Jones v. Harris Associates L.P. and the Limits of Public Choice Textualism

Daniel Birk

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The pronouncement “A book is the words that comprise it” risks seeming an insipid axiom.  Nevertheless, we are all inclined to believe that there is a form separable from the content and that ten minutes of conversation with Henry James would reveal to us the “true” plot of The Turn of the Screw.  I think that the truth is not like that . . . .1 

Introduction

Judges Frank Easterbrook and Richard Posner recently clashed over the economics of the mutual fund industry in Jones v. Harris Associates L.P., a case challenging the fees paid to a fund’s investment adviser.2  The opinions also delineate Easterbrook’s and Posner’s differing philosophies of statutory interpretation and reveal the strengths and limits of Easterbrook’s textualism.

Section 36(b) of the Investment Company Act of 1940 imposes “a fiduciary duty with respect to the receipt of compensation” upon investment advisers.3  In Jones, Chief Judge Easterbrook disavowed the longstanding test for suits under § 36(b), holding that advisers have a duty to make full disclosure and avoid fraud but are not subject to a limit on compensation.  Dissenting from a denial of rehearing en banc, Judge Posner argued that the Jones decision was based “on an economic analysis that is ripe for reexamination.”4

The Seventh Circuit’s opinion does rely heavily on an economic analysis that counts on competition to restrain adviser compensation.  But the opinion can also be viewed as the product of two strains of thought in Judge Easterbrook’s scholarship: first, a unique theory of statutory interpretation based on public choice principles and, second, a preference for limited government regulation.

Judge Easterbrook’s theory of interpretation can be a powerful tool.   However, the theory also guided the court to a conclusion inconsistent with the text of § 36(b), virtually nullifying the statute’s intended effect. Jones suggests that Easterbrook’s theory of interpretation is inadequate as a solitary tool for interpreting statutes.

Public choice principles help to set limits on interpretation, but they do not provide a guide to interpretation within those limits.  Ultimately, Judge Posner’s own theory of pragmatic interpretation, applied obliquely in his dissent, provides an important counterpoint to Easterbrook’s skeptical textualism.

I. Conflicting Theories on Statutory Interpretation

Public choice theory rejects the view that legislation is crafted by a group of representatives working rationally in the public interest.  Instead, it sees legislation as a compromise between many different public interests—competing groups vying for bills that serve their own purposes rather than those of the public as a whole.

Judge Easterbrook has molded these principles into a comprehensive theory of statutory interpretation.5  First, a judge should ascertain a statute’s plain meaning.  Anything not within the statute’s clear and direct purview is simply not covered.  Second, legislative history and freestanding references to purpose are irrelevant and perhaps counterproductive: A judge who goes too far in attempting to advance the “purpose” of the statute is betraying that compromise by giving one group more than they could secure in the legislative bargaining process.

Third, if Congress implicitly delegates power to the courts through the use of common law terms, then courts have the discretion to “solve new problems as they arise, but using today’s wisdom rather than conjuring up the solutions of a legislature long prorogued.”6

Judge Posner’s own theory of pragmatic interpretation takes a different approach.  For Judge Posner, ascertaining the purpose of a statute may be difficult, but it is not impossible, and one of the judge’s functions is to adapt the imperfect and necessarily myopic words of a statute to actual situations as they arise.  Posner recognizes the risks of unbalancing the compromise.

Judge Posner and Judge Easterbrook also possess different conceptions of their duties as agents of the legislative will.  Easterbrook’s theory of strict construction derives from a sense of fidelity to the principles of republican government and constitutional limits on judicial discretion.  By contrast, Posner’s duty is “to reach the most reasonable result in the circumstances.”7  He therefore uses all the tools at his disposal, including the text, structure, and background of the statute, any relevant legislative history, and “the values and attitudes . . . of the period in which the legislation was enacted.”8

II. Judge Easterbrook’s Theory Applied: Jones v. Harris Associates L.P.

One method for testing Judge Easterbrook’s brand of textualism is to evaluate how well his principles serve to interpret a statute in a particular case.  His panel opinion in Jones is an ideal candidate for such a case study because it reveals both the utility and the limits of Easterbrook’s theory.

