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Student Brief: More from Professor Birdthistle on Mutual Funds in the Supreme Court

By student blogger Orijit Ghoshal

    On Tuesday, October 27, Professor William Birdthistle kicked off a series of lectures designed to give students a glimpse into the faculty’s academic scholarship with a lecture on Jones v. Harris Associates. In addition to writing an article to be published by the University of Illinois Law Review on the subject, Prof. Birdthistle served as counsel of record on two Briefs Of Amici Curiae Law Professors In Support of the Petitioners.

    Prof. Birdthistle began with an examination of why the Supreme Court may have chosen to hear this particular case. First, the current economic climate (what Prof. Birdthistle termed as “the worst 18 months in the past 75 years”) is ripe for examination by the Court. The Court seems to have taken notice, granting certiorari for an unusually large number of corporate cases it will hear during the upcoming term. Second, some have speculated that Chief Justice Roberts may be attempting to build stronger consensus on his court. By hearing fewer political cases and more cases dealing with criminal law or corporate law he may hope to preside over fewer 5-4 decisions. However, Prof. Birdthistle discounted this theory since the Court’s lineup on corporate issues will likely mirror its lineup on political cases. Third, the presence of recently confirmed Justice Sotomayor provides the Court with expertise on corporate issues. As a private practitioner, trial judge in Manhattan, and appellate judge in the second circuit, Justice Sotomayor accumulated significant experience with issues of corporate law, even hearing a case on the precise issue at stake in Jones. 

    Prof. Birdthistle then detailed the composition of mutual funds and how investment advisors operate within them. Mutual funds technically serve as clients for investment advisors, contrary to the misconception that these funds are a product of the advisors. The relationship between the advisor and the fund is purely contractual, where the advisors exchange their managerial expertise in exchange for a percentage of the fund’s assets under management. Investors enter the equation as shareholders in the mutual funds. Prof. Birdthistle noted that the investment advisor industry has boomed along with mutual fund growth, with advisors making $100 Billion annually through a compensation system which rewards advisors as their assets under management grow. Those assets can grow in two basic ways, either the existing money in the funds can expand as a result of smart investment or the sheer number of investors can increase and grow the fund. 

    Prof. Birdthistle then traced the evolution of mutual fund regulations. In 1940, Congress passed the Investment Company Act and Investment Advisers Act as the first attempts to regulate the mutual fund market. Section 36(b) of the Investment Company Act was amended in 1970 to create a fiduciary duty for investment advisors owed to the shareholders of mutual funds with respect to the receipt of compensation. The Senate Reports accompanying the 1970 amendments noted the uncompetitive, in fact “incestuous” nature of the industry. The first case to reach a federal appellate court under Section 36 was Gartenberg v. Merrill Lynch, where the Court of Appeals for the Second Circuit defined excessive fees as those which could not have been the product of arm’s length bargaining. The court in Gartenberg examined other mutual funds, the economies of scale which larger pools provide, fallout benefits from fund investment, and other factors to assess whether the fees were excessive. No plaintiff in a Section 36 action has ever won a verdict under this test, and the Gartenberg standard for excessive fees was followed widely until Jones v. Harris

    In Jones, Prof. Birdthistle explained, the Court of Appeals for the Seventh Circuit refused to apply the Gartenberg test. Chief Judge Easterbrook broke from the Second Circuit standard and ruled that, absent deception or fraud, no fee agreed upon between investors and advisors could be excessive. Easterbrook noted that 8,000 different mutual funds, the ability to redeem investments, and the existence of sophisticated investors placing downward pressures on overall market fees provide enough competitive pressure on the industry to foreclose any cries of an incestuous or uncompetitive market. At least one Seventh Circuit judge disagreed with Easterbrook’s characterization of the mutual fund industry and called for a rehearing en banc. After the Chief Judge recused himself from the rehearing vote, only five of the remaining ten judges voted in favor of rehearing, failing to reach a majority. Judge Posner dissented from the denial or rehearing and wrote a lengthy critique of the assumptions underlying Easterbrook’s opinion. 

    Prof. Birdthistle suggested that Posner may have benefitted from the knowledge gained from the recent financial collapse, which occurred after Easterbrook’s opinion but before the vote on rehearing. Posner attacked Easterbrook’s assumption that all investors make rational decisions by computing fees. Moreover, Posner argued that comparing charges between advisors was insufficient to determine whether fees were excessive because everyone’s fees could be unfair. Instead, Posner compared charges for the same advisors between different clients, and found that institutional clients paid half the fees that individual investors paid. Posner concluded that the sophisticated investors failed to exert downward pressures on fees charged to personal investors because they were placed in different pools by advisors. Prof. Birdthistle noted that the tension between Posner and Easterbrook represents a larger philosophical divide between behavioral and neoclassical economists. 

    Finally, Prof. Birdthistle addressed what the two likely options were for the Supreme Court in the Jones litigation. First, the Court could apply the Gartenberg standard as it has been followed for decades, in which case Petitioners would lose. Second, the Court could create a Gartenberg plus standard, emphasizing the disparity between institutional and individual fees. Although Respondent could justify the difference in fees based on differing costs of dealing with institutional as opposed to individual investors, this option would at least impose a burden on investment advisors to produce data justifying the fee gap. Neither party argued for affirming Easterbrook’s opinion, Petitioners for obvious reasons and Respondent because they believed they had a better chance of persuading a majority of the Court to apply the Gartenberg precedent. If the Court chooses to affirm Easterbrook or to endorse Gartenberg as it has been applied, mutual fund fees could increase because advisors know they are virtually impervious to legal attack. 

    If the Court chooses the Gartenburg-plus option, the door would open for mutual fund litigation as well as litigation on executive compensation, since the Court makes itself receptive to analyzing the fairness of compensation schemes. Either way, the Jones opinion will reveal how the Court deals with issues of econometrics, specifically in determining how to conclude whether an industry is competitive (choosing from analysis of the volume of competitors, market share, or price dispersion). Also, the Court’s opinion will signal which side the majority favors in the behavioral versus neoclassical economic debate, which informs virtually all other economic decisions the Court may be called to make. 

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