Taking exit rights seriously: why governance and fee litigation don't work in mutual funds.

AuthorMorley, John

ARTICLE CONTENTS INTRODUCTION I. BACKGROUND A. Summary of Regulation 1. Voting 2. Boards 3. Fee Liability B. Existing Thought on Mutual Fund Governance II. EXIT AS A DOMINANT STRATEGY A. The Basics of Exit in Mutual Funds B. The Exit/Activism Decision C. The Costs and Benefits of Activism D. The Benefits of Exiting E. The Costs of Exiting 1. Switching Costs 2. Search Costs F. Evidence on Shareholder Involvement in Activism 1. Voting 2. Fee Liability 3. Boards G. Contrast with Ordinary Companies and Closed-End Funds III. HARMFUL INTERACTIONS BETWEEN EXIT, VOICE, AND FEE LIABILITY A. Voting B. Boards 1. Doubtful Benefits 2. Significant Harms C. Fee Liability IV. EXIT'S AMBIGUOUS CONSEQUENCES V. POLICY PROPOSALS A. A Shift in Regulatory Style B. Voting C. Boards D. Fee Liability VI. THE PERSISTENCE OF VOTING, BOARDS, AND FEE LIABILITY CONCLUSION INTRODUCTION

Since the publication of a widely read book by Albert Hirschman in 1970, social scientists have come to agree that all organizations give to their members and owners some combination of the same three basic kinds of rights: exit, voice, and liability. (1) Social scientists have devoted considerable effort to understanding the relationships among these different categories of rights and the ways in which these rights complement and substitute for one another. This Article explores the relationships among these categories through a case study of a peculiar kind of organization: the American open-end mutual fund. As a result of regulation and market forces, mutual funds combine exit, voice, and liability in fascinating and highly unusual ways. By studying mutual funds, we hope both to gain general insight into the relationships among exit, voice, and liability and to learn something concrete about the protection of mutual fund investors.

The study of mutual fund regulation is important and timely. At the end of 2009, the mutual fund industry held assets worth more than $11 trillion and comprised approximately one-fifth of America's household financial assets and retirement savings. (2) Additionally, a form of liability unique to mutual funds that allows investors to sue their fund managers under the Investment Company Act of 1940 (ICA) for excessive fees was the subject of a recent Supreme Court decision, Jones v. Harris Associates L.P. (3) The case produced a widely discussed dispute between Judges Frank Easterbrook and Richard Posner in the Seventh Circuit (4) and extensive amicus briefing in the Supreme Court by corporate law professors and financial economists. (5)

To date, commentary about excessive fee liability and forms of shareholder voice in mutual funds, such as voting and boards of directors, has framed the debate about these matters almost entirely in terms of the robustness of market competition. (6) Those who believe in the importance of statutory mandates for voting, boards, and fee liability, such as Judge Posner, argue that these mandates are necessary because competition among funds for investors is not robust enough to protect investors on its own. Those who say voting, boards, and fee liability are not necessary, such as Judge Easterbrook, argue that competition is adequate on its own. The perceived connection between competition and the need for governance and fee liability has produced an extensive debate in academic journals and amicus briefs before the Supreme Court about whether the mutual fund market is competitive.

Our perspective differs radically from both sides of this existing debate. We argue that the problem with voting, boards, and fee liability in mutual funds is simply that investors will almost never use them. Investors will almost always prefer instead either to do nothing or to use a unique right of exit that is not available in ordinary companies. Mutual fund investors can be expected to behave this way under any reasonable view of mutual fund market competition and regardless of whether investors are large and sophisticated or small and unsophisticated.

Mutual funds differ from ordinary companies in all three categories of shareholder rights, but they are most unusual in terms of exit. In ordinary companies, individual shareholders can exit, but assets cannot. When a shareholder sells, the assets that underlie the shares remain stuck inside the company. In a mutual fund, in contrast, shareholders do not sell their shares--they redeem them from the issuing funds for cash. When a shareholder redeems, the fund pays the underlying assets to the shareholder, the fund correspondingly declines in size, and the shares are extinguished.

