Does the Securities and Exchange Commission fundamentally misunderstand the differences between mutual fund governance and corporate governance, thereby failing to properly interpret the roles of fund and corporate directors? Eric Roiter, a lecturer at Boston University School of Law and former general counsel at Fidelity Research & Management Corp., thinks so, and he makes his argument in a soon-to-be published paper, entitled “Distentangling Mutual Fund Governance From Corporate Governance.”
In the 73-page paper (see link to paper here), to be published in the fall edition of the Harvard Business Law Review, Roiter argues that the differences between mutual funds and ordinary corporations should be considered during the rulemaking process, and that “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 three areas the SEC has erred most significantly relate to the distribution of mutual fund shares, the composition of fund boards, and affording a proxy access right to fund investors for the nomination of fund directors, he maintains.
If the SEC were to consider fund governance apart from corporate governance, the rulemaking process would be improved and could even open the way for “alternative types of mutual funds, including unitary investment funds and ‘crowdfunded’ mutual funds,” Roiter states.
Roiter told Fund Board Views he wrote the paper simply to share with the market his “unique perspective” as both a legal educator and a practitioner within one of the largest mutual fund firms in the world and not necessarily because he expects regulators to heed his advice. “I’m speaking from my vantage point as the general counsel of only one mutual fund company, and I’m making the assumption that what I observed is not unique to Fidelity but describes a great many—if not all—mutual fund companies,” he said.
Funds v. Corporations
In the paper, Roiter points to two “essential features” of mutual funds that differentiate them from ordinary corporations:
- Mutual funds are not only separate legal entities; they also are 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,” Roiter explains. This hybrid nature of both entity and product means that fund investors also have a hybrid character, as 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.” Roiter points to the Investment Company Act of 1940, which “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.”
- “To be sure, investment management is a fiduciary product, but it is a product nonetheless,” Roiter explains. This hybrid nature of both entity and product means that fund investors also have a hybrid character, as 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.” Roiter points to the Investment Company Act of 1940, which “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.”
- Mutual funds offer investors the right of redemption.
- “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,” Roiter says. “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.”
- “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,” Roiter says. “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.”
Because of these differences, fund governance “should be evaluated on its own merits, not as a derivative of corporate governance,” Roiter underscores.
“I think [Roiter] has a valid point regarding the inapplicability of certain corporate regulatory regimes,” a fund industry executive told FBV. “If you compare a fund (as an investment) to other investments (a house, stocks, real estate in general, even a car), market forces drive both price and service. Consumers select these products based on available information regarding performance, value, risk, etc. I think investors could do the same thing via a structure where mutual funds are seen as a product of the investment adviser. The investment adviser would be responsible for all fees and services and the investing public would see total expenses only and continue to see all the reporting, etc., on holdings and performance,” he said.
While audits still would occur, the board would be responsible solely for the adherence to the strategy and some general oversight. “This would dramatically reduce fees and put the responsibility of compliance with the adviser,” he offered.
Successes & Failures
Roiter examines a number of rulemaking efforts by the SEC, deeming many to be failures and a few successes.
On the issue of distribution of fund shares, Roiter devotes a lot of time in the paper to Rule 12b-1. “In considering the role of fund directors, the experience that has unfolded over more than three decades under Rule 12b-1 provides the SEC with an opportunity for reevaluation,” he says. “The value of fund boards arises from their policing role, safeguarding funds and their shareholders from over reaching by fund advisers.” This, he adds, is “quite different” from exercising business judgment over the growth or shrinkage of funds due to net sales or net redemptions. “Business judgment has got nothing to do with 12b-1 fees,” he told FBV. In the paper, he argues that “latitude must be left for fund management firms to exercise their own business judgment and for investors to make their own choices based upon full and fair disclosure.”
Roiter also looks at regulatory efforts to prescribe boards’ independence and composition, which he maintains just make boards less efficient. “It is difficult to see how changing the composition of a fund board will unleash the ‘business judgment’ of independent directors because this does nothing to alter their understanding that investors have chosen their fund adviser as well as their fund,” he says.
Roiter points to the chief compliance officer rule, adopted in 2003, and the portfolio manager compensation rule as successes, however. “The SEC got the CCO rule right and the portfolio manager compensation structure right because those two looked at mutual funds separately,” he told FBV. “The CCO rule enhanced the role of the CCO within the adviser; it works in large part because the board strengthens the role of trustees within legal and compliance…With the portfolio manager compensation rule, [the regulator] opted for disclosure and helping shareholders by giving them additional [information].”
Roiter’s paper examines these issues in depth and concludes with ways the SEC can improve its rulemaking process and make way for alternative structures for mutual funds. “I think [Roiter] is on the right track,” one independent chairman told FBV.