Commoditized Governance: The Curious Case of Investment Company Shared Series Trusts.

Author:Franco, Joseph A.
 
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  1. INTRODUCTION II. THE EMERGENCE OF SERIES TRUSTS IN THE INVESTMENT COMPANY INDUSTRY A. The Origins of Registered Investment Company Use of Series Trusts B. The Regulatory Response to Series Funds in the Registered Fund Industry III. THE ROLE OF GOVERNANCE IN THE REGISTERED INVESTMENT COMPANY CONTEXT A. The Typography of RIC Governance 1. The Push for Independence on Fund Boards 2. Affirmative Delegated Regulatory Role of Independent Trustees B. The Theory of What Fund Boards "Should be Doing" 1. Current Appraisals of Fund Governance: The Good, the Bad and the Ugly 2. A Process-Oriented Perspective on Fund Governance IV. SHARED SERIES TRUSTS: PROMISES AND PITFALLS A. The Shared Series Trust Business Model B. Pitfalls in Practice C. Implications for Commoditized Governance V. THE LESSONS AND LIMITS OF COMMODITIZED GOVERNANCE A. Situating the Issue of Commoditized Governance in Corporate Theory B. A General Theory of Commoditized Governance VI. CONCLUSION VII. APPENDICES Appendix A Appendix B I. INTRODUCTION

    Use of series structures for multiple registered investment company funds (such as mutual funds or exchange-traded funds (ETFs)) is well-established both in practice and, as a regulatory matter, under the Investment Company Act of 1940 (ICA). (1) Essentially, in a series trust, multiple distinct funds reside in a single entity, most commonly a trust, as separate series of the trust. (2) Because registered funds are publicly offered, each fund series will invariably be owned by shareholders that differ from shareholders in other funds in the same trust. The assets and liabilities of each fund within the trust are legally segregated from its sibling funds. More recently the use of series structures in business entities has spread to other forms of business and types of business entities (most notably, LLCs (3)). But there should be no mistake about the significance and dominance of series structures among registered investment companies. Together, mutual funds and ETFs oversee $22 trillion in assets under management (AUM) (4) in roughly 10,000 funds, (5) and 91% of these funds reside in entities organized as Massachusetts common law business trusts, Delaware statutory trusts, or Maryland corporations. (6) All three of these entity structures permit use of series structures and so the vast majority of funds are organized in entities that are series eligible. Even a very conservative estimate would suggest that a significant majority of the funds are organized in series form and these funds almost surely represent a majority of the $22 trillion in assets managed by these funds (i.e., more than 50% of total industry AUM is held in series funds). (7)

    This Article focuses on a relatively recent development in the fund industry that involves a variation on the series structure concept: the shared series trust. (8) The series trust and shared series trust differ in one fundamental respect: the relationship of the trust's sponsor to the sponsor of the funds in the trust. In a conventional series trust, the trust sponsor is an investment adviser or an affiliate of the adviser, and the investment adviser typically manages the assets of each fund in the trust. In contrast, in a shared series trust, the sponsor of the trust is typically not a fund investment adviser and has little interest and no stake in the management or strategic decisions of the underlying funds in the trust. Rather, in the shared series trust, the trust sponsor or its affiliate is a third-party provider of non-advisory fund services (such as fund administration, compliance, and transfer agency). The sponsor of the individual funds in the trust (not to be confused with the trust's sponsor) typically will be the future investment adviser for the proposed new fund that will become a new series in the trust. In this arrangement, the fund sponsor/investment adviser will select a trust to house the proposed fund as a cost-efficient way to secure non-advisory services, including entity governance. This particular service feature, namely participation in a shared trust, provides the fund sponsor with an entity to house the fund and an "offthe-rack" board of trustees (including, most importantly, the requisite complement of independent trustees). (9)

    The distinction between a series trust and a shared series trust can be concretely illustrated. The Fidelity family of funds has several hundred funds, and virtually all are housed in more than a dozen series trusts. (10) The principal advisers to each of the funds in the Fidelity family is a privately-owned adviser, Fidelity Management & Research (FMR) whose primary source of revenue are the management fees it derives in managing funds in the Fidelity family. In virtually all cases, FMR or an affiliate serves as the original sponsor of each fund in the Fidelity family of funds.

