Disentangling Mutual Fund Governance from Corporate Governance
Eric D. Roiter
This Article addresses mutual fund governance, explaining how it has recently become entangled with the norms and rules of corporate governance. At one level, it is understandable that the Securities and Exchange Commission (SEC) and courts have viewed mutual funds as a type of ordinary corporation. Both mutual funds and corporations are separate legal entities, having directors and shareholders. Directors of each are held to fiduciary duties, charged with serving shareholders’ interests, and expected to aspire to best practices. However, there are fundamental differences between mutual funds and ordinary corporations.
This Article contends that these differences have important implications for governance, differences that should lead to the disentanglement of mutual fund governance from corporate governance. There are two essential features of mutual funds that differentiate them from ordinary corporations. First, mutual funds are not only separate legal entities, but also financial products (or services) by which fund investors obtain professional investment management from investment advisers. Mutual funds have, therefore, a hybrid nature—both entity and product. Accordingly, fund investors, too, have a hybrid character: they are both customers of the fund’s adviser and shareholders of a legal entity. This hybrid character stands in marked contrast to ordinary corporations, whose shareholders and customers are two groups, distinct in the law and the marketplace. For an ordinary corporation, decision-making authority and oversight of all facets of its business rest squarely with the board of directors. By contrast, under federal law (the Investment Company Act of 1940), decision-making over a fund’s core business—investing in securities—rests with the fund’s investment adviser, a third party who in nearly all cases has borne the risks and expenses of organizing and promoting
Second, mutual funds are fundamentally different from ordinary corporations due to the right of redemption, a right of the investor to withdraw her capital. This right is antithetical to the organizing principles of ordinary corporations (at least public corporations), whose economic viability depends upon the ability to lock in shareholders’ capital. 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 because fees are tied to the amount of assets under management
in the fund.
In light of crucial differences between mutual funds and ordinary corporations, this Article argues that fund governance should be evaluated on its own merits, not as a derivative of corporate governance. 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 duties owed by the fund’s adviser. This Article examines, in particular, three areas of rulemaking where the SEC has tended, mistakenly, to equate mutual fund governance with corporate governance. These areas relate to the distribution of mutual fund shares, the composition of fund boards, and the “proxy access” right given to mutual fund investors for the nomination of fund directors.
This Article concludes with recommendations for how the SEC can improve its approach to mutual fund rulemaking. These recommendations include specific ways in which the SEC can conduct its rulemaking process as well as two 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 type is a “crowdfunded” mutual fund that would allow for investors, rather than investment advisers, to initiate and organize funds.
Where Have All the IPOs Gone? The Hard Life of the Small IPO
Paul Rose and Steven Davidoff Solomon
We examine firm lifecycles of 3,081 IPOs from 1996–2012. We find that small IPOs have a different lifecycle than other, larger companies. Within five years of an IPO, only 55% of small capitalization companies remain listed on a public exchange, compared to 61% and 67% for middle and large capitalization companies, respectively. Small capitalization companies generally delist either voluntarily or involuntarily, while mid and large capitalization companies largely exit the public market through takeover transactions. Those small companies that remain listed largely fail to grow, remaining in the small capitalization category. We use our findings to examine various theories explaining the decline of the small IPO. We find only minor evidence that regulatory changes caused the decline of the small IPO. The decline appears instead to be more attributable to the historical unsuitability of small firms for the public market. Absent economic or market reforms that change small firm quality, further regulatory reforms to enhance the small IPO market are thus unlikely to be effective or bring firms into the public market that have the horsepower to remain publicly listed.
The Conflict Minerals Experiment
In Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress instructed the Securities and Exchange Commission (SEC) to draft rules that would require public companies to report annually on whether their products contain certain Congolese minerals. This unprecedented legislation and the SEC rulemaking that followed have inspired an impassioned and ongoing debate between those who view these efforts as a costly misstep and those who view them as a measured response to human rights abuses committed by the armed groups that control many mines in the Democratic Republic of the Congo.
This Article for the first time brings empirical evidence to bear on this controversy. I present data on the inaugural disclosures that companies submitted to the SEC. Based on a quantitative and qualitative analysis of these submissions, I argue that Congress’s hope of supply chain transparency goes unfulfilled, but amendments to the rules could yield useful information without increasing compliance costs. The SEC filings expose key loopholes in the regulatory structure and illustrate the importance of fledgling institutional initiatives that trace and verify corporate supply chains. This Article’s proposal would eliminate the loopholes and refocus the transparency mandate on disclosure of the supply chain information that has come to exist thanks to these institutional efforts.