As I reflect on my almost 50 years in the financial services industry in a variety of roles—as a regulator, an officer and director of registered investment companies, and an executive and lawyer at financial services firms—I realize the importance of the identification and proper resolution of conflicts of interest. A review of past difficulties that have occurred in the financial services industry, including those involving mutual funds, reveals that those difficulties have typically involved conflicts of interest that were not properly identified and resolved.

Funds typically do not have any employees and rely on a variety of service providers to perform the functions necessary for their proper operation. Those service providers include the investment adviser, distributor, administrator, transfer agent, custodian, auditor, and counsel, each of which is a separate entity with its own potential conflicts of interest. In particular, the service providers can have business interests and compensation structures that are not always fully aligned with the interests of the fund. Fund directors, and particularly independent directors, have important oversight responsibilities that fund shareholders are relying on and they therefore should be familiar with any potential conflicts. It is from the perspective of an independent director that I will explore, in a series of articles over the coming weeks, the continuing importance of the identification of conflicts of interest and their proper resolution. This is an important topic, and we all need to make sure that we get it right.

Setting the Scene

It is worth noting that prior to the enactment of the Investment Company Act of 1940, the mutual fund industry was affected by a number of significant abuses, most of which involved conflicts of interest. Those abuses were well documented in a report by the Securities and Exchange Commission[1] and in the April 1940 congressional testimony of SEC Commissioner Robert E. Healy[2].  The abuses took many different forms but often had the same result: the subordination of the interests of fund investors to those of the fund’s sponsor, investment adviser, or other insider. The 1940 Act did an excellent job in addressing those abuses, and the fund industry and fund investors have benefited greatly.

It has been well over 80 years since the 1940 Act was implemented, and significant changes have occurred since then in the markets, in the industry, and among participants. In fact, today’s fund directors need only to look back a mere five to ten years to note the significant changes that they have witnessed. Still, I suggest we all will benefit from employing a renewed focus on the potential for conflicts of interest that are inherent in financial services and, in particular, in the fund industry.

The breadth and depth of the financial services industry, including mutual funds and their importance to our economy and investors, cannot be overstated. The investment management sector of the financial services industry is quite significant. As was pointed out in Congressional testimony by the SEC in June 2024[3], 58 percent of U.S. households own stocks, and more than half own registered funds. It was also noted that more than 15,400 investment advisers advise 57 million clients, and there are over $32 trillion in registered funds, $30 trillion in private funds, and nearly $50 trillion in separately managed accounts. According to a 2024 Financial Industry Regulatory Authority report[4] there are more than 3,200 broker-dealers with over 625,000 registered representatives and over 85,000 persons associated with the 32,000 or so investment advisory firms they work for.

As I focus on those numbers, I cannot help but be impressed by the enormous success they represent. However, I also see the complexity of the financial services industry and the variety of potential conflicts of interest that the many participants have. As funds utilize the services of many of those participants, understanding those potential conflicts of interest is of critical importance for everyone, but particularly for fund directors as they review, approve, and oversee the arrangements their funds have with those service providers. And while the success of funds and the financial services industry might tempt us to conclude that all is well, I rather worry that such complacency would not be well founded. Especially with the considerable changes that are occurring in business, the marketplace, and the regulatory arena, as well as the challenges market participants are facing in tandem with those changes, it is important for us to continue our focus on this area.

In a series of five upcoming articles, I will examine potential conflicts of interest with each discussion tailored to a particular type of financial services participant: mutual funds, investment advisers, broker-dealers, service providers, and other professionals. In the articles, I will discuss many of the areas where potential conflicts may exist, some abuses involving conflicts that have arisen, some resolutions that have been employed to resolve those conflicts, and the legal and regulatory standards, if any, that may apply. My goal is to create a series that is of interest and helpful to fund directors and push this very important topic into focus in fund boardrooms. Stay tuned.

Andrew J. Donohue (Buddy), who has almost 50 years of experience in the financial services industry, is currently the chair of the Mutual Fund Directors Forum and an independent director of various BNY Mellon Funds. He previously served as chief of staff, from 2015 to 2017, and director of the Investment Management Division, from 2006 to 2010, at the Securities and Exchange Commission. Donohue also was executive vice president and general counsel at OppenheimerFunds, global general counsel at Merrill Lynch Investment Managers, and managing director and investment company general counsel at Goldman Sachs.