Defining excessive pay
Investor case may hint at high court approach to compensation

By Robert Barnes and Steven Mufson
Washington Post Staff Writer
Sunday, November 1, 2009

The Supreme Court this week will hear a case that raises bedrock questions about the ability of the market to set "reasonable" corporate compensation, and experts say its outcome could hold important clues about the judiciary's view of extraordinary interventions in the economy by the executive branch and Congress.

At issue in Jones v. Harris Associates is whether investment advisers charged too much for their services to a mutual fund under their control. But it contains natural parallels to the current controversy over executive compensation at publicly held companies.

"The fact that the Supreme Court is looking at compensation again is in itself extraordinary," said Charles M. Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, adding that the court's history is to defer to the markets rather than to intervene. "But I think it also demonstrates the political reality that compensation is sort of foisted onto the national scene, whether in Congress and now certainly at the Supreme Court."

It may also set up what could be years of judicial review of the measures that the Obama administration and Congress have taken -- and envision -- to deal with the worst collapse of the economy in 75 years.

"It's like the thin edge of the wedge," said William A. Birdthistle of the Chicago-Kent College of Law, who has closely followed the mutual fund case. He said the economic solutions of the Obama administration and a Congress solidly in Democratic hands will be judged by "the last of the branches controlled by conservatives."

Business decisions

The case is just one of many that the business community is watching. Another could affect when the statute of limitations starts to run in certain types of cases. Cases involving the power of regulatory agencies are likely to come up later, as the Obama administration takes a more assertive role in matters such as antitrust or the environmental regulation of greenhouse gases. It also remains unclear how the court will respond to a Solicitor General's Office that is more likely to oppose businesses, as it is doing in a case against the National Football League's power to negotiate exclusive licensing agreements.

Business-related cases will also pose an early and interesting test for the court's newest justice, Sonia Sotomayor, who was a corporate lawyer and has ruled on many business cases as a Manhattan district judge and as a member of the business-heavy U.S. Court of Appeals for the 2nd Circuit. "She may have more corporate experience than the rest of the court combined," Birdthistle said, and the docket laden with business cases allows her "immediately to have a disproportionate impact" compared with a typical first-year justice.

Duty vs. profit

In the case that comes to the court on Monday, three investors in the Oakmark family of mutual funds have alleged that the funds' manager, Harris Associates, violated its fiduciary duty by charging investors "excessive" fees -- more than twice the amounts Harris charged for advising other clients. In one year alone, the mutual funds paid between $37 million and $58 million more in fees than they would have if they had been charged the same as other clients of Harris Associates, the investors said. But because of the cozy relationships between the boards of the mutual funds -- whose members were all appointed by Harris Associates -- the fees were not challenged.

Lawyers for Harris responded that the mutual fund business is competitive and that investors are free to choose funds with lower fees. In fact, the size of the Oakmark funds has grown, which they say shows that investors think they are getting good value for their money, even with the higher fees. According to the Investment Company Institute, assets invested in mutual funds grew from $2.8 billion in 1995 to $9.6 billion at the end of 2008.

One of the giants of the mutual fund industry has weighed in on the side of the investors. John C. Bogle, founder of the Vanguard Group and a champion of index funds and other funds with low fees, said in a brief that the explosive growth of the mutual fund industry has made it harder to monitor the "conflicting loyalties" of investment advisers and the failure of fund managers to share economies of scale with investors. Therefore, he said, it is up to the courts to enforce "fiduciary duty" required by a 1970 law to ensure that fund managers charge only "reasonable" fees.

"It is difficult to imagine a clearer violation of an adviser's fiduciary duty than when the adviser charges its captive fund more than others for similar (or lesser) services," Bogle's brief says.

The case was set up for the high court by competing opinions of two of the appeals courts' leading thinkers on economics and the law.

Chief Judge Frank H. Easterbrook of the U.S. Court of Appeals for the 7th Circuit in Chicago found that the law requires only that the management's fee process be transparent. He noted that fund directors were not likely to fire the advisers for high fees but that investors could effectively fire the advisers by moving their money elsewhere. He wrote that there was no evidence that Harris "pulled the wool over the eyes" of its shareholders and that there was no reason to engage in "judicial price-setting."

But Easterbrook failed to convince a longtime colleague, Judge Richard A. Posner. When the full court split on whether to rehear the case, Posner penned a dissent that reads like an invitation to the Supreme Court, writing that the notion that the market can police excessive compensation is "ripe for reexamination."

"Executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation," Posner wrote, adding that "competition in product and capital markets can't be counted on to solve the problem."

In two different blog postings, Posner also took aim at the big bonuses Goldman Sachs is paying its top executives and traders, saying that while "regulating financial compensation is a mistake," he also thinks that "financial executives probably are overpaid from a social perspective." The disagreement between two judges who have been "philosophically aligned for many, many years," Elson said, elevates the importance of the case. Both were University of Chicago professors appointed to the court by President Ronald Reagan. Birdthistle said the split also blurs what could be seen as liberal and conservative positions on the issue.

Lines are drawn

Reaction to the case, though, has created familiar alliances. The U.S. Chamber of Commerce and other business and conservative groups support Harris Associates and urge the court to stay out of pay decisions. Ilya Shapiro of the Cato Institute said the decision will likely be seen as a "marker" for future court actions, and he filed a brief urging the justices not to "stretch the judiciary's role far beyond its constitutional boundaries" and in the process threaten "the fundamental right to earn an honest living."

The Obama administration has taken the same side as consumer groups. Solicitor General Elena Kagan wrote that Easterbrook took a narrow reading of what Congress intended, adding that a court reviewing such a claim should make a "more encompassing inquiry."

However the Supreme Court rules, many lawyers expect it to focus narrowly and avoid the larger compensation issue.

"I don't think that the court will use this case as a vehicle to send a message about executive compensation. The court's a judicial branch and not a political branch," said Richard Bernstein, a partner at Wilkie Farr Gallagher who worked with the Chamber of Commerce on its friend-of-the-court brief.

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