Why Do Investment Funds Have Special Securities Regulation?

America’s securities laws are generic. We have only a single body of securities law for all types of companies. The two centerpieces of American securities regulation, the Securities Act of 1933 and the Securities Exchange Act of 1934, regulate almost every industry imaginable, from software making to clothing retail to food service, banking, coal mining, insurance, for-profit higher education, hotels, book publishing, art dealing, and real estate investing. American securities regulation contains multitudes.

Except, that is, for one very special industry: the investment company industry. Unlike all other companies, mutual funds, closed-end funds, hedge funds and private equity funds have their own special securities regulatory regime in the form of the Investment Company Act of 1940. This act is administered by the Securities and Exchange Commission, the same agency that administers the other securities laws, but it imposes a different body of regulations in place of (and sometimes on top of) the generic securities regulations that apply to every other kind of company. No other large industry has a special securities regulatory scheme of this scope and magnitude. The investment company industry is one of a kind.

But why? What exactly makes an investment company so different from every other kind of company that it alone deserves special securities regulation? Surprisingly, the answer has never been very clear and (in living memory, at least) even the question has never been directly posed.

This brief essay, a version of which has been published as a chapter in the Research Handbook on the Regulation of Mutual Funds, tries to find an answer. I review a number of possible rationales for special investment fund regulation, including the peculiar tendency of investment funds to own securities, the tendency of publicly registered funds to attract small investors, the desire for a unified collective brand to manage the way the investing public perceives the investment fund industry, and the potential risk large investment funds might pose to the financial system. I find each of these possible rationales wanting. They are both inconsistent with the content of investment fund regulation and unpersuasive as a matter of policy.

I thus offer a different theory. Whatever the logic of investment company regulation in the past, I argue that the most compelling rationale for this regulation today is an investment company’s unique organizational structure. An investment fund and its manager together exhibit what I call a divided structure: the fund and manager each have a separate legal existence and a separate set of owners and they relate to each other only by a contract that allows the manager to dominate the fund. This pattern relates investors and managers in a radically different way from conventional operating companies.

Though this pattern of organization is often efficient in investment funds, it is nevertheless often imperfect and it poses an array of problems that call out for regulation. The special job of the Investment Company Act is to provide that regulation.

The complete article is available for download here.