Congress enacted the Investment Company Act of 1940 (ICA) in order to curtail abuses in the mutual fund and investment adviser industry.  The ICA installed a comprehensive federal regulatory scheme for investment companies that supplemented what had previously been solely state oversight.  In 1970, Congress amended the ICA by adding § 36(b), which imposes on investment advisers “a fiduciary duty with respect to the receipt of compensation for services,”9 and permits any investor in the fund to bring an action on behalf of the fund against the adviser for violations of the fiduciary duty.  Congress did not, however, define what it meant by fiduciary duty.

Since 1982, courts in many circuits, the SEC, and the fund industry have determined whether this duty has been breached by looking to the so-called Gartenberg factors to evaluate “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.”10

The plaintiffs in Jones argued that the Gartenberg standard relies too heavily upon the market to regulate fees.  The crux of the plaintiffs’ allegations was that the adviser charged its client funds (composed of individual investors) a fee twice as high as what it charged institutional investors such as pension funds (who have real bargaining power) for comparable services.

Fortunately for the plaintiffs, the Seventh Circuit agreed that Gartenberg should be abandoned.  Unfortunately for them, however, the Seventh Circuit felt that the problem with Gartenberg was not that it was too market-driven, but that it was not market-driven enough.  The court held that “[a] fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.”11

Jones is a comprehensive example of Chief Judge Easterbrook’s application of his theory of statutory interpretation.

The plaintiffs, relying upon statements from legislative history, argued that the correct standard was whether the fees were reasonable.  Judge Easterbrook, however, sought little guidance from Congress, refusing to find in the statute a directive to review fees for reasonableness because the plain language could have included it, but does not.

Further, after finding that the statute does not mean that fees must be reasonable, he avoided reference to the legislative history to decide what the statute does mean.  To Judge Easterbrook, fiduciary duty had no meaning unique to the context of the statute or its history.  “Congress did not enact its members’ beliefs,” he asserted; “it enacted a text.”12

And that text says “fiduciary duty.”  The statute’s use of this common law term was a delegation of authority to the judiciary.  Judge Easterbrook therefore applied “today’s wisdom,” surveying economic studies and compensation in a number of fiduciary contexts, such as that paid to corporate managers, lawyers, and university presidents.  Because competition is more than adequate to regulate fees today, he explained, § 36(b)’s fiduciary duty requirement does not require judicial review for excessiveness except in rare instances.

Instead of using litigation, shareholders must rely upon competition to rein in excessive fees.  The opinion evinces a faith in competition and a suspicion of regulation that are recurring characters in Judge Easterbrook’s scholarly work.

Judge Posner’s dissent challenged the panel opinion’s reliance upon laissez-faire principles to create efficient markets for adviser compensation, citing to an array of studies suggesting that the mutual fund board structure and competition among funds cannot effectively regulate advisory fees.  First, he contended, boards of directors are massive breeding grounds for agency conflicts.  Second, he questioned the panel’s casual dismissal of the disparity between the fees Harris charges mutual funds and the fees it charges its institutional clients.  In fact, studies demonstrate that the principal reason for the disparity is the lack of bargaining between the mutual fund board and its adviser.

Finally, Judge Posner disputed the panel’s analysis of common law fiduciary duties.  For Posner, every captive fund in an industry that has similar agency problems will exhibit similar price structures—all of them too high and all negotiated by a servile board of directors.

Judge Posner did not explicitly apply pragmatic statutory interpretation.  Nevertheless, his critique of the court’s decision comports with his theory.  His engagement with the kinds of problems that beset fiduciary relationships in the mutual fund industry represents an attempt to imagine how the enacting legislators would have applied § 36(b) to the case at bar.  Moreover, Posner resisted employing a fiduciary duty standard that would make achieving the legislative purpose more difficult.

III. Critique: Theory and Practice in Jones

Judge Easterbrook correctly rejected the plaintiffs’ contention that, under the Investment Company Act, the fees charged by investment advisers must be reasonable.  During enactment, the mutual fund industry strongly opposed two previous amendments to the Investment Company Act precisely because they contained a reasonableness standard.  Those bills both failed to pass, and the Senate Report accompanying § 36(b) explained that Congress did not wish to equate a fiduciary duty with a rate regulation standard.13

Judge Easterbrook’s decision to reject their reading thus comports with the legislative compromise embodied in the statute.  By refusing to consider misleading congressional statements to the contrary, he excluded a patently incorrect meaning outside the text’s purview.  In other words, Easterbrook’s theory is quite effective at discerning what the statute does not mean.  The theory is less successful, however, at explaining what the statute does mean.

