Disentangling Mutual Fund Governance from Corporate Governance
Boston University – School of Law
This Article addresses mutual fund governance, explaining how in recent years it has become entangled with the norms of corporate governance. There are two essential features of mutual funds, however, that differentiate them fundamentally from ordinary corporations. First, mutual funds are not only separate legal entities; they are also financial products (or services). Mutual fund investors are therefore both shareholders and customers. This stands, of course, in marked contrast to ordinary corporations, whose shareholders and customers are two distinct and separate groups. Second, mutual funds are fundamentally different owing to the right of redemption, a right of investors to withdraw their capital. 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. In contrast, redemption rights are antithetical to the organizing principles of ordinary corporations, whose economic viability in the markets depends upon the ability to lock in shareholders’ capital. This Article examines how recent mutual fund rule-making by the SEC rests on mistaken comparisons to corporate governance, and makes recommendations as to how the SEC can improve its approach. In particular, this Article proposes that the SEC take steps to allow two new 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.
Disentangling Mutual Fund Governance from Corporate Governance – Introduction
For years, mutual fund governance has been converging with corporate governance. What makes for sound governance of our nation’s public corporations, it is presumed, must do likewise for mutual funds, as they, too, have boards of directors and shareholders. The Securities and Exchange Commission (“SEC”), the regulator of mutual funds, has embraced this presumption, not in all instances, but in several of its most important rule-making initiatives, emphasizing, in particular, the importance of fund directors’ exercising “business judgment.” As a consequence, fund directors have had heightened expectations thrust upon them, and fund investors have been treated more as shareholders than as consumers of a fiduciary product or service, investment management, from their fund adviser. For its part, Congress has enacted laws lumping mutual funds with public companies, as exemplified by the Sarbanes-Oxley Act1 and the Dodd-Frank Act2, statutes arising from breakdowns in corporate governance, not mutual fund governance.
It has not always been thus. The Investment Company Act of 1940 created a framework where boards of directors of mutual funds3 have an important role but limited in ways not found in the enabling statutes for ordinary corporations. Most notably, the ICA 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. From the investment adviser’s standpoint, a fund is the means by which it offers investment services to its customers, the fund’s shareholders. As for a fund shareholder, she can choose among a multitude of funds and fund advisers, and at any time can terminate her conjoined relationship with fund and adviser by exercising a right of redemption, causing the fund to repurchase her shares at a price matching her proportionate ownership interest.
As fund boards are expected to emulate corporate boards and broaden their business judgment role, neither the SEC nor the courts have undertaken a detailed analysis about underlying assumptions and issues.4 Do fund governance and corporate governance share the same premises and purposes? How does a corporate governance model square with the provisions of the Investment Company Act and the principal role played by the fund’s investment adviser? Does it even make sense to expect that fund boards, especially independent directors, are in a position to exercise “business judgment” over investment management policies or strategies? And, if those decisions are beyond the ken of fund boards, what is left of the notion of “business judgment,” as it is understood in the corporate governance world? Further, do fund shareholders and corporate shareholders have essentially the same stake in “governance” issues, or does the economic model of a mutual fund suggest that important differences separate fund shareholders from corporate shareholders?
This Article argues that mutual fund governance should disentangle itself from corporate governance. Corporations have shareholders and customers—two groups distinct not only in law but the marketplace. Mutual fund investors are both shareholders of funds and customers of fund advisers. The product provided by fund advisers is investment management, and it is offered in the form of fund shares.5 While investment management is a fiduciary product, it is a product nonetheless. This Article does not contend, however, that mutual funds should be seen exclusively as products. Legal form has consequences, and this is true for mutual funds because they almost always have a separate legal personhood, either as a corporation or a trust. Mutual funds thus have a hybrid nature: both product and legal entity. Consequently, fund governance should be evaluated on its own merits, not as a derivative of corporate governance. In particular, the primary role of fund directors is not to exercise an all-encompassing business judgment over a fund’s operations, but instead to monitor the fund adviser for compliance with legal and fiduciary duties. Fund directors can establish policies and procedures to ensure that advisers do not place their interests ahead of those of shareholders. They can establish and oversee an internal reporting regime to oversee compliance, and they can act on behalf of funds in resolving errors or losses for which the adviser is responsible.
It is in these ways that fund directors can exercise a discrete type of business judgment, and this should guide the SEC, courts and legislators when setting or construing norms of mutual fund governance. A monitoring role for fund boards comports with the economic reality that fund directors do not occupy, and generally do not see themselves as occupying, a position to negotiate with advisers in any sense comparable to how corporate directors or officers negotiate deals. Ordinary corporations, when choosing among competing third parties for the provision of services, seek optimal contractual terms while retaining the ability simply to walk away from any would-be counter-party. This dynamic simply is inapposite for mutual funds. It is not only that a fund’s very existence is owing to the initiative and entrepreneurial risk of the fund adviser, but also that fund directors are keenly aware that investors, by choosing a fund, have also chosen a fund adviser. This is not to say that improvements cannot be made to mutual fund governance. The point is that a debate over fund governance is not won, nor even necessarily advanced, simply by invoking norms of corporate governance. Further, there are other possible constructs for mutual funds that can offer alternatives to the historic model for fund investors, allowing them to choose not only among different funds and different advisers, but also different levels of fund governance.
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