiduciary standard the same for [Harris], for a guardian, for a trustee, for a corporate officer or a corporate director, always the same?"
"Do you think Congress used the term 'fiduciary' in a very special sense here?"

Why is he so preoccupied with this question? After asking all those questions, he tells us:

I will just tell you the problem I'm having with the case. If I look at a standard that the fees must be reasonable and I compare that with what a fiduciary would do, I thought a fiduciary has the highest possible duty. But apparently the submission is the fiduciary has a lower duty, a lesser duty than to charge a reasonable fee. I just find that quite a puzzling use of the word "fiduciary.... I don't know why Congress didn't use some other word." (emphasis added)

I laughed out loud at that last sentence. I wonder if he had another word in mind?

In my experience, many business people and judges who do not specialize in fiduciary law (like Justice Kennedy) have a vague notion that the law imposes a standard set of (demanding) obligations on those who are called "fiduciaries." As I observe at the beginning of my article, The Critical Resource Theory of Fiduciary Duty, this is half right: "courts require fiduciaries to adhere to a general obligation of loyalty, but countless variations on that theme tailor the general obligation to the specific context." So it seems to me that Larry Ribstein is on the right track when he asks, "What fiduciary duties are appropriate to this particular standard form?" (If you are in the mood for a more extensive treatment of this issue in the context of this case, check out William Birdthistle's article, Investment Indiscipline: A Behavioral Approach to Mutual Fund Jurisprudence, where he writes, among other things, "As every law student knows, the term 'fiduciary duty' describes a broad range of obligations, from the most minimal requirements of a bailee to the far more onerous responsibilities of an executor.")

Of course, in this case, the term "fiduciary" was used by Congress in §36(b) of the Investment Company Act of 1940: "the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services." Thus, we could just view this as an exercise statutory interpretation, though "fiduciary" is not a defined term in the statute, so it's not clear how this change in perspective helps things. In the end, it appears that Congress was leaning on the common law to give content to the term.

Where do we start? William Birdthistle surely is correct in asserting, "Any argument that market forces are and ought to be the only restraints on the fees that investment advisors charge fund shareholders – and that courts are ill-suited to this task – must first acknowledge that Congress has already decided otherwise in its enactment of Section 36(b)." Of course, this is a bit of straw man because even Judge Easterbrook did not hold that "market forces are and ought to be the only restraints on the fees." Instead, he held that investment advisors are subject to a fiduciary duty of candor. That is a fairly minimalist understanding of fiduciary duty.

The Gartenberg case has a more expansive understanding of the duty, variously framed as a duty to avoid a fee “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” and a duty to charge a fee “within the
range of what would have been negotiated at arm’s length in light of all the surrounding circumstances.” Lyman Johnson, in A Fresh Look at Director “Independence”: Mutual Fund Fee Litigation and Gartenberg at 25, says that the first formulation looks substantive while the second looks procedural, but I disagree. They both look substantive to me. The focus is on the size of the fee, and the process is mentioned only as a guide to determining a reasonable size. Substantive tests for breach of fiduciary duty are extremely difficult for courts to assess, and courts rarely pull the trigger under a substantive test ... go read Chancellor Allen's Gagliardi case if you need more convincing on that point. Nevertheless, if the process is compromised -- and the process here looks very compromised -- courts don't have much choice but to look at substance. By the way, Judge Posner seems to embrace the substantive standard in his dissent from denial of rehearing en banc: "unreasonable compensation can be evidence of a breach of fiduciary duty."

Usha noted another option from the oral argument that made me laugh. This one came from David Frederick, who was representing the petitioners. Going back to Justice Kennedy's questions, Frederick announced:

What Judge Cardozo, when he was on the New York Court of Appeals, said [is that] a fiduciary represents the punctilio of honor, and that is contrasted with the morals of the marketplace operating at arm's-length. It surely cannot be the case that, where you are dealing with a fiduciary duty -- which is a higher standard recognized in the law -- that you can charge twice as much as what you are obtaining at arm's-length for services that you are providing.

