Comments on the SEC’s Mutual Fund Governance Rules

Editor’s Note: This post is by John Coates of Harvard Law School.

An article in today’s Wall Street Journal describes the continuing debate on the Securities and Exchange Commission‘s rulemaking on mutual fund governance.  In 2004, the SEC adopted rules (by a split vote of 3-2) that would have required mutual funds to have a 75% independent board and would have required that the chairman of the board be independent.  The D.C. Circuit struck down that rule (for the second time) last June.  In December, the SEC released for comment two papers on mutual fund governance prepared by the Office of Economic Analysis.

At Fidelity‘s request, I reviewed and commented on the OEA’s papers in this report filed with the SEC.  The report, which draws on a recent paper I coauthored with R. Glenn Hubbard, Competition and Shareholder Fees in the Mutual Fund Industry, notes that the OEA’s analysis contributes significantly to the debate on the desirability of the mutual fund governance rules.  The report also points out, however, that the OEA papers:

–Acknowledge (although underemphasize) that no empirical data supports the need for the 75% independence rule or the independent chair mandate;

–Acknowledge that optimal governance structures are likely to vary from fund to fund;

–Offer no evidentiary support for the notion that fund board structures are chosen suboptimally, and fail to note that nearly all mutual fund boards have long had a majority of independent directors, who have always been free to nominate additional independent directors or choose an independent chair;

–Offer no evidentiary support for the idea that there are significant agency costs in mutual fund governance;

–Argue that investment advisors alter fund risk mid-year, although the academic economic literature on this point is mixed at best;

–Contend that taxes undermine competition among funds by raising switching costs, even though the tax-exempt portion of the mutual-fund industry has grown dramatically in recent years, and direct evidence shows that significant switching occurs annually by fund investors;

–Ignore the fact that the SEC’s rules would eliminate variation in board structure at mutual funds and thus limit future research on the optimal approach to mutual fund governance; and

–Fail to acknowledge that increased reliance on independent directors could give rise to additional agency costs, such as excessive risk aversion, increased conflict among members of the board, and/or increased pay for managers, who may demand more compensation in light of their reduced control in the boardroom.

In view of these considerations, my report concludes that the SEC’s mutual fund governance rules are unlikely to generate net benefits — and that, at a minimum, the SEC should await direct evidence of high agency costs at investment companies before imposing a one-size-fits-all governance approach on all mutual funds.

As the Journal noted today, a decision from the SEC on whether to re-adopt these rules is expected before long.

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