Judge Easterbrook took the presence of a common law term as a delegation to apply his own conception of fiduciary duties.  A fiduciary duty exists where a principal gives a fiduciary control over her property or affairs; when the fiduciary consents, he is then obliged to act for the benefit of the principal within the scope of the fiduciary relationship.

That said, before consenting to serve as a fiduciary, the agent can bargain with the principal for his compensation.  The court in Jones applied this conception in holding that § 36(b)’s fiduciary duty “with respect to receipt of compensation”14 requires very limited review of advisory fees.

One can see the problem here.  Section 36(b) does not say merely that investment advisers owe the fund a fiduciary duty.  Instead, it says that advisers owe a fiduciary duty with respect to their compensation.  A fiduciary negotiating for his own compensation has an inherent conflict of interest if he owes his principal a duty regarding that compensation.

Section 36(b) also states that “[i]t shall not be necessary to allege or prove that any defendant engaged in personal misconduct.”15  That language does not comport with a view that the only situations in which a plaintiff can bring an action for excessive fees are those in which the fee is so disproportionately large that the court must infer that deceit or abdication of duty—both forms of personal misconduct—have occurred.

Despite Judge Easterbrook’s misgivings, the legislative history can help to resolve those difficulties.  Before § 36(b), courts evaluated advisory fees by “common-law standards of corporate waste, under which an unreasonable or unfair fee might be approved unless the court deemed it unconscionable or shocking.”16  But because of rapid growth in the mutual fund industry, the SEC began to fear that fund advisers were failing to pass along savings from economies of scale to fund customers.

Although the Senate Report indicates that the term fiduciary duty does not imply reasonableness in the sense of rate regulation, cost-plus pricing, or courts substituting their business judgment for that of the board, it also lowers the bar for plaintiffs by removing the requirement that the board or the adviser be guilty of misconduct and by asking the court to consider all of the circumstances surrounding negotiations.

Because Congress felt that the board–adviser structure of mutual funds created conflicts of interest that made traditional arm’s-length bargaining impossible, it imposed a duty requiring that the adviser simulate the results of arm’s-length bargaining.  Relevant to the inquiry are factors indicating whether meaningful negotiations had taken place.

Jones essentially attempted to nullify § 36(b), returning the standard to where it was prior to 1970: corporate waste.  “Shocks the conscience” is so similar to “so unusual that a court will infer that deceit must have occurred, or that the persons responsible for decision have abdicated”17 that in practice there would be no difference between either principle.

Thus, in trying to avoid giving regulators and investor plaintiffs more than they got at the legislative bargaining table, Judge Easterbrook actually gave investment companies more than they were able to secure from Congress.  Congress almost surely did not set out to use language that accomplished absolutely nothing.

IV. The Limits of Public Choice Theory

Jones reveals several problems with the application of Judge Easterbrook’s theory of statutory interpretation.  These problems may be inherent:  Proceeding from its deep suspicion of the legislative process, public choice textualism looks at the text of a statute and sees only the competing interests of various factions, and shiftless, reelection-focused representatives.

Many statutes, however, actually attempt to serve the public interest, and in many cases the legislative history accurately reflects what the legislature was trying to do.  In Jones, public choice textualism guided the court to add a requirement of deceit to a statute that expressly disclaims any such requirement, to allow parties who owe a fiduciary duty with respect to compensation to demand whatever compensation they can get, and to respond to a bill designed to ease the corporate waste standard by requiring a showing of corporate waste.

Jones also suggests that public choice textualism may be less suited to accurately identifying the legislative compromise than it is to limiting the scope of legislation.  The standard for assessing mutual fund advisory fees did not change merely because the court asserted that the mutual fund industry did.

In Statutes’ Domains,18 Judge Easterbrook provides an example of a statute that requires the leashing of dogs in public parks to illustrate that his theory is a valid check on judicial discretion.  According to Easterbrook, considering the purpose of the law—perhaps to prevent dangerous animals from prowling city parks—might also lead the judge to extend the statute to require the leashing of lions.

