AFFILIATED AGENTS, BOARDS OF DIRECTORS, AND MUTUAL FUND SECURITIES LENDING RETURNS

• Date: 01 December 2014
• Author: Takeshi Nishikawa,Sattar A. Mansi,John C. Adams
• DOI: http://doi.org/10.1111/jfir.12043
• Published date: 01 December 2014

AFFILIATED AGENTS, BOARDS OF DIRECTORS, AND MUTUAL FUND

SECURITIES LENDING RETURNS

John C. Adams

University of Texas at Arlington

Sattar A. Mansi

Virginia Tech

Takeshi Nishikawa

University of Colorado Denver

Abstract

Using a manually collected U.S. index mutual fund sample, we find that funds with

sponsor‐affiliated lending agents have lower annual returns on lent securities and that

securities lending returns are significantly higher when funds administer their own

lending programs. We also document that multiple board of director appointments, more

director fund ownership, higher board independence, and lower excess director

compensation are associated with higher lending returns. Overall, the evidence has

implications for mutual fund boards as they consider lending proposals and for future

regulatory actions.

JEL Classification: G20, G32, G34

I. Introduction

In 2004, the Securities and Exchange Commission (SEC) launched an investigation into

the management of securities lending programs for mutual funds administered by a

number of investment houses including State Street, Bank of New York Mellon, Northern

Trust, and JP Morgan. The investigation revealed potential conflicts of interest when

funds employed securities lending agents that were affiliated with their sponsor.

1

It also

revealed that there were numerous instances where sponsors manipulated the bidding

process so that mutual fund boards would select affiliated over nonaffiliated lending

agents and that most boards failed to adequately oversee securities lending programs.

Further concerns were expressed about off‐the‐books side payments not being disclosed

to fund shareholders, lending proceeds not going back to lending funds, and securities

We are grateful to Gary Sanger (associate editor), an anonymous referee, Patrick Kelly, Pete Kyle, Bruce Leto,

Chris Plantier, Brian Reid, Laura Starks, Russ Wermers, Jason Zweig from the Wall Street Journal, and seminar

participants at the 2013 ICI/CFP Academic and Practitioner Conference on Mutual Funds and ETFs for comments

and suggestions that helped improve the paper. The remaining errors are ours.

1

See Tom Lauricella, “SEC Discovers Breaches in Lending Securities,”Wall Street Journal (January 29,

2007). The term sponsor refers to the investment company that manages the fund. The term affiliated refers to

sponsors and lending agents that are part of the same corporate entity.

The Journal of Financial Research Vol. XXXVII, No. 4 Pages 461–493 Winter 2014

461

© 2014 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

lending being profitable only to the fund’s sponsor or lending agent and not to the

shareholders.

2

The result is a widespread criticism and lawsuits alleging that many

securities lending agents either misled investors about the risks of lending securities or

inappropriately invested lending collateral in risky investments that resulted in significant

losses during the market crash of 2008.

3

Despite these concerns, anecdotal evidence

points to an increase in the use of securities lending as a means to enhance returns and the

market has grown to over $12 trillion as of 2012.

4

In this article, we examine whether affiliated lending agents and mutual fund

boards affect securities lending returns in a hand‐collected sample of U.S. index mutual

funds. This issue is important as securities lending income benefits shareholders by

offsetting fund expenses. The extant literature largely ignores agency considerations

between beneficial owners and lending agents.

Figure I illustrates the securities lending agency environment at a large mutual

fund complex. The lending fund advisor, lending agent, collateral reinvestment manager,

and broker are all affiliated subsidiaries of the financial services parent firm. Conflicts of

interests are potentially severe in affiliated lending agent arrangements and in all securities

lending arrangements because fund sponsors (or their corporate parents) have financial

incentives to favor affiliated lending agents.

