SCOTUS Takes on Exec Pay in Jones v. Harris

Dale Oesterle comments:

The Supreme Court has agreed to take a case on executive pay, Jones v Harris Associates.  In case is on manager's fees in the mutual fund industry but the holding will have profound effects on corporate governance in all industries.  The question is whether a mutual fund board of directors or mutual fund investors have adequate incentives to police executive fees, in this case the fees of the mutual fund managers.  Judge Easterbrook, writing for the majority, said yes; Judge Posner, writing alone in dissent said no.  On the facts, the mutual fund paid higher fees for managers managing its large public funds that it did for the same manager managing its private funds controlled by large institutional investors.  The Court could go with the new "behavorial economic" theorists that say small investors make predictable mistakes in both voting (incumbants always win) and in investing (holding losers too long and chasing winners) and that the boards of directors selected by small investors are not accountable in fact to them.  Or the Court could go with traditional economists that argue that investors power to sell their investments is power enough to control boards and executives that invest their funds and that other paternalistic overview systems (government oversight) would be worse, stifying innovation and competition.  This case will reaffirm or change existing practice and either result will have ripples across the governance of companies countrywide.   

I'm not sure about that ripple effect. Donald Langevoort’s article, Private Litigation to Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty, 83 Wash. U. L.Q. 1017, 1019 (2005), suggests a certain need for caution drawing parallels between mutual funds and corporations. Indeed, Langevoort expressly argues that, in light of the unique features of mutual fund governance, “judges and policymakers should not even try to reason by analogy to governance in other kinds of corporations.” He highlights “the convergence of the capital and product markets that occurs when the products being sold by the mutual fund are its own securities. Here, the ideology of consumer sovereignty easily crowds out a strong norm of fiduciary responsibility.”

Langevoort further argues that “‘Disinterested’” directors see little need to measure the behavior of the fund’s advisor by reference to anything other than marketplace success—and indeed can be chosen precisely because they embrace the ideology of the markets and see the law’s assignment to them of strong fiduciary responsibilities as something of an exercise in formalism.”

Finally, he notes that:

Mutual funds are not enough like business corporations for there to be any more than a facile analogy.

Any plausible theory of effective market discipline in corporate law generally rests on some combination of the following: an efficient capital marketplace that prices both good and bad corporate governance with reasonable precision; compensation of key insiders using stock or options, so as to better align the interests of managers and investors; the emerging power of institutional investors who can actually threaten to exercise their voting rights; and a reasonably active market for corporate control. Without passing judgment on the sufficiency of any of these in the world of corporations—each is contestable there as well, as the contemporary corporate law literature points out—the simple fact is that none even arguably operates with any power in the world of mutual funds. Because mutual funds are not traded in an organized market, arbitrage opportunities cannot work to keep prices in line with rational expectations. Mutual fund prices are simply the product of net asset value at the time of purchase or redemption. Insider compensation is largely based on assets as well, which creates the conflict rather than aligns insider-shareholder interests, and directors are typically paid all or mostly in cash. Institutional shareholder voice does not exist in the fund area, and there is no external market for corporate control at all because shareholders can only sell their shares back to the fund. Thinking about mutual funds by imagining them simply as a species of “corporations” in a way that is directly informed by contemporary corporate law theory is completely misguided.

Comments

[Lawrence Cunningham]

Small but non-trivial corrections to Dale's report. Easterbrook did not write "for the majority" and Posner did not write "alone in dissent." Easterbrook's panel (for him, Kanne and Evans) was unanimous and that panel also unanimously denied a motion for rehearing. On an unidentified Circuit Judge's suggestion for rehearing en banc, a majority of the Circuit Judges voted against. Posner dissented from that denial, in an opinion joined by Judges Rovner, Wood, Williams and Tinder. Ripple did not participate in the decision on rehearing en banc. So the vote appears to have been about 9 to 5.

[Lawrence Cunningham]

HT to William Birdthistle, updating my previous comment: the en banc vote appears to have been 5 to 5, not 9 to 5. My earlier guess assumed, incorrectly, that Senior Circuit Judges vote on en banc rehearing, but 7th Circuit rules say they don’t, unless they were on the subject panel. The case is nearly as close as can be.