The Dissent in Jones v. Harris Associates – Defending Gartenberg, Requesting Review

On August 8, 2008, Judge Posner, former chief judge of the 7th Circuit, writing on behalf of a group of 7th Circuit judges, issued a highly critical dissent of the Jones opinion and the panel’s subsequent refusal to allow an en banc rehearing. Jones v. Harris Associates, ___ F.3d ___, 2008 WL 3177282 (7th Cir. 2008). In his dissent, Posner explains the need for en banc review of the underlying case, highlighting the circuit split created by Jones,one which may find its way to Supreme Court review.

Gartenberg and its rejection by the Jones panel

For more than 25 years prior to the 7th Circuit’s opinion in Jones v. Harris Associates, federal courts had relied upon the standard articulated by the 2nd Circuit in Gartenberg v. Merrill Lynch Asset Management Inc., 694 F.2d 923 (2nd Cir. 1982) to determine whether a fund manager breached its fiduciary duty by charging excessive management/ advisory fees in violation of section 36(b) of the Investment Company Act of 1940.

Gartenberg articulated two similar versions of a test to determine a violation of section 36(b): 1) “whether the fee schedule represents a charge within the range of what would have been negotiated at arm’s-length in the light of all of the surrounding circumstances;” and/or 2) whether the advisor-manager charges “a fee that 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.

But the Jones panel rejected Gartenberg – actually, the Jones court rejected the premise that the courts, rather than the market, should assess the reasonableness of advisor fees except in extraordinary circumstances. The Jones panel stated: “A fiduciary differs from rate regulation. A fiduciary must make full disclosure and play no tricks, but is not subject to a cap on compensation. 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.” Jones v. Harris Associates, 527 F.3d 627, 632 (7th Cir. 2008). Added the court: “Judicial price-setting does not accompany fiduciary duties. Section 36(b) does not call for a departure from this norm.” Id. at 633.

Judge Posner’s dissent to Jones and his defense of Gartenberg

On August 8, 2008 – nearly three months after publication of the Jones panel’s opinion -- Judge Posner, joined by Circuit Judges Rovner, Wood, Williams and Tinder, published a highly critical dissent in Jones; none of the dissenting judges had served on the original Jones panel. Following publication of the Jones opinion, 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.” (2008 WL 3177282, p*1). The Posner-authored dissent responded to this denial of a rehearing en banc.

Judge Posner began by citing the overwhelming, long-standing support for Gartenberg by courts and practitioners across the country. The Jones panel had cited two cases for the proposition that the court had previously questioned the Gartenberg approach – Posner stated that neither of those cited cases stood for that proposition at all. Indeed, noted Posner, “there is a slew of positive citations” in support of Gartenberg, and he proceeded to list merely some of the slew. Id. Moreover, Posner noted that Gartenberg has not been so hard on fund advisors that the standard should be changed; he cited legal treatises to show that post-Gartenberg cases have nearly all ended in judgments for the fund manager defendants. Id.

But the heart of Posner’s dissent focused on the economic climate in the financial services market, and among fund managers in particular. Id. at *2 - 3. Rampant abuse in the financial services industry in general combined with inherent conflicts of interest and significant, essentially incestuous, favoritism among fund directors and advisory firms create a dangerous anti-consumer brew, according to Posner. Id. at *3. Posner referred to the panel opinion’s rationale dismissing these concerns as “pure speculation.” Id. at *3.

Harris Associates, notes Posner, is a prime example of this environment of intertwined relationships: Harris founded the Oakmark funds in question; the Oakmark Board of Trustees reselects Harris as the fund advisor every year, and Harris manages the entire Oakmark portfolio. Id. When the directors and the managers are closely connected like Harris and Oakmark, the boards are less likely to monitor and question the fund advisor than if the board was more independent. The result is a situation where consumers have little choice or control – there is no “arm’s length” bargaining power in play. Id.

Posner noted that if the entire industry took advantage of the wide discretion afforded it by Jones, and all fund advisors charged similar exorbitant fees, consumers would have no alternatives even if they did seek to “vote with their feet.” Id. This lack of consumer choice that may result from Jones directly contradicts the “let the market decide” premise of the Jones holding – if the entire market is uniformly too high, consumers have no reasonable alternative decision to make. Id.

Finally, Posner notes that the Jones panel created a split among circuits, with the 7th Circuit’s Jones opinion now contradicting the 2nd Circuit’s Gartenberg holding. Id. at *4. When a panel’s decision is going to create such a split, claims Posner, court procedure is to circulate the decision to the full court in advance of publication, which the Jones panel failed to do. Id. Posner concluded by stating: “[T]he 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.” Id.

An issue ripe for Supreme Court Review

Posner’s dissent indicates a split not only among circuits, but among the 7th Circuit judges themselves. The debate comes down to the old question of how much protection government – and the judiciary in particular -- should provide consumers who may be vulnerable to market controllers. Posner argues that the Jones opinion fails to provide adequate consumer protection; the panel believes the consumers in these circumstances can take care of themselves and the judiciary should step out of the way.

Future federal courts no longer have the comfort of relying on the tried-and-true Gartenberg standard; they will have to make a choice of whether to side with Posner or Easterbrook. Posner’s dissent is more favorable to Section 36(b) plaintiffs; the Jones panel opinion provides more leeway for fund managers and advisors. Due to the current economic and political climate in this country, with rising accusations of unanswered abuse in corporate and financial markets, this debate is ripe for resolution by the Supreme Court.

Even though the Jones panel rejected Gartenberg, it still upheld the district court’s determination (which was based on the Gartenberg analysis) that the advisory fees at issue in the case were “ordinary” and not unreasonable. 527 F.3d at 631 and 635.