Disentangling Mutual Fund Governance from Corporate Governance

The following post comes to us from Eric D. Roiter of Boston University School of Law.

Disentangling Mutual Fund Governance from Corporate Governance addresses mutual fund governance, explaining how in recent years it has become entangled with the norms and rules of corporate governance. At one level, it is understandable that mutual funds have been seen simply as a type of ordinary corporation, leading the SEC and the courts to treat mutual fund governance as simply a variation on the theme of corporate governance. Both mutual funds and corporations are separate legal entities, having directors and shareholders. Directors of each are held to fiduciary duties, charged with serving shareholders’ interests, and aspire to best practices. But there are fundamental differences between mutual funds and ordinary corporations, and this article contends that these differences have important implications for the governance of mutual funds, differences that should lead not to further entanglement of fund governance with corporate governance but to disentanglement.

There are two essential features of mutual funds that differentiate them from ordinary corporations. First, mutual funds are not only separate legal entities; they are also financial products (or services), the means by which fund investors obtain professional investment management from investment advisers. To be sure, investment management is a fiduciary product, but it is a product nonetheless. Mutual funds have, therefore, a hybrid nature—both entity and product. This means that fund investors, too, have a hybrid character: They are both customers of the fund’s adviser and shareholders of a legal entity, the fund. This stands, of course, in marked contrast to ordinary corporations, whose shareholders and customers are two groups, distinct in law and in the marketplace. For an ordinary corporation, decision-making authority and oversight of all facets of its business rest squarely with the board of directors, and for this reason corporate directors are called upon to exercise wide-ranging business judgment over the corporation’s business and operations. This is not the case for mutual funds. Most notably, federal law, the Investment Company Act of 1940, leaves decision making over a fund’s core business—investing in securities—not with the fund’s directors or officers but with a third party, the fund’s investment adviser, who in nearly all cases has taken the risks and borne the expenses of organizing and promoting the fund.

Second, mutual funds are fundamentally different from ordinary corporations owing to the right of redemption, a right of the investor to withdraw her capital. This is antithetical to the organizing principles of ordinary corporations (at least public corporations), whose economic viability in the markets depends upon the ability to lock in shareholders’ capital. For mutual funds, however, their investors’ right to withdraw capital, to redeem their ownership interest from the fund, is a defining feature. The right of redemption is not only a financial right, it is also essential to the governance of mutual funds, imposing direct discipline upon a fund’s adviser. As each share is redeemed, a fund adviser’s compensation is directly reduced, as fees are tied to the amount of assets under management in the fund.

In light of crucial differences between mutual funds and ordinary corporations, this Article argues that fund governance should be evaluated on its own merits, not as a derivative of corporate governance. The emphasis should not be upon expanding the “business judgment” decision making of a fund’s directors, but rather upon their role as monitors of legal and fiduciary duty owed by the fund’s adviser.

The article examines, in particular, three areas of rulemaking where the SEC has tended, mistakenly, to equate mutual fund governance with corporate governance. The first rulemaking involves the distribution of mutual fund shares, more particularly, the question of who bears the cost of distribution expense. To address a fund adviser’s perceived conflict of interest, the Investment Company Act prohibits the imposition of distribution costs on mutual funds themselves, leaving either fund advisers or fund investors (or both) to bear this expense. The SEC, invoking its power to grant exemptions, adopted Rule 12b-1 in 1980 to allow boards in the exercise of their ostensible business judgment to shift distribution expense onto funds. In practice, however, there is little evidence that fund boards exercise, or are in a position to exercise, any meaningful business judgment over the distribution process. Rather, this is a business judgment made by the fund adviser subject to the ultimate judgment of market forces and investor choice. This was finally acknowledged by the SEC staff in 2010 in recommending that Rule 12b-1 be replaced and the “business judgment” test abandoned. The staff’s proposal has, however, not been implemented by the SEC.

In a second rulemaking, the SEC mistakenly attempted to impose corporate governance notions on mutual funds by requiring all funds to have independent board chairmen as well as a 75% supermajority of independent directors. The SEC did so without critically evaluating the costs and benefits of these requirements or considering their relevance (if any) to fund investment returns or, for that matter, compliance with investor protection rules.

In a third rulemaking, involving proxy access, the SEC lumped mutual funds together with ordinary corporations with little scrutiny as to whether mutual fund investors and corporate shareholders have similar stakes in the process of nominating and electing directors, overlooking among other things, the key role that fund investors’ redemption right plays in this context.

The article concludes with recommendations as to how the SEC can improve its approach to mutual fund rulemaking. These recommendations include not only specific ways in which the SEC can conduct its rulemaking process, but also two types of mutual funds that can compete in the marketplace alongside traditional mutual funds. One type is the unitary investment fund, which would retain fund boards solely to serve as monitors of fund advisers’ legal and fiduciary duties, while leaving judgments over the competitiveness of an adviser’s fees to the marketplace. The other is a “crowdfunded” mutual fund that would allow for investors themselves, rather than investment advisers, to initiate and organize funds.

The full article is available for download here.

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