To be sure, a statute that requires the leashing of dogs should not extend to lions, a term outside the text.  Another common interpretive problem, however, is a dispute about the meaning of a term in the text.  Consider a statute that requires dogs to be “on a leash,” but this time imagine a situation in which the leash is attached to the dog’s collar, but the dog’s owner is not holding the leash.  Is the dog on a leash?  The dog is certainly attached to a leash.  Yet what is the use of allowing an owner to hook up the leash and let the dog run about with abandon?  In this instance, inquiring into a statute’s purpose is a useful way to decide between competing interpretations of an ambiguous text.

Conclusion

Public choice theory can provide valuable insights into the process of statutory interpretation.  But the notion that laws are products of compromises between competing interest groups does not mean that one may utterly abandon the search for meaning in a statute or that one should conclude that the purpose of the legislature is not an important consideration in interpretation.  Public choice theory can tell us where to draw lines, but it cannot tell us what to do inside those lines.

We may never know what song the Sirens sang19 or the true plot of The Turn of the Screw.  But we can, by applying standard methods of interpretation, be reasonably certain that characters played by Paul Newman and Robert Redford are shot to death by the Bolivian cavalry at the end of Butch Cassidy and the Sundance Kid.  Even if we cannot see it.

Acknowledgments

Daniel D. Birk received his J.D. from Northwestern University School of Law in 2010, his M.A. from Brooklyn College in 2007, and his B.A. from University of Notre Dame in 2003.

I would like to thank Professors Ezra Friedman and Allan Horwich for their guidance and Ira Karroll, Mark Nadeau, Ana Sempertegui, and Judd Stone for their helpful comments and suggestions.

This Legal Workshop piece is based on Mr. Birk’s Note:  Daniel D. Birk, Note, Jones v. Harris Associates L.P. and the Limits of Public Choice Textualism, 104 NW. U. L. REV. 1587 (2010).

Copyright © 2010 Northwestern University School of Law.

  1. JORGE LUIS BORGES, The False Problem of Ugolino, in SELECTED NON-FICTIONS 279 (Eliot Weinberger ed., Esther Allen trans., 1999) (1948).
  2. Jones v. Harris Assocs. L.P., 527 F.3d 627 (7th Cir. 2008), reh’g denied, 537 F.3d 728 (7th Cir. 2008), vacated, 130 S. Ct. 1418 (2010).
  3. 15 U.S.C. § 80a-35(b) (2006).
  4. Jones v. Harris Assocs. L.P., 537 F.3d 728, 730 (7th Cir. 2008) (en banc) (Posner, J., dissenting).
  5. Judge Easterbrook first articulated this theory in Frank H. Easterbrook, Statutes’ Domains, 50 U. CHI. L. REV. 533 (1983), but has subsequently reiterated it in several scholarly writings.
  6. Id. at 545.
  7. Richard A. Posner, The Jurisprudence of Skepticism, 86 MICH. L. REV. 827, 862 (1988).
  8. Richard A. Posner, Statutory Interpretation—In the Clasroom and in the Courtroom, 50 U. CHI. L. REV. 800, 818 (1983).
  9. 15 U.S.C. § 80a-35(b) (2006).
  10. Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923, 928 (2d Cir. 1982).
  11. Jones v. Harris Assocs. L.P., 527 F.3d 627, 632 (7th Cir. 2008).
  12. Id. at 633.
  13. S. REP. NO. 91-184, at 5–6 (1969), reprinted in 1970 U.S.C.C.A.N. 4897, 4902.
  14. 15 U.S.C. § 80a-35(b) (2006).
  15. Id. at § 80a-35(b).
  16. Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 540 n.12 (1984) (internal quotation marks and citations omitted).
  17. Jones v. Harris Assocs. L.P., 527 F.3d 627, 632 (7th Cir. 2008).
  18. Easterbrook, supra note 6.
  19. See Edgar Allan Poe, The Murders in the Rue Morgue, in THE PORTABLE POE 332 (Philip Van Doren Stern ed., 1945) (quoting Sir Thomas Browne, Urn-Burial) (“What song the Syrens sang, or what name Achilles assumed when he hid himself among women, although puzzling questions, are not beyond all conjecture.”).

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