Two points here. First, Frederick is stuck in a world in which "fiduciary" has meaning independent of context. The reason I laughed at his invocation of Meinhard v. Salmon is that this articulation of fiduciary duty stands for the proposition that the fiduciary loses. Seriously, can you live up to the "punctilio of an honor the most sensitive"? Can anyone? The standard is largely vacuous, a fun rhetorical flourish without any meaningful content. If you tried to derive content from this standard, you would be led astray because the talk is too tough.

Second, Cardozo's standard is clearly procedural. It's about how the fiduciary behaves in exercising discretion. Frederick slides from that straight into Gartenberg's substantive standard. Apples and oranges.

So where does this leave us? I think Brett McDonnell got it right: "Gartenberg [is] the worst alternative available, except for all of the others."

Jones v. Harris: The Worst Alternative (Except for all the others)

2009-11-03T14:18:44-07:00

I don't think I buy the crucial arguments for either side in Jones v. Harris. Judge Easterbrook thinks the market for mutual funds is working just dandy, and needs little help from the law. I know the empirical arguments are complex and indeterminate (they always are), but this strikes me as highly unlikely. There are too many unsophisticated retail investors out there, and those gaps between captured and independent funds sure do look suspiciously large. The conflicts and backscratching in this area are ubiquitous. Market competition does set some outer bounds, but it leaves a lot of room for skimming nice pools of money off the top. In part, that's a consequence of the huge amounts of money that get thrown around in American financial markets today. You don't have to divert very much at all in percentage terms into your own pockets in order to make out very well indeed.

So markets are probably not working so well. Still, to make their case, those who want active regulatory intervention need to show that either courts, the SEC, some other agency, or Congress can make things better. Maybe the market level isn't right, but then what is? I haven't seen any really good answer to that question.

Which rather leaves us stuck, I'm afraid. In a forthcoming paper on Executive Compensation and the Optimal Penumbra of Delaware Law, Claire Hill and I suggest using case law to reinforce norm-setting mechanisms that may limit excessive compensation. The idea is that case law often has a low probability of leading to actual liability, but nonetheless sets standards of conduct that agents may follow for reasons other than, or in addition to, avoiding the risk of liability.

Does that approach favor the Gartenberg factors or Easterbrook's position? I'm not sure. I suspect that Easterbrook's position is so hands off that it dictates no norms of conduct whatsoever, beyond that of open disclosure. The Gartenberg factors risk creating too much intervention by courts. But at p. 3 of his dissent, Judge Posner notes, quoting James Cox, that "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." If that is right, it suggests to me that in practice Gartenberg is getting it roughly right, and is worth preserving.

So count this as one cheer for Gartenberg. It's the worst alternative available, except for all of the others.

Independence and Jones v. Harris

2009-11-03T12:57:34-07:00

Here's my Jones v. Harris analogy: say on the University of Georgia's campus each Coke machine was set up by Coke as its own private corporation. Coke picked a board of directors for each Coke machine, and told that board to negotiate supply fees with Coke. Congress imposed on Coke a "fiduciary duty with respect to the receipt of compensation." Petitioners argue that fiduciary duty means a fair fee, which means a fee that would be obtained in an arm's length transaction. And they further argue that there's no arm's length bargaining here; although the Coke machine directors are not interested in the transaction, neither are they really independent--if they reject Coke's offer and ask Coke to lower its fee, then they'll basically be out of a job next year. And that Coke charges "non-captive" machines--i.e., machines in a rest stop or shopping mall--half the price of fees they charge on Georgia's campus. Easterbrook thinks that the fact that there's a soda machine market solves everything: consumers know how much they're paying for a can of Coke, and if they think the campus Cokes are too expensive, they can walk somewhere else. Petitioners disagree. I actually know very little about the Investment Company Act or mutual funds, so this analogy may be seriously flawed, and I invite people to tell me so.

As an independence maven, what interests me is the lack of traction this "can't be fired" argument seems to be have found with the Court. David Frederick (for the plaintiffs) tried to make the point to Justice Sotomayor, who appeared to ignore it. Justice Scalia asked Frederick questions indicated he didn't believe in the disparity of power between board and adviser:

JUSTICE SCALIA: Mr. Frederick, I don't understand your statement that they can't fire the investment adviser. Maybe they can't fire him, but they can insist that he accept a lower fee, right? Surely they can do that, can't they?
MR. FREDERICK: They --
JUSTICE SCALIA: Can they insist that he accept a lower fee? Can they do that.
MR. FREDERICK: In practical terms, no.
JUSTICE SCALIA: Why?
MR. FREDERICK: Because the adviser picks the board of directors.
JUSTICE SCALIA: Oh, no, that's something different. Let's assume you have a disinterested board of directors, which is what the statute requires. You tell me even though they are disinterested, they can't fire the adviser. It seems to me, while they can't fire him, they can say: We are going to cut your fee in half. Whereupon they don't have to fire him. He will pack up and leave, and they will get a new adviser. Doesn't that work?
MR. FREDERICK: There is actually no evidence in any record I am aware of where that has actually happened. The directors have no leverage.

And then Frederick ran out of time.

I was reminded of these acidic lines on independence from Aronson v. Lewis: "it is not enough to charge that a director was nominated by or elected at the behest of those controlling the outcome of a corporate election. That is the usual way a person becomes a corporate director." How much work is the concept of independence doing here? Does independence mean the power to act free from outside influence? Or the absence of conflict? Or something else?

As an aside, I was getting kind of anxious as I neared the end of the 50 page oral argument transcript. Could we possibly have a conversation about fiduciary duty and not mention Meinhard v. Salmon? But there on page 49 was the Cardozo shoutout, courtesy of Fredrick: "what Judge Cardozo, when he was on the New York Court of Appeals, said, a fiduciary represents the punctilio of honor, and that is contrasted with the morals of the marketplace operating at arm's-length."

As those of you familiar with Glom history know, this phrase resonates.

Jones v. Harris: Early Reaction to Today's Argument

2009-11-02T22:17:12-07:00

Have investment advisers chosen a strategic withdrawal to the relative safety of trial courts, where they have never lost a case? Perhaps the most surprising development at today’s oral argument was not the decision of the respondent to abandon Chief Judge Easterbrook’s opinion in the Seventh Circuit, which it had already done on the briefs, but instead to acknowledge the propriety of comparisons between institutional and retail fees. Heretofore, Harris Associates – and the industry generally – had consistently maintained that such comparisons are inapt, unworkable, and unwise.

In the face of this morning’s pointed questioning from Justices Ginsburg, Sotomayor, and especially Breyer, however, oral advocate John Donovan of Ropes & Gray conceded that comparing the fees that advisers charge to different clients “is a factor . . . likely to be relevant.” For years, defendants in these lawsuits have consistently resisted efforts by plaintiffs to petition courts to include and indeed to privilege such a comparison among the Gartenberg series of factors. Unlike comparisons to other mutual fund fees, comparisons between clients reveal that some investors pay twice as much as others for similar investments. So why then would the defendant accede to such a new standard today?

Perhaps Harris Associates calculated that appearing conciliatory before the Court by agreeing to the inclusion of this factor in the overall test would ward off harsher and more dramatic responses either from the Supreme Court in an adverse decision in this case or subsequently from Congress in a revised statute. The adviser might be gambling that the addition of one more factor – even one that most directly highlights large disparities in fees – to an already fact-intensive legal standard can effectively be combated and neutralized on remand with the same force of experts, data, and attorneys that have won advisers every previous excessive fees case at trial for the past forty years.

If, as some of today’s questions seem to indicate, the eventual decision from the Court in Jones v. Harris will read like Gartenberg with just one additional factor included in an already long and nebulous evaluation, we might have to wait for the next wave of litigation in trial courts to see whether the new Jones standard makes any practical difference on fees. If, on the other hand, the justices highlight and strongly emphasize the institutional/individual fee comparison in an opinion that reads like Posner’s dissent or Ameriprise v. Gallus, the pressure upon the industry to lower fees could be more acute and immediate.