For our purposes, mutual funds look more like products or services than like ordinary companies. Just as buyers of auto tires and breakfast cereal can sever their relationships with manufacturers by refusing to buy their products any longer, investors in mutual funds can sever their relationships with managers by withdrawing their money and refusing to pay managers' fees any longer. The force that disciplines fees and returns, therefore, is not financial market arbitrage or shareholder voting, but product market-style competition. This kind of competition may be imperfect, as competition sometimes is in other product markets, but it is still a kind of product market competition.

We make four primary claims about the significance of exit in mutual funds. First, exit almost completely eliminates mutual fund investors' incentives to use fee liability, voting, and boards of directors. We support this claim in the body of this Article with a detailed exploration of a mutual fund investor's decision problem. We can illustrate the basic intuition, however, with a simple (albeit rough) example.

As a consequence of exit rights, mutual fund share prices are always exactly equal to the net asset value (NAV) of the issuing funds. The NAV is the pro rata portion of a fund's assets that corresponds to each share. The NAV is unaffected by expectations about future fees or portfolio changes. Indeed, it is possible for shares in two funds with different expected returns to have the same NAV. (7)

Imagine, therefore, two mutual funds with identical NAVs and different expected returns. Investors in the fund with the lower expected returns could theoretically improve the fund's returns by voting and fee liability. But they will not bother, because they will prefer instead to redeem their shares in the low-return fund and switch to the high-return fund. Since the two funds have the same share price, it costs no more to invest in the high-return fund than in the low-return fund. And since mutual fund share prices do not reflect expected returns, any improvement that voting and fee liability may be expected to produce in a fund in the future will not be reflected in the share price at which an activist investor can sell today.

Shareholders of ordinary companies cannot switch so easily. Switching from a company with low expected cash flows to one with high expected cash flows is costly, because shareholders in a company with low expected cash flows can only sell their shares at a low price reflecting the low expectations.

And they can only buy shares in a company with higher expected cash flows at a higher price reflecting the high expectations. Additionally, activism that improves a company's future returns raises the stock price in the present, creating immediate value for activist investors. Sometimes, therefore, it makes more sense for an ordinary company's shareholders to use voting and boards to improve the company's returns and raise the share price than to sell at the current price.

The claim that exit destroys incentives to use voice and fee liability is consistent with any reasonable view of mutual fund market competition, because nearly every commentator in the debate about mutual fund market competition agrees that at least some funds in every investing style offer competitive fees and returns (even if many funds do not). (8) And investors will prefer exit to activism so long as they can locate even one competitive fund with a given investing style.

The claim that exit destroys incentives to use voice and fee liability is also consistent with any reasonable view of mutual fund investors' size or sophistication. Although large and sophisticated investors often become active in ordinary corporations, they do not become active in mutual funds, since even large and sophisticated investors stand to gain more from exit than from activism. And although small and unsophisticated investors will sometimes fail to exit mutual funds because they lack time or knowledge, they will fail to use voting and fee liability for the very same reasons.

Second, exit distorts the operation of voice and liability in mutual funds. For example, exit causes fee litigation recoveries to go to the wrong investors. It also causes fee litigation to be even more completely dominated by plaintiffs' lawyers than ordinary class action litigation is, to be unlikely to target the highest-fee funds, and to discourage investors from moving to lower-fee funds. Exit also interacts with voting to make firing managers impossible, to make boards of directors unrepresentative of shareholders, and to prevent shareholders from receiving notice when funds raise their fees.

Third, even though the form of exit available in mutual funds is more favorable to shareholders than its counterpart in ordinary companies, the net effect of exit on the least sophisticated mutual fund investors is ultimately ambiguous. Because exit eliminates activism, investors who fail to exit underperforming funds (perhaps because these investors lack time or sophistication) cannot expect activism by other investors to improve these funds. Investors also cannot rely on financial arbitrage to maintain the efficiency of share prices, creating the possibility that uninformed investors will end up in low-return funds.

Finally, we propose a general shift in the approach of...

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