Rethinking the Regulation of Securities Intermediaries

In the paper, Rethinking the Regulation of Securities Intermediaries, which is forthcoming in the University of Pennsylvania Law Review [Jill E. Fisch, Rethinking the Regulation of Securities Intermediaries, 158 U. Pa. L. Rev. (forthcoming 2010)], I argue that existing regulation of mutual funds has serious shortcomings. In particular, the Investment Company Act, which is based primarily on principles of corporate governance and fiduciary duties, fails to support and, in some cases impedes, market forces. Existing evidence suggests that retail investing behavior and the dominance of sales agents with competing financial incentives further weakens market discipline.

As a solution, I propose that funds should be treated primarily as financial products rather than corporations and, correspondingly, investors should be treated primarily as consumers rather than corporate shareholders. To implement this approach, I propose the creation of a new federal agency that would develop standardized financial products coupled with corresponding disclosure principles. Sellers of retail products would be required either to conform their products to these standards or to explain material differences. The goal is to enhance market discipline while making retail funds less complicated and more understandable for individual investors.

Mutual funds and other intermediated retail investment products offer the potential for consumers to participate in capital market growth, protect their savings from the effects of inflation, and build a nest egg for education, retirement and other financial goals. This potential has led an increasing number of investors—including many of limited means and sophistication—to purchase such products. As such, it is time for regulators to respond to these developments through a regulatory approach tailored to the needs of those retail investors.

Although the SEC has endeavored to protect retail investors pursuant to the ICA, an examination of the market for retail investment products suggests deficiencies in that approach. At the same time, the regulatory and governance components of the ICA are costly and limit innovation. Compliance costs could be reduced and investors protected through an alternative approach premised on giving investors the choice of standardized financial products or comparative disclosure of product differences.

Conform or explain couples increased transparency through the promulgation of standardized products with a set of objective and predictable sales practices that would enhance consumer protection while limiting excessive liability exposure. Conform or explain enables providers of retail investment products to innovate and to differentiate their products from those of competitors with the assurance that market forces can adequately evaluate such innovations. Finally, conform or explain provides a template for CIRA, a new agency, to structure regulation and to develop expertise in the retail market that can facilitate future developments in investor education.

It is difficult to predict the effect of this proposal on existing products and fee structures. Conform or explain may dramatically reduce the number of retail investment products as improved disclosure unmasks limited product differences and strategic complexity. Alternatively, new products and product structures may emerge as fund sponsors are freed from existing regulatory constraints regarding leverage, compensation structure, liquidity and concentration. The critical component of the proposal is that it does not depend on regulatory omniscience to determine which products are suitable for investors but instead enhances the ability of market forces to make these choices.

The full paper is available for download here.