It is well documented that funds can increase investor cash inflows by increasing

fund performance. One way to increase fund performance is to maximize securities

lending returns. However, what matters is the marginal effect to the corporate parent (i.e.,

collecting higher fees vs. increased cash flows to the lending funds they manage). That is,

rebate rates, collateral reinvestment pool management fees, and lending agent fees can

potentially be set to levels that maximize overall parent profitability at the expense of

mutual fund shareholders.

Although it is customary for mutual funds and lending agents to split lending

proceeds, details on these fee splits are rarely disclosed to investors. This lack of

transparency likely exacerbates agency problems associated with self‐dealing behavior.

Figure I also illustrates that even if affiliated lending agents offer favorable agent fees,

they can be still associated with lower mutual fund lending returns if they are unable to

negotiate competitive rebate rates and/or collateral reinvestment pool management fees.

We posit that the level of self‐dealing (i.e., administering lending programs to

unduly benefit sponsors at the expense of fund investors) is potentially greater, and mutual

funds’securities lending returns are lower, when funds employ sponsor‐affiliated lending

agents. Mutual funds can select their custodian bank or a third‐party specialist (i.e.,

broker/dealer), both of which may be affiliated with their sponsors, as their lending agent.

Mutual funds can also act as their own securities lending agents. They can use an auction

service, grant a principal intermediary or other third‐party specialist rights to all or a

2

Robert Wittie, “SEC Concerns with Securities Lending by Mutual Funds,”12th Annual Beneficial Owners’

Summit on Domestic and International Securities Lending and Repo (February 2006).

3

See, for example, Jason Zweig, “Is Your Fund Pawning Shares at Your Expense?”Wall Street Journal

(May 30, 2009); Emily Lambert, “Securities Lending Meltdown,”Forbes (June 22, 2009); and Louise Story,

“Banks Shared Clients’Profits, but Not Losses,”New York Times (October 17, 2010).

4

See “Securities Lending Best Practices,”eSEC Lending (2012).

462 The Journal of Financial Research

portion of their portfolios, or lend directly to borrowers (e.g., such as hedge funds, market

makers, and broker/dealers). Alternatively, mutual funds can use some combination of

custodian, third‐party specialist, and self‐lending routes to the securities lending market

(i.e., not using a single agent but instead seeking competitive prices from various agents

and borrowers for each security to be loaned).

5

Self‐lending funds likely retain a greater

portion of the proceeds from lending and are able to mitigate the conflicts of interest

inherent in all, and especially affiliated agent, lending agreements. Therefore, we expect

that securities lending returns are higher when funds administer their own lending

programs.

We also consider the impact of lending program indemnification. Some lending

agents indemnify mutual funds from counterparty and collateral reinvestment risk.

Because indemnification is costly and increases risk to lending agents, mutual fund

lending returns will likely be lower when funds elect to employ indemnifying lending

Figure I. Mutual Fund Securities Lending. This figure illustrates one of many ways a mutual fund can access the

securities lending market. A customer of the broker/dealer sells a particular security short to a long

investor. The broker/dealer locates and borrows securities to facilitate the short sale using the proceeds of

its customer’s short sale to collateralize the borrowed securities. For this example the reinvestment rate is

4.00% and the lending fund/agent and broker/dealer agree to a 1.00% rebate rate. The lending fund

approves the lending agreement and instructs the lending agent to invest the collateral in the agent’s

collateral pool to earn the reinvestment rate (for the sake of simplicity we assume the lending fund does

not choose an alternative investment vehicle for the collateral). The lending agent and the mutual fund

split the net interest profit of 3.00% (4.00% –1.00%) with at least 50% of the proceeds going to the

lending mutual fund. The broker/dealer uses the borrowed securities to make settlement with the long

investor. If the short‐selling customer earns 50 basis points on the cash proceeds from the short sale, the

broker/dealer earns the remaining 50 basis points. Mutual funds can increase their profits by searching for

borrowers and/or agents who are willing to receive the lowest rebate rates and fee splits.

5

See the Appendix for a detailed discussion of securities lending agreements.

Mutual Fund Securities Lending Returns 463