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On September 3, 2003, New York Attorney General Eliot Spitzer filed a complaint against hedge fund Canary Capital Partners LLC, alleging Canary defrauded consumers by engaging in both late trading and market timing of mutual fund shares. At the same time, Spitzer charged certain mutual fund families with allowing Canary to engage in these practices, resulting in injury to the funds' long-term investors.
Spitzer's allegations rocked the mutual fund industry, setting off a series of investigations and enforcement actions by state and federal regulators. Several large fund families were implicated in the scandal, which has resulted in over $2.8 billion dollars in settlements to date.
In the wake of the fund scandal, the Securities and Exchange Commission (SEC) adopted several new rules forcing dramatic changes in the governance of mutual funds.
A mutual fund typically is organized by a registered investment adviser that retains a significant role -- indeed, de facto operating control -- in fund management. In return for its services, the investment adviser charges the fund a management fee, and various other charges, typically based on a percent of the firm's assets.
The Investment Company Act of 1940 sought to protect fund shareholders from possible abuses by the fund adviser by requiring that funds have a board of directors that is formally charged with a number of tasks, including oversight of the fund's relationship with its adviser. Although the Act allows interested individuals to serve as directors, it long has required that a certain percentage of directors be independent of fund management. The idea, of course, is that these independent directors will function as watchdogs of fund management.
Because the SEC believed that the recent scandal resulted from a failure by those watchdogs to supervise insiders of fund advisers, which allowed those insiders to use the fund for their own financial gain, the SEC adopted new rules requiring 75% of a fund's directors to be independent, a dramatic increase from the 40% previously required. In addition, the chairman of the board must be an independent director. The new rules also require the board to conduct an annual self-assessment and to hold separate quarterly meetings outside the presence of management and inside directors. In addition, the rules permit independent directors to hire employees and retain advisers to assist them in carrying out their duties.
The core problem with these new rules is that they ignore basic principles of how rational actors respond to incentives. Normally a mutual fund has no employees of its own, but is managed by its investment adviser. In turn, because the adviser is compensated by a fee based on a percentage of the fund's average annual net assets, the adviser has an incentive to maximize the fund's average net asset value, which is precisely what the fund shareholders will want.
A director who is affiliated with the fund's adviser thus has a strong incentive to enhance fund performance, since a higher net asset value means a higher advisory fee. In contrast, an independent director who has no financial stake in the fund may not have as strong a commitment to enhancing fund performance, because his compensation is not dependent on fund assets.
Granted, Spitzer's investigation turned up cases in which advisers pursued self-interest at the expense of investors. In most cases, however, those decisions were made by subordinate employees not the adviser's top management. It's hardly clear that a 75% independent board would have been any better at preventing those abuses than a 40% board. Indeed, because the abuses were mostly inconsistent with the long-term interests of the fund adviser, the argument that rational interested directors have far stronger incentives to prevent such abuses than do independent directors still holds.
Inside directors also have significant information advantages relative to independent directors. A director with knowledge of fund operations is the most qualified person to identify problems with the adviser's service, and to propose changes to improve the quality of those services. Similarly, a director affiliated with the fund is best positioned to maximize economies of scale since he is familiar with management functions and will be able to identify ways in which the adviser can consolidate certain functions to reduce costs. Granted, they have a conflict of interest, but that conflict is best dealt with by disclosure. As long as shareholders are fully informed, they can decide for themselves whether the conflict of interest is such that they are uncomfortable investing in that fund.
This observation leads to our final criticism of the new rules. In enacting them, the SEC underestimated the power of the market to correct abuses by investment companies. One of the defining characteristics of mutual fund ownership is that a shareholder may redeem his shares at anytime. This gives the shareholder power to express dissatisfaction with fund performance by cashing out and moving his money elsewhere. As a result, if a fund consistently under performs due to dishonest management, it will lose shareholders and perhaps even be forced out of business unless the abuses are corrected.
To be sure, mutual fund investments are somewhat sticky. Many funds charge back-end fees of 3-7% when investors pull their money out. Many more funds charge front-end load fees that reportedly run as much as 5.75% in the case of equity funds. In addition, many investors hold their mutual funds through brokerage accounts, which is another potential source of fees. In light of these fees, the transaction costs of switching funds may well be significant.
While we thus acknowledge transaction cost barriers to switching funds thus may somewhat impede market forces from being fully corrective, we believe that the market is not sufficiently sticky to preclude it from self-correcting. The fund families that were accused of improper market timing and late trading were negatively impacted by the accusations. For instance, when Putnam Investment Management was charged with engaging in abusive market timing practices last fall, it suffered redemptions of over $21 billion dollars within a two-week period. Similarly, soon after fund giant Janus settled its market timing suit with regulators, ING U.S. Financial Services redeemed $5 billion dollars in Janus funds held by its variable insurance products. These examples demonstrate the power of a shareholder's right of redemption. Despite the potential for investment stickiness, a fund complex that does not place the shareholder's interest above its own likely will lose enough money for insiders to be adequately incentivized to prevent abuses.
What then should the SEC have done? If investors care whether their funds permit things like market timing and late trading by favored investors, honest firms could attract investors by promising to prevent such trading. If investors cannot distinguish between honest and dishonest firms, however, they may begin to perceive the whole industry as a lemons market.
Assume there are two classes of investors. One class believes the magnitude of the harm posed by insider self-dealing justifies restricting such self-dealing. Accordingly, this class is willing to pay higher fees to funds who promise not to allow self-dealing. The other class is willing to allow self-dealing by managers of its funds, so long as those funds charge lower fees. An unscrupulous fund will try to maximize its income by attracting investors in the first class while secretly self-dealing. Investors in the first class will be aware of this phenomenon, but the high detection and enforcement costs associated with self-dealing make it almost impossible for them to distinguish between honest and dishonest funds.
Accordingly, there must be a way for honest firms to provide a credible promise -- a bond -- that guarantees that the fund will abide by its stated policies. Law can facilitate private ordering by providing such a bond. Candidly, we are somewhat skeptical that one needs the full panoply of disclosure and procedural rules imposed by U.S. securities law in order to provide such a bond (see here). At the very least, however, facilitating the making of credible commitments requires an antifraud rule and enforcement regime.
A prohibition of self-dealing enforced by public law enforcement agencies thus makes the first class of investors better off, but makes the second class worse off. If one believes that most investors fall into the first class, however, a prohibition of insider trading would be efficient (so long as one is willing to use the Kaldor-Hicks definition of efficiency.) Hence, a prohibition of self-dealing may have advantages for the industry as a whole, by giving credibility to their promises not to allow self-dealing and thus reducing agency costs.
Instead of enacting arbitrary new independence requirements, the SEC therefore should have focused on enforcing the laws on the books. Indeed, it's not too late for the Commission to start over by ditching the new rules in favor of strict enforcement of the rules against fraud and self-dealing.