Given the skepticism of Chief Justice Roberts and Justice Scalia for judicial involvement in this issue, combined with the lack of engagement in the particulars of this case by Justices Stevens and Kennedy (who asked only general and theoretical questions about the concept of fiduciary duties), and even the relatively modest concern by Justices Ginsburg, Breyer, and Sotomayor (who seemed supportive of the petitioners but not terribly impressed that the institutional fee comparison would be definitive), it’s hard to foresee a passionate opinion arising out of this case. Joining Justice Thomas in silence today was Justice Alito, which was a great shame given his personal involvement on the SEC's brief in the last major mutual fund case before the Supreme Court (Daily Income Fund v. Fox) and significant expertise on this topic.

Jones v. Harris Transcended Time Itself

2009-11-02T15:33:07-07:00

I'll leave the heavy lifting to the experts, but I found one fact about the oral argument to be amusing: due to the apparently confusing end of daylight savings time, the argument began at 6:20 by the Court's own clock, flashed forward to 10, and hit 11:00 before everything was said and done. The WSJ roundup suggests that affirmed with revisions may be a likely outcome; that looks like a pretty big hedge to me.

Is Jones v. Harris Boring? Is My Boss Overpaid? Blawg Readers Be The Judge

2009-11-02T15:21:55-07:00

The teacher’s manual to Klein, Ramseyer, & Bainbridge opens discussion of Jones v. Harris in typically Ramseyeresque fashion:

This case deviates from our usual practice. In general, we pick cases for the facts. This case has no facts of interest. We include it instead for the reasoning – for Frank Easterbrook’s in-your-face explanation for why compensation is best left for the market.

Judging from the outpouring of interest in the case, many law professors appear to disagree with Ramseyer that Jones v. Harris has no interesting facts. (Or, alternatively, we share Klein, Ramseyer, and Baindridge’s fascination with Easterbrook’s “in your face” market defense). But Ramseyer is certainly correct that executive compensation (and compensation issues more generally) is “hot” at the moment.

I expected, prior to reading Easterbrook's opinion (Download Easterbrook), to disagree with the 7^th Circuit ruling. In the end, however, I did not. Easterbrook’s basic argument that the appropriate reference point for the court’s decision should be the fees that other funds of similar size and investment goals pay their advisers, rather than the fees charged to unaffiliated institutional clients seems correct to me, at least based on the information we currently have available. And, according to the 7^th Circuit, it is undisputed in Jones v. Harris that the fees Oakmark paid Harris Associates are roughly equal in both level and breakpoints to those paid by similar funds. (I’ll leave aside, for present purposes, the extent to which Easterbrook’s opinion abandons Gartenberg and replaces it with a disclosure standard, as that question is addressed at length elsewhere, including in today’s oral argument).

Why did I expect to disagree with the 7^th Circuit ruling? Posner’s dissent from rehearing en banc (Download Posner dissent) resonates in some fairly basic ways. Chief among them is his discussion of the incentuousness of the mutual fund industry. As Posner notes on page 5:

“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 management are more connected, advisors capture more rents and are monitored by the board less intensely.”

Quoting 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).

This is a reality that should resound with even casual students of board life. In my own research on boards of directors (designed to study questions of race and gender diversity on boards but, in fact, revealing a trove of information about the daily workings of boards, management, and their corporate constituent relations) narratives of board interconnectedness and “it’s all about who you know” recur.

Yet Easterbrook anticipates such objections well. As he notes, there are thousands of mutual funds, and investors can (and apparently do) shift money at will, creating competition. True, funds may not explicitly compete on management fees, but mutual funds’ total expenses as a percentage of assets are a widely publicized benchmark and even lazy investors seek maximum returns net of expenses.

Very few observers of today’s financial and corporate landscape believe that the market perfectly sets compensation to align management incentives with shareholder welfare. Concluding that courts can systematically do better, however, requires more evidence than what I’ve seen so far in Jones v. Harris.

