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August 16, 2008
Market Place

Judges in Dispute Over Mutual Funds


THEY are both known as conservatives and were pioneers in the economic analysis of the law. Each is a past president of the American Law and Economics Association. They have written papers together and teach at the University of Chicago law school while serving as judges of the United States Court of Appeals for the Seventh Circuit, to which each was appointed by President Ronald Reagan.

One academic study found the two judges, Richard A. Posner and Frank H. Easterbrook, were the circuit court judges most often quoted by other judges. A 2001 poll of Legal Affairs Magazine readers listed them among the 20 most influential legal thinkers in the country. Only one other circuit court judge made the list.

But now they have parted ways on a dispute involving what the courts should do about high pay for the investment managers of mutual funds.

In a vigorous dissent, Judge Posner criticized the “one-sided character of the panel’s analysis” in a major decision by Judge Easterbrook, which said fund directors, also called trustees, should have the final say on pay for managers.

“The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth,” Judge Easterbrook wrote.

To Judge Posner, that analysis was naïve.

“Competition in product and capital markets can’t be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds,” he said. “Mutual funds are a component of the financial services industry, where abuses have been rampant.”

Judge Posner issued his comments last week in a futile effort to get the entire Seventh Circuit to consider the case, rather than allow the decision by Judge Easterbrook and two colleagues to stand. One of the 11 judges recused himself, and the others split 5 to 5 on the question. Without a majority vote, the original opinion stood.

At issue is a section of the law passed by Congress in 1970, which provides that fund managers have a “fiduciary duty with respect to compensation for services,” and gives shareholders the right to go to court and argue that fees are excessive.

Until now, the dominant precedent on that issue was a 1982 ruling by the Second Circuit in a case known by the name of the plaintiff, Irving L. Gartenberg. That ruling stated that a fee could be deemed excessive if it was “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.”

Judge Posner complained that although the Easterbrook opinion did not precisely say it was rejecting the Gartenberg precedent, that was what it did, and that Judge Easterbrook had violated a Seventh Circuit rule requiring that such an opinion be sent to all circuit judges before its release.

The Easterbrook opinion relied in part on what it called a “a recent, careful study” study written by two academics, John C. Coates, a Harvard professor of law and economics, and R. Glenn Hubbard, the dean of Columbia Business School and a former chairman of President Bush’s Council of Economic Advisers.

That study, which was financed in part by the Investment Company Institute, a mutual fund trade group, concluded, Judge Easterbrook wrote, “that thousands of mutual funds are plenty, that investors can and do protect their interests by shopping, and that regulating advisory fees through litigation is unlikely to do more good than harm.”

Judge Posner, in his dissent, said that even the Coates and Hubbard study “explicitly approves Gartenberg.” But he also said there was more evidence of abusive behavior on Wall Street than there was when their article was written in August 2007. He pointed to a May 2008 study by Camelia M. Kuhnen, an assistant professor of finance at Northwestern, which found evidence that connections between fund directors and managers “foster favoritism, to the detriment of investors.”

Judge Posner added, “The panel bases its rejection of Gartenberg mainly on an economic analysis that is ripe for re-examination 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.”

In the case decided by the appellate court, against Harris Associates, the managers of the Oakmark family of funds, the plaintiff, Jerry N. Jones, argued that the courts should consider evidence that Oakmont charges much more to the mutual funds than it charges to manage similar portfolios for institutional investors.

Judge Easterbrook rejected that comparison, saying that the courts should rely on competition to keep fees reasonable and that there were many possible reasons for the difference, like differing demands on managers’ time.

Judge Posner was unimpressed, quoting a study that concluded the difference existed because there was real competition in the institutional market but that mutual funds were captives of their managers, who normally start the funds and sell them to investors.

“The panel opinion throws out some suggestions on why this difference may be justified,” Judge Posner wrote, “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.”

James C. Bradley, a lawyer in South Carolina who brought the suit, said he would ask the Supreme Court to review the case. The dissent by Judge Posner, with his emphasis that there is now a split between circuit courts, reads almost like an appellate brief, and could help to get this issue before the Supreme Court.