I. Introduction.

• Author: Freeman, John P.
• Position: The Mutual Fund Distribution Expense Mess

Holding more than $10 trillion in assets, (1) the mutual fund industry is a powerful financial force in this country. Ninety-one million individual shareholders own mutual funds, representing about one in every two American households. (2) The vast majority of Americans who invest in the equity markets do so through stock mutual funds; fewer than half of the nation's equity investors own stock directly. (3) The mutual fund industry's stunning growth led one government official to muse: "Could mutual fund assets surpass the value of all U.S. public companies? Probably yes, and in the not so distant future." (4)

Though it was singled out by Congress for special legislation in light of serious fiduciary duty abuses uncovered in the aftermath of the 1929 stock market crash, (5) the investment company industry prospered following enactment of the Investment Company Act of 1940. (6) Captained by lavishly compensated mutual fund sponsors and their powerful trade association, the Investment Company Institute (ICI), the fund industry enjoyed six full decades of growth and scandal-free operations. Lately, however, both the fund sponsors and the ICI have experienced a fall from grace. For both leadership groups, the decline is traceable to a common failing: conflicts of interest. (7) The fund sponsorship industry revolves around accumulating assets in separate mutual funds, selling advisory, distribution, and administrative services to those funds, and thereby extracting fee income. More dollars in fee income for the sponsor translates into fewer dollars of assets for the mutual funds being served. Fund sponsors' dealings thus epitomize a classic conflict of interest. (8) We shall see that it is this nettlesome conflict of interest that explains fund managers' penchant for improperly draining assets from funds to generate greater income for the managers at fund shareholders' expense.

The sea change in how fund leaders are viewed occurred suddenly. Not too long ago, hubris was the order of the day when fund industry leaders held forth. As recently as February of 2003, the ICI's president was writing Congress extolling the industry's embrace of "transparency and accountability principles" and proclaiming that the "mutual fund industry's governance and investor protection standards "read like a blueprint for the guidelines publicly traded companies are only now being urged to follow.'" (9) Three months later, on May 22, 2003, ICI Chairman Paul Haaga...