New Special Study of the Securities Markets: Institutional Intermediaries

Allen Ferrell is Harvey Greenfield Professor of Securities Law at Harvard Law School and John D. Morley is Professor of Law at Yale Law School. This post is based on their recent paper.

This paper, written for the Conference on the New Special Study of Securities Markets at Columbia Law School, identifies and reviews the key regulatory challenges posed by institutional intermediaries in America’s capital markets. We cover investment funds, credit-rating agencies and broker-dealers. We review existing research, identify new areas of research and suggest possibilities for legal reform.

We begin with investment funds, focusing primarily on publicly registered investment companies, such as open-end mutual funds. The first task of the regulation of these funds is to define what exactly an investment fund is. And on this score the existing regulation is doing poorly. The industry’s principal regulatory statute, the Investment Company Act of 1940, defines an “investment company” (the statute’s name for what is commonly known as an “investment fund”) as a company that holds a lot of securities, rather than a company that holds operating assets like land and intellectual property. This definition is impractical and often has the unintended effect of treating operating companies—including Microsoft and Yahoo!—as though they were the legal equivalent of mutual funds. We suggest that rather than focusing on securities ownership, the definition of an investment company should focus on organizational structure. The truly distinctive feature of an investment fund, we argue, is a fund’s unusual tendency to maintain a separate existence and a separate set of owners from the management company that operates it.

We also survey the regulation of mutual fund fees and find several potential areas for improvement. Existing fee disclosure formats have never been scientifically tested and too little is known about the characteristics of the highest-fee funds in the industry. Additionally, the system of fiduciary liability for excessive fees created by Section 36(b) of the ICA is hobbled by mechanical problems, with the consequence that excessive fee litigation tends mainly to attack the largest advisers, rather than the most expensive advisers.

The regulation of capital structure in registered investment companies is similarly badly designed. Though we could imagine many reasons for wanting to regulate the capital structure of mutual funds, the rules on capital structure that appear in the ICA are not actually consistent with any of these reasons. If, for example, the reason we limit borrowing by mutual funds is to reduce risk to the financial system, then why do we permit unlimited borrowing by hedge funds? The ICA exempts hedge funds from the ICA on the theory that hedge fund investors are large and sophisticated enough to protect themselves, but this theory makes no sense if the goal is to protect the financial system, rather than to protect fund investors.

Shareholder voting and governance also require reform. The ICA’s voting scheme—which makes shareholder voting mandatory on certain matters—was constructed at a time when the investment fund industry was still dominated by closed-end funds. The ICA scheme thus ignores the distinct needs of open-end funds, which have long since eclipsed closed-end funds in size and significance. Voting is much less useful in open-end funds than in closed-end funds, because the legal feature that defines an open-end fund—redemption rights—completely eliminate a shareholder’s incentive to vote. Voting requirements should thus be eliminated for open-end funds, even if they are retained for closed-end funds.

We also suggest a need to revisit the distinction between private and public investment funds. The ICA distinguishes public funds (such as mutual funds), from private funds (such as private equity and hedge funds), on the basis of the number, size and sophistication of their investors. In drawing the distinction this way, the ICA followed a pattern previously established by the Securities Act of 1933 and Securities Exchange Act of 1934, which regulate ordinary operating companies. This pattern may not be appropriate to investment funds, however, because the governance of investment funds is radically different from ordinary companies, with the effect that investor size and number are much less important in investment funds than ordinary companies.

The second part of our paper surveys credit rating agencies and broker-dealers. To understand the regulation of credit rating agencies, we survey the economics literature for answers to a number of questions, including how much the market actually relies on credit ratings; how flawed the ratings are; and whether regulation can prevent inaccurate ratings. We argue that social scientific evidence suggests that credit ratings are reasonably reliable for most corporate and municipal debt securities, so that most of the problems in credit ratings concern complex structured finance products. Indeed, much of this research has been focused on the performance of ratings for complex structured finance products during the financial crisis of 2007-2008. It is thus these products that should attract the greatest concern. Special concern should also attach to ratings given to securities issued during good economic times, to securities that are highly rated, and to securities issued by larger issuers. We explore a number of specific possibilities for reform.

We conclude by examining the regulation of broker-dealers. We examine the controversy over whether broker dealers should be fiduciaries and call for research to identify more precisely the differences between a fiduciary standard and the older suitability standard. We also examine the controversy over commission-based compensation for brokers and suggest that the evidence is complex and conflicting. We conclude by examining several areas of possible reform, including enhanced disclosures, improved enforcements, and greater uniformity between broker-dealers and investment advisers.

The complete paper is available here.

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