Elaborating on Easterbrook’s university president hypothetical, my boss, Duke University president Richard Brodhead, may be overpaid (for the record, I do not believe this to be the case, but you get the picture). If Brodhead receives “$50 million a year, when no other president of a comparable institution receives more than $2 million,” then a court might reasonably conclude that the compensation is so unreasonable that deceit must have occurred or the trustees abdicated their responsibilities in approving the compensation. But should the court inquire whether a salary normal among similar institutions is, nonetheless, excessive, because all university trustee-president relationships are insular? Absent a clearer statutory mandate than §36(b), or more evidence of market failure than was presented in Jones v. Harris, I think not. In Easterbrook’s words, “a fiduciary duty differs from rate regulation.”

Thanks to Usha and the other Glommers for hosting me, and feel free to visit me at my regular home over at The Faculty Lounge.

Cross-posted at The Faculty Lounge

Michael Goldsmith, RIP

2009-11-02T10:30:12-07:00

Yesterday, my colleague Michael Goldsmith succumbed to ALS. I blogged about Michael's work with Major League Baseball here.

Late last week, we received word that Michael wasn't doing well, and as I left my office on Friday, I glanced at his baseball card from a Baltimore Orioles fantasy camp. He gave me the card after we served on the Curriculum Committee together. He was a wonderful guy, and I wish we could have had more time together.

Michael's NYT obituary is here, and his hometown obituary is here. Rest in peace, Michael.

What is the real issue in Jones v. Harris?

2009-11-02T09:28:03-07:00

The Jones v. Harris case is attracting some popular media attention, most of which focuses on the higher rates that mutual fund advisers generally charge their captive funds versus their institutional investor clients. For example, NPR covered the case this morning and tried to present both perspectives on this particular rate issue, with comments from David Frederick, counsel for mutual fund investors, and Karrie McMillan, general counsel for the trade association for mutual funds. You can listen to the story here. Judge Posner also acknowledged this issue in his dissent, stating that “[a] particular concern in this case is the adviser’s charging its captive funds more than twice what it charges independent funds.”

An adviser’s rate structure obviously is an important factor to consider, but I think we also need to analyze factors like any difference in services provided captive funds versus institutional investor clients, the actual services provided to captive funds in exchange for the negotiated fees and the independence of the fund’s directors or trustees who negotiated the adviser’s contract. For an excellent discussion of the difference between “interestedness” and “independence” in the context of mutual fund directors/trustees, see Professor Lyman Johnson’s article titled A Fresh Look at Director “Independence”: Mutual Fund Fee Litigation and Gartenberg at 25. And yes, I think courts should have the flexibility to consider market standards and competition.

That being said, what troubles me about Judge Easterbrook’s majority opinion in Jones v. Harris is not his reference to market standards and competition, but his level of deference to those factors. Perhaps his strong opinion was necessary to call attention to an arguable imbalance in the courts’ weighing of the Gartenberg factors. Based on Gartenberg’s dicta, many courts do not consider market standards and competition; according to Professor Lyman’s article, many courts do not consider director/trustee independence. I have not conducted a review of all court decisions applying the Gartenberg test, but I suspect other factors might get more or less attention than they deserve.

At the end of the day, the mutual fund’s advisory contract needs to reflect terms negotiated in good faith and at arm’s length. If a mutual fund goes beyond the definition of interestedness and retains truly independent directors/trustees, a court might grant more deference to the actual terms of the negotiated contract. If director/trustee independence is lacking, a court might place greater emphasis on evidence regarding disclosure of conflicts and terms of fee structures, market standards, competition in the markets, profitability of the fund and the like. Although such judicial discretion and flexibility may make some uncomfortable, I think it is an appropriate standard given that markets, investors and fund practices can change and are not static concepts. It will be interesting to see the Supreme Court’s decision and whether it has any impact on the larger executive compensation debate.

In addition, I want to say how much I appreciate Professor Larry Ribstein’s post yesterday on Jones v. Harris. It highlights the utility of the case beyond the basic fee dispute and reminds us of the importance of entity form selection both as we teach the concepts to our students and as they ultimately advise their clients in practice. I also think Professor Ribstein raises an important issue regarding the use of the term “fiduciary” in the business context—again, an issue that extends beyond the case and Section 36(b) of the Investment Company Act.