Industry hallmarks: conflicted management and redeemable securities.

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

Typically, companies are "internally managed" in that the managers are full-time employees working for the benefit of the company's owners, not independent contractors owing their primary allegiance to an outside entity. The typical American business thus has managers and boards of directors who operate with their eyes focused on doing what is best, within legal constraints, to serve the pecuniary interests of the entity and its owners. Most mutual funds are different.

Funds typically have their own boards of directors or trustees, but when it comes to the crucial tasks of investment management and marketing fund shares, the norm in the fund industry is "external management" of the enterprise. (31) A mutual fund is normally created and managed by an outside entity. It is this outside entity's control that gives rise to the fund industry's predominant external management governance structure. (32) The fund's sponsor or an affiliate functions as the fund's investment adviser, managing the fund's investment portfolio, and as the fund's principal underwriter, handling sales and marketing or "distribution" activities involving the sale of fund shares. (33)

This phenomenon means that the investment decision making for most funds is not done by fund employees operating under the oversight of the fund's board of directors or trustees. (34) Indeed, usually the mutual fund itself, as a freestanding entity, has no full-time employees on its payroll. The fund's sponsor or an affiliated entity generally contracts with the fund to supply the fund with key services, ranging from rendering investment advice, to handling fund sales ("distribution" and "underwriting") and record-keeping. Sometimes the sponsor contracts with an outside entity to provide for transfer agent or custodianship services. Workers who serve the fund customarily are supplied by and often employed by the adviser or an affiliate. (35)

In short, contrary to the Biblical aphorism, (36) the conflicted mutual fund sponsor/investment adviser is serving two masters: the shareholders of the management company and the shareholders of the mutual funds to which the adviser sells services. (37) It is the mutual fund industry's chronic conflict of interest affecting the vital governance function, and a documented record of abuses flowing therefrom, that caused Congress to single out investment companies for special regulatory treatment when it enacted the Investment Company Act of 1940. (38)

The...