    The shared series trust entails an alternative hypothetical scenario in which a third party (A1 Service Provider) forms (sponsors) a shared series trust entity--for example, the Generic Series Trust. Unlike the model in which an adviser sponsors the entity and the component fund series, the shared series trust sponsor is a non-adviser and the trust may have a dozen funds, each managed by unaffiliated investment advisers, such as Adviser X, Adviser Y, etc. The individual funds are typically sponsored by the adviser who manages the funds sponsored by that adviser. For example, A1 Service Provider may sponsor the Generic Series Trust, Adviser X would be the sponsor of the Adviser X Premium Fund, and Adviser Y would be the sponsor of Adviser Y Tactical Fund.

    The governance outcome for the two types of series trust are starkly different. For the conventional series trust sponsored by an adviser, the board for any new fund will be the board of an existing series trust sponsored by the adviser. (11) An unaffiliated adviser who sponsors a new fund will likely approach the governance question differently. The unaffiliated adviser could seek to form the fund in a new stand-alone business entity (and recruit a board). Alternatively, the unaffiliated adviser might seek to have the new fund become a series within an existing shared series trust entity, such as the Generic Series Trust, under that trust's board. This latter situation--searching for an existing registered investment company entity and board to govern the fund--effectively treats governance as a commodity rather than as a core aspect of the fund's business. The unaffiliated adviser shops for an entity and board whose purpose is to provide a formal entity and board for the new fund.

    The commoditized governance result should be of interest to both policymakers and legal scholars. For policymakers, this type of arrangement offers insights into how investment company governance functions in practice. The selective emergence of this approach to fund governance is a consequence of the evolution of governance practices in the registered investment fund space resulting both from changing business models in the industry and the unintended effects of fund governance regulation that places paramount significance on board independence. (12) An obvious concern is whether this form of commoditized governance model (an extreme form of independence) can effectively achieve the overarching governance objectives sought by regulation. In addition, if merely by contrast, an analysis of the shared series trust situation raises explanatory and normative implications for fund governance as a whole.

    The commoditized governance phenomenon is also significant for legal theorists who focus on governance of business entities. As noted, the way governance functions for a shared series trust offers, at the very least, an unusual, and possibly unique, example in which entity governance is commoditized (i.e., procured by a business from an external provider). More formally, when I refer to commoditized governance, I mean situations where (i) governance is treated as a non-core feature of an operating business; (ii) that can be obtained through a third-party arrangement; and (iii) whose selection is primarily the result of price and quality attributes associated with its provision.

    Shared series trusts provide a means to study the theoretic implications of commoditized governance--both in terms of conditions and utility--generally for business entities. Quite simply, why is commoditized governance feasible in the shared series trust context? And more importantly, does commoditized governance in that context shed light on why governance of most business entities, in contrast, is a core feature of the business and not commoditized?

    As argued here, commoditized governance is viable in the investment company industry as a result of special factors peculiar to the industry. As discussed below, commoditized governance requires two conditions to be feasible, both of which apply in the fund industry: (i) there must be sufficient similarities among otherwise segregated businesses to permit realization of economies of scale in governance; and (ii) the board's decision-making responsibility must primarily concern compliance and conflict- of-interest oversight rather than review of managerial or strategic enterprise objectives. The relevance of the first condition is fairly intuitive. No business will seek a third-party to provide governance unless it is cost-effective. The most likely source of cost efficiencies are economies of scale that might be derived from governing many similar, but independent, businesses.

    The second condition, as explained below, is more complex. Specifically, governance can be thought of as involving two broad types of decisions being made by a board (which, in turn, can be divided into a host of sub-categories): (a) compliance and conflict-of-interest monitoring and (b) managerial and strategic decisions about the business. Compliance and conflict-of-interest oversight